By Steven L. Lubetkin
You did your graduate work and your doctoral work at the University of Chicago. Do you consider yourself a member of the Chicago school in terms of your academic philosophy?
Plosser: I’m not sure I know what that is, but certainly my training is there and I have always been a firm believer in markets. If that’s what you characterize as being the Chicago school, I certainly fall into that category.
How do you find the transition from academia? Tell me a little about your academic career and what led you into the study of economics and then we can move into how you arrived at the Fed.
Plosser: As an undergraduate, I was trained as an engineer actually. I got my MBA at the University of Chicago in 1972 and then I worked at Citicorp for a little while before going back to Chicago to complete my Ph.D. It really wasn’t until I got to Chicago as an MBA student that I became interested in or very knowledgeable about economics. So it really grabbed my interest at that time. But since then, I’ve been an academic. I spent some time at Stanford business school and, of course, the University of Rochester, where I taught for the last 28 years. For 12 of those, I was dean of the business school, so I was running an organization as well as being an academic. But I’ve always had an interest in economics. I’ve done research in monetary policy and macroeconomics most of my career and I just find it fun.
You were a co-chair of the Shadow Open Market Committee, which comments on what the actual Open Market Committee does and on other issues. Now you’re on the other side of that fence, you’re a member of the Federal Open Market Committee. What are the differences? Is there anything that surprised you when you came over to the other side?
Plosser: Well, first, I’d say that it’s great fun to switch chairs. I guess the other thing I would say is that good economic analysis doesn’t change. Economics is the same as it was, whether I was sitting on the outside looking in or sitting on the inside looking out. So, not a whole lot surprises me. Obviously, in terms of the dynamics and learning who the people are, how they react to various things and how the meetings are run inside the big room, it’s a little different. But there haven’t been many surprises on that side. It’s been a very interesting time for monetary policy in the last six months, so it’s been a lot of fun.
People locally are very interested in the regional economy, so in terms of your outlook for the economy over the next eight to 12 months, can you talk about the national level and then maybe focus a little bit on the regional economy?
Plosser: I think the national economy actually is looking pretty good. The Federal Open Market Committee stopped raising the funds rate in August after 17 increases and has since held interest rates steady. And while housing has been the biggest concern for people, the outlook seems to be that housing looks like it’s beginning to stabilize. And I’m anticipating that economic growth, after a relatively slow third quarter in ’06, will pick up in the fourth quarter. Then the outlook for ’07 is really pretty good. Long-term growth, or trend growth, if you want to think of it that way, is probably close to 3 percent. I would think that during the course of 2007 we’d see GDP [the gross domestic product] real growth approaching 3 percent for the year, maybe a little less, but very close to what we would consider long-term trends. The labor market ended on a strong note and continues to be very healthy.
So, in general, I think the outlook for the economy is pretty good, broadly speaking. There are still some sectors that people are concerned about and housing is one of them. Hopefully that’s beginning to stabilize. And over the course of the coming year, housing investment activity will gradually begin to pick up, which will lend further strength to the economy over the year.
Just focusing on housing for a minute, you triggered a thought – that in particular in New Jersey, there’ve been a couple of very high profile residential developers who’ve gotten themselves into financial trouble recently, and it’s raised questions about the banking system for some of the people watching the banks that are particularly heavily concentrated in that sector. Do you have any thoughts on whether the fears are well-founded or do you think there’s going to be a rebound there?
Plosser: Let me make two observations there. First of all, the housing business is incredibly geographically localized. If you look across the country, even across our region here in the Third [Federal Reserve] District, what you think the housing market looks like depends on where you’re standing at that moment in time. A lot of the big declines in housing have been concentrated in a few areas. I moved here from Rochester, NY, a little less than six months ago, and I assure you that there was no housing bubble in Rochester, and so there was no housing crash in Rochester. So, markets are very localized in housing, and some of the largest declines have been in the markets that had the biggest run-ups in 2005 and 2006. I think it’s also true that in those localized markets where things have been tough, they have been very tough. The Jersey shore, I’m sure, has been a very difficult place for housing. Lancaster County in south central Pennsylvania has been more stable. So it depends on where you are. I also think that it’s true that banks are a lot more sophisticated than they used to be. In the ’70s and ’80s, banks were very susceptible to mortgage markets in their local areas. I think that’s less true today. Banks have been smarter about diversifying; they don’t always hold the loans they’ve issued – they sell them off. That’s been a great boon to the stability of the banking system. So, while it’s tough on the banks in those geographic areas in terms of originations because the markets are bad, in terms of the health of the bank itself, I’m less concerned.
