Plosser: Raise rates to prevent wage-price spiral

The Federal Reserve should raise interest rates to prevent "the kind of wage-price spiral" that boosted prices and slowed the economy in the 1970s, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, said today in a speech burnishing his reputation as a leading Fed inflation hawk.

Plosser wants his colleagues on the Fed's Open Market Committee to boost the price of money.

From September to May, it cut the federal funds rate to 2 percent, from 5.25 percent, to ease stress on the banking system as home foreclosures soared, loan markets shriveled, and Wall Street funds that buy and sell loan-backed bonds lost big.

"Inflation is already too high and inconsistent with our goal of price stability. We will need to reverse course," Plosser said to a business audience at the Morton's steakhouse at the King of Prussia mall, in an event sponsored by the Philadelphia Business Journal.

"The reversal will need to be started sooner rather than later," he added, "and I believe it will likely need to begin before either the labor market or the financial markets have turned around."

Plosser said the Fed can afford to boost rates because the economy shows signs that it's doing better than expected.

In question-and-answer sessions after his prepared remarks, Plosser said the Philadelphia home market "is in reasonably good shape" compared with high-priced markets that have collapsed in California, Florida and Las Vegas, and recession-wracked pockets of the industrial Midwest. "I wouldn't say it's booming," but home values are stable here, "except for the Jersey Shore," where inflated prices have been falling.

What about jobs? "Unemployment is going to continue to rise between now and the end of this year," following last year's business slowdown. "We will have to raise rates before unemployment peaks."

The Fed has two missions, which sometimes conflict, Plosser said: "We have to keep the financial system functioning" by helping banks stay in business, which implies low interest rates, while also "ensuring financial stability" by fighting inflation, which means higher rates. Fed money today is so cheap that "real interest rates are negative"; cheap funds will spur inflation in the months ahead if the Fed doesn't act.

Plosser is betting that high energy prices, the weak dollar, and other volatile prices won't stay at current levels because extreme prices usually "end up reversing themselves." He's more worried that high prices, spurred by easy money, will spur 1970s-style inflation by spreading to other products and services, weakening the Fed's restraining influence as workers and suppliers start boosting prices to keep ahead of rising costs.

The proposed Fannie Mae-Freddie Mac rescue plan, Plosser said, "is the consequence of creating institutions that create moral hazard." Fannie and Freddie enjoy taxpayer guarantees, so they funded too many bad home loans.

"They took on extra risk because they had this backstop," he said. "Some would argue, we should never do that."

The Fed has crossed an invisible border by setting up a fund to help investment banks, instead of confining itself to business and consumer lenders. Plosser said the "unprecedented" expansion of the Fed's mission raises tough questions.

"At some point there will have to be a decision: Do these go away? Or will there have to be a legislative solution? The Federal Reserve is not intentionally seeking to extend its powers."

He added, "We're making many changes in the heat of battle. I hope we can be careful and analytical."

Plosser also gave his forecast for key economic indicators:

2008 gross domestic product: plus-1.7 percent, which is more than other Fed projections.

2009 economic growth: 2.75 percent.

2009 year-end unemployment: 5.25 percent.

2008 personal consumption expenditures: 4 percent.

2008 core personal consumption expenditures (not counting food or energy): 2.5 percent.

2009 personal consumption expenditures: 2 percent to 2.25 percent

2009 core personal consumption expenditures: also 2 percent to 2.25 percent, "as energy and other commodity prices level off."

Plosser said that inflation is high this year because of food, energy and other commodity costs; take that out, he said, and inflation isn't that high.

Next year, he said, both rates will be the same and they will be a little lower.