Philadelphia Fed president Charles Plosser on the risks from Europe:
Q&A: Philadelphia Fed President Charles Plosser, by Brian Blackstone, WSJ: On whether Europe could have a significant effect on the U.S. economy:
Plosser: Europe is clearly near recession. That impacts the U.S. in part through trade … but Europe is not our largest trading partner at the end of the day. The thing that people really worry about is you have some financial implosion in Europe and markets freeze up and you have some serious financial disruptions.
There are several ways this could go. At one level the U.S. has been trying to insulate itself from that risk. The Fed and regulators have tried to stress to money market funds, for example, to reduce their exposure to European financial institutions. So on a pure exposure basis I would say U.S. financial institutions are taking the steps they need to ensure that … financial distress in Europe it doesn’t necessarily lead to distress for them…
People have made the analogy that an implosion in Europe would be a Lehman Brothers-type event. It might be a Lehman Brothers-kind of event for Europe. And if the market is sort of indiscriminate in whom they withdraw funding to, you could have indiscriminate funding restrictions on U.S. institutions just because everybody’s scared.
There’s another scenario that is exactly the opposite. There might be–and you already see some of this–a flight to safety. So rather than the markets freezing access to short-term funding for U.S. institutions, you could have a flood of liquidity that gets withdrawn from European institutions … and floods into the United States. That’s exactly the opposite problem.
On which scenario is more likely:
Plosser: I don’t have the answer to that. … I don’t think a flood of liquidity is a huge problem. That would be manageable. The bigger problem is if it dries up for everybody. The Fed still has the tools it used during the crisis. … So I think we have the tools at our disposal if they become necessary. …
Thus, he thinks the Fed can handle whatever comes its way, and hence sees no need to alter his forecast:
On his economic forecasts:
Plosser: I’m still looking for 2.5% to 3% growth over the course of this year. I think the unemployment rate is going to continue to drift downward to 7.8% by the end of this year. I would think for 2013 we’ll see similar developments. As long as that’s continuing then I don’t see the case for ever increasing degree of accommodation.
Since he believes output will grow no matter what happens in Europe, inflation is the biggest risk:
Plosser: I think headline will drift down just because of oil and gasoline. It will be interesting to see what happens with the core. The inflation risk we have is longer term. The problem is that as the U.S. economy grows we have provided substantial amounts of accommodation. We have $1.5 trillion in excess reserves. Inflation is going to occur when those excess reserves start flowing into the economy. When that begins to happen we’ll have to restrain it somehow. The challenge for the Fed is will we act quickly enough or aggressively enough to prevent that from happening.
It may be a challenge politically when we have to start selling assets, particularly if we have to start selling (mortgage backed securities) to shrink the balance sheet and to prevent those reserves from becoming money.
My view is different. I’m more worried about output and employment being affected by events in Europe than he is, and less worried about long-run risks from inflation (both the chance that it will happen and the consequences if it does). So I see a far greater need for policymakers — monetary and fiscal — to take action now as insurance against potential problems down the road.
It is interesting, however, that he sees the political risk as the primary challenge for controlling inflation for a supposedly independent Fed, especially since several Fed presidents recently assured us that politics plays no role whatsoever in the Fed’s decision making process (I also wonder why he didn’t mention raising the amount paid on reserves as a way of keeping reserves in the banks).
Finally, I’m glad he said “I don’t see the case for ever increasing degree of accommodation,” rather than saying he thought we needed to begin reducing accommodation. We may not get any further easing, but perhaps there’s a chance we can keep what we have, at least for now.
This post originally appeared at Economist’s View and is posted with permission.