On the regional economy, you’ve had a few months to take a look at things. Are there any particular sectors of the regional economy that stand out in your mind as being maybe more pivotal locally than others? Or having more of an impact?
Plosser: Well, I’m still learning a lot about the region. I’m new to the area and learning about the different sectors. My impression so far is that this region, the Third District, which is eastern Pennsylvania, Delaware, and southern New Jersey, in many ways mimics the national economy in a lot of respects. It really looks a lot like the national economy in terms of the mix of services and manufacturing. Parts of the district have lots of manufacturing and parts of it are heavily service and financially oriented. So it’s an interesting mix and I think it’s quite representative of the nation as a whole. I don’t really view the district – at least what I’ve seen so far – as unusual relative to what we would look at in the national economy. There are quite broad differences, though, in how different regions perform at different times of the year or different times of the business cycle. There’s obviously the Jersey shore, which has a lot of vacation homes and resort areas. There’s also Delaware, which has its own distinct sectors, such as biotechnology, chemistry, and financial and insurance services. So there are microcosms around the district, but the district as a whole really looks like the national economy.
In terms of the banking industry in this region, what are some of the challenges you think they ought to be thinking about – the things that you consider most important for them to keep an eye on?
Plosser: I would start off by saying that from what I’ve learned and what I’ve seen, the banking industry in the Third District is remarkably healthy. Banks’ balance sheets look strong, loan quality looks good, return on equity looks good, return on assets looks good, loan loss provisions are healthy and loan losses are not very high. Banks typically are doing remarkably well.
That makes the Fed’s job considerably easier.
Plosser: It makes the supervisory job easier. Going forward, there are always concerns. I think there are a couple of things that are very important. One is that financial markets in general over the last decade or two are getting increasingly sophisticated. The technology and the skills necessary to run a financial institution are getting increasingly complex. The financial instruments we have available to us to minimize risk, to move money around and to manage money, are increasingly sophisticated. So I think that banks, in general, face a growing challenge – as do many businesses – in training and retaining employees with the skills necessary to operate efficiently in this increasingly competitive and technologically sophisticated market.
Are there any particular areas you think they should concentrate on in training people?
Plosser: Technology is clearly one of them. Whether we are talking about security issues that banks are facing in their online business or managing flows of information, technology has become more sophisticated and bankers need to understand how markets work, what instruments are available and how to use them effectively – not only for the bank itself, but for its customers. If a bank is out selling services and making loans to its business customers or individuals, understanding what instruments are available for managing money and managing risks and structuring balance sheets is critical. Having those skill sets is very, very challenging. So I think banks in general are going to continue to grapple with questions such as “Where do I find these people?” and “How do I keep them from leaving?” It’s a very tight labor market and I think that’s going to be a challenge for banks, and is going to be a challenge in other industries as well – but banking in particular.
One of the things we’ve continued to see over the past five years – and I’ve experienced this firsthand while working for three different banks in five years at the same location – is that as banks merge and acquire other banks, there is a continued trend of consolidation and then revival, because we also see de novo banks popping up as the larger banks consolidate.
Plosser: I certainly think one of the signs of a healthy banking system is lots of de novo banks. That suggests that some people out there think there’s money to be made by starting a new bank. I also think it’s a sign that community banks, in particular small banks, are alive and well and can thrive in this marketplace. That doesn’t mean there’s not going to be some consolidation, but the industry seems generally healthy.
It doesn’t seem to stop people from starting new banks.
Plosser: Exactly. So I think that’s my sense, the industry itself is pretty healthy. Some banks are going to do well and some banks are not going to do as well. That’s just the nature of competition and thriving and striving to succeed in a competitive marketplace. But I think that smaller banks are not going to go away. They can continue to thrive. They’ll have challenges, as we just talked about, in terms of holding onto the right people who will allow them to be competitive in this marketplace. But I think there is ample opportunity for them to do well. And, as you said, the fact that people are entering this market all the time suggests that there are opportunities there and that’s healthy.
You talked earlier about the Fed’s supervisory role and I don’t know if you had a chance to look at Chairman Ben Bernanke’s speech, “Central Banking and Bank Supervision in the United States.” He talked about the question that’s sometimes raised about separating the supervisory responsibilities from the Fed’s other monetary policy responsibilities, but he made a very strong case for keeping the two together because the knowledge gained from both sides of those two pieces of the pie, its value, if you will, enables the Fed to make more appropriate, smarter decisions. Do you have any thoughts on the supervisory role versus the monetary policy role?
Plosser: Clearly, monetary policy and the supervisory responsibility are very different responsibilities, in many respects. I think the chairman was trying to make the point that the Fed’s supervisory role has benefits or spillover effects for monetary policy. More important, the benefits arise in our efforts and provide a secure and stable payment system. The Fed has a critical role in maintaining financial stability and the viability of the payment system. When crises occur, the knowledge the Fed has gained through its supervisory role is very valuable – not because the Fed supervises banks per se, but because the information it gathers in the process allows the Fed to respond, perhaps more effectively, efficiently and quickly, in crises. Therefore, its crisis management becomes very important. However, there’s always this tension in any regulatory environment between the supervisory role, which is trying to ensure stability in the financial system, versus stepping back and allowing the marketplace and banks to be competitive and innovative in what they do. That tension between supervising versus allowing markets and innovation to occur is a tough balance. In our efforts to be protective of the payment system and ensure its stability – whether it be crises like 9/11, the demise of Long-Term Capital [Management] in 1998 or the stock market decline in 1987 – we want to make sure that we don’t become so overbearing in our supervisory function that we stifle innovation, stifle creativity and stifle the natural market processes that are trying to innovate in the industry. And that’s a tough balance. I think the Fed struggles with that but is very conscious of that trade-off.
It seems like what you’re saying, what he was saying, is that there is some value in the sort of central collection of information and the knowledge base.
Plosser: Right. I think Bernanke’s view is that it’s very useful, particularly in managing in these crises environments.
Let’s talk a little bit about the yield curve. Right now, people are struggling with the inversion of the yield curve and I think a Wall Street Journal article the other day compared it to a basketball player whose shooting percentage at the free-throw line is worse than his percentage from the field, which is exactly the opposite of what you would expect, but that sends information to people.
Plosser: That’s typically true for the seven-foot centers!
I’m not a big sports fan, but according to this article, Shaquille O’Neal was really lousy from the free-throw line, so the strategy was to foul him a lot and get him to the foul line, so he won’t make points from the field – who knew?
Plosser: Because he is always shooting baskets from one foot away …
So not being a sports fan, that didn’t resonate too well, but the question that comes up whenever the yield curve goes this way is, is it an indication of bad times to come – is it a recession indicator? Some people think it is, some people don’t.
Plosser: Certainly, the yield curve has some inversion to it right now and it has for a while, and there’s been a lot of discussion about the implications. The recent article in The Wall Street Journal is not saying anything new. I mean, the discussion has been around for many, many months now. I think the general view of many economists, and I share this view, is that just because the yield curve is inverted does not mean that it is forecasting or foreshadowing a recession, even though in the past that has sometimes certainly been the case. Typically in the past, when the yield curve has been inverted what has been true is that inflation-adjusted yields – that is real interest rates – have been very high. Today, that’s not really the case. Therefore, the circumstances are a little bit different than in some past episodes. I do not believe that the current inversion of the yield curve is foretelling bad times to come, so I’m more sanguine about that than many people are. And of course, no one knows what’s going to happen in the future, but that certainly is my take on it right now. The other thing about the yield curve – and I hear this a lot in my conversations with bankers and community people who have visited me over the last few months – is how hard it is to make money when the yield curve is inverted, how tough life is out there, and I certainly appreciate that. But one of the things I tell them is that I feel like the industry, bankers in particular, probably ought to anticipate not that the yield curve is going to be inverted all the time, but that the yield curve is likely to be flatter on average than perhaps they have been used to seeing it. Certainly, the last few years, when the Fed was keeping the federal funds rate at 1 percent for a long time, are likely to be the exception rather than the rule. Thus, while the yield curve may have appeared steep during that time, I wouldn’t anticipate that it would be that steep any time in the near future. There are a couple of reasons why I say that. One reason why the yield curve rises in general is because people expect short-term interest rates to rise in the future and that means long-term interest rates, on average, will be higher than short-term rates. So that’s one reason the yield curve might be upward sloping. But the other reason why the yield curve is upward sloping is something we call a term premium. That is, there is a compensation for holding long-term securities that’s associated with uncertainty – that is, the risk that interest rates might be different from what people expect. In particular, risks about inflation are important. For example, one reason long-term rates might be higher is that people might expect inflation to rise.
So, if you look over the last 10 or 20 years and look at the average slope of the yield curve, a couple of things have been going on. One is that people were uncertain about whether the Fed was going to be successful in keeping inflation low and stable. However, over the last several years, confidence in the fact that inflation in the United States is going to stay low and stay more stable means that there is less of a premium built into long-term rates for rising expectations of inflation or rising inflation. That’s going to keep longer rates lower. There is also the belief that inflation will be less volatile in the future than it has sometimes been in the past. So that also reduces the risk premium. As a consequence, the expectation that inflation will remain low and stable contributes to a flatter yield curve. So I would submit that, going forward, as bankers think about what kind of environment they’re going to be in, they may want to anticipate a world where, on average the spread between short-term rates and long-term rates is likely to be smaller than it has been in some recent periods. Now that’s on average. It doesn’t mean that in some periods it is not going to be bigger than others, but I suspect that it’s going to be a smaller spread than they are used to. So the financial industry – and banks in particular – which is used to living off that spread, needs to anticipate that the spread is not going to be as big as perhaps it’s been in the past.
In some respects, the yield curve is a vote of confidence in the Fed’s ability to manage inflation in the future?
Plosser: Exactly. And that’s a good thing.
What should banks be thinking about as they reposition themselves to perform better in that kind of interest rate environment?
Plosser: That’s a tougher question. For each bank it may be different, depending on what market they’re in. They may have to be more sophisticated about how they manage their cost structures; they may have to find new market niches, where they supply priced services. They’ve just got to be a little more attuned to the fact that it’s going to be tougher to be profitable by just borrowing short and lending long than perhaps they have been used to in the past. So that means providing different types of services to their customers, whether they be business customers or individuals.
And they will have to have more sophisticated interest-rate risk managers able to deal with a flat curve?
Plosser: Well, that ties back into our earlier discussion about talent, about hiring good people and the skills necessary to be competitive in a more sophisticated world where these margins may be getting smaller.
You touched on the cost side of the income statement as an area that banks have to handle better. And the Fed has been at the center of one of the big trends in cost reduction, Check 21, and the move away from paper checks. You do a lot of check clearing right here in Philadelphia – in fact, you are one of the largest check processors in the Federal Reserve System. In terms of the volume that you are seeing, and even though you continue to be one of the largest, has the volume been changing here? Have you seen any impact from Check 21?
Plosser: Check 21 volumes are growing dramatically and they are growing at a pace that is far outstripping what the Fed thought would happen. So there are huge volume increases in Check 21. We’ve seen an increase in paper checks here in Philadelphia, in part because of consolidation from other check clearing operations around the country. In general, the Fed is anticipating that standard paper checks will continue to decline. We are both encouraging and anticipating further substitution toward Check 21, and we are structuring our business plans and technology accordingly. In 2006, the Philadelphia Fed began processing the volume of checks previously handled by the Federal Reserve Bank of New York’s East Rutherford Operations Center as part of the Federal Reserve’s consolidation initiative.
Is it more image transfer and debit card or can you not tell?
Plosser: I’m not sure I know the answer to that. When I’m talking about Check 21, I’m primarily talking about image transfers, but I’m not sure what the mix is. One of the issues here is banks’ ability to receive the images, so one of the things that the Fed is trying to do is encourage bankers to invest in the technology necessary to receive digital images. Some of them are willing to send it, but they’re not in a position to receive it.
The other thing I’m seeing a lot of, at least at the local bank level, is a big push to get business customers to put in the truncation machines to scan a check and hand it right back to the customer. I know you don’t want to be proscriptive or prescriptive, but are there any other technologies you’re looking at or you’ve seen that intrigue you or that you think could be really useful to banks in the next three to five years?
Plosser: Nothing comes to mind immediately. There’s a word that somebody used the other day – “electronification” – which I’m not even sure is a word. But there’s just a huge shift toward more sophisticated technologies and I think that banks are well advised to do their best to keep up. And here, again, the skills, the technology, the ability to manage their way in that world are going to be put increasing demands on banks and the people that work for them.
And at the same time that they need to increase their use of technology, we’re still seeing a trend back to the basics of brick and mortar branches and changing the way those branches look. There was an announcement that recently came out stating that one of the banks in Wilmington, Del. is putting in a fancy new branch with a Starbucks café, wireless Internet access and couches for people. It’s a different kind of bank.
Plosser: And if you think about how the next generation, not our generation, but the next generation, interacts with the world, I mean, someday they’re going to be doing online banking from their iPod. I think that yes, branches are coming back, but as you said, the nature of what they do there is going to change. And it’s going to be a very interesting world. The next generation may not want the same sort of hand-holding that our generation did when we wanted to go in and talk to a banker face-to-face. They may not care as much.
I remember a few years ago when Fleet Bank came into the territory and Terry Murray was the chairman, he talked about the difference between his 85-year-old mother, himself and his kids, and the way they deal with banking. His mother would to go to the bank every week, like a hairdresser appointment, and see her favorite teller. He would sometimes go to the branch, but sometimes use an ATM machine; his kids never went near a bank branch and that’s what I see a lot. My mother likes to have a small account at several different banks in the area so that she can go into any one of them and cash a check. And I say to her all the time, why don’t I just get you a debit card? She doesn’t want any part of a debit card, she does want to go near an ATM machine.
Plosser: It took me a long time to start using ATM machines. It’s going to be very different. I think trying to figure out how banks are going to evolve, and how our institutions are going to evolve to adapt to that is going to be very interesting and challenging.
As the president of one of the most influential Federal Reserve Banks in the country, what are some of the issues you lie awake at night thinking about? Although, since it’s such a well-run Fed, you probably don’t have to worry about too much.
Plosser: The Philadelphia Fed is actually a very well-run organization. I think the things that I worry about are big picture issues: where the financial industry’s going, what role the Fed is going to play in that as checks decline, what that is going to do to the financial industry and what’s going to happen to the role of the Fed. There’s also the whole arena of monetary policy. I sit on the Federal Open Market Committee and have to think about what’s going on in the economy as a whole and where monetary policy is heading. That’s a very important part of my responsibilities and in some ways, it’s one of the most important contributions I can make.
Have you had an opportunity to interact with your former colleagues on the Shadow Open Market Committee?
Plosser: Yes, we talk periodically. Some of them are former bank presidents, many of them are economists, academic economists and some of them are bank economists. I get to chat with them periodically and I also get to chat, obviously, with other Fed bank presidents. I’m also enjoying meeting with bankers in the district, listening to what they have to say, talking to them and learning my way around the district. I’m looking forward to going out in the spring, visiting various areas and meeting with bankers and getting to know more and more of them.
Putting a human face on what you do, not that you don’t already have one, do you have time for any hobbies or personal interests or pleasure reading? What book is on the nightstand these days?
Plosser: Frankly, between the new job and moving from Rochester to Philadelphia, including buying and selling a home, I haven’t had a whole lot of time for leisure activities. I do like to play golf, but I haven’t played much since June because of the transition. We are beginning to get settled in our new house and enjoying the city. This is a great adventure for us, moving from a big house in the suburbs to a smaller house in the city and we’re enjoying it very much. What am I reading? I actually have three books; I like to read all sorts of different things. Recently, though, I’ve just completed reading “The Americanization of Benjamin Franklin” by Gordon S. Wood, which actually is quite good. Another fascinating book I’m in the process of reading is “The First Wall Street: Chestnut Street, Philadelphia, and the Birth of American Finance” by Robert E. Wright. It’s all about America during the 18th and 19th centuries, and how financial markets and our banking institutions evolved. Philadelphia and Chestnut Street played a key role, but ultimately lost out to Wall Street. It’s a fascinating history of financial innovation. So I like to read history. The other book I’ve been reading is completely different, “A House for Mr. Biswas” by V.S. Naipaul, the British author. In fact, this book won the Booker Award. It is very intriguing. Then occasionally, I’ll read mysteries, just for something completely light.
What kind of music do you like?
Plosser: I like it all. I love music. I grew up in the ’60s so there’s a lot of ’60s music that I like and I love classical music and jazz. I like choral and church music. I’m not really into rap or hip-hop. I really do like music in general and I can listen to almost anything. I turn the radio on in the car; it can be anything from classical music to jazz to rock and roll or folk music. It could even be country music.
Is there anything else we haven’t talked about that you think the bankers would be interested in reading?
Plosser: I’m delighted to be in the region and in Philadelphia. It’s obviously new to me, but I’m learning about the area and it’s exciting. I am looking forward to meeting many more of the bankers in the district in the months to come.