Speech

AN INSIDER'S VIEW OF INNOVATIONS AND MONETARY POLICYMAKING Address by Lawrence K. Roos President Federal Reserve Bank of St. Louis Seventh Annual Economic Policy Conference Federal Reserve Bank of St. Louis St. Louis, Missouri October 1, 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis It is a pleasure to welcome all of you to the Federal Reserve Bank of St. Louis. It is a privilege, as well, to have the opportunity of joining you in considering what I believe to be one of the most important, as well as most controversial, issues currently facing monetary policymakers, namely the impact financial innovations have on financial markets and on the relationship between monetary aggregates and the economy. Assertions by some that financial innovations have made monetary targeting obsolete have set off a frenzied search for alternative policy targets and approaches. Legislation has been introduced in Congress that would require the Federal Reserve to target on some measure of interest rates; academicians have offered a variety of other possibilities, ranging from the monetary base to the broadest of credit aggregates. Even Federal Reserve officials themselves have entered the fray, openly airing their differences of opinion in the pages of the Wall Street Journal, their respective Reviews, and a variety of other publications. Conferences such as this that provide an opportunity for sober (I trust) discussion of fundamental issues can be extremely helpful to policymakers. First, they serve as a means for clearing away the more irrelevant aspects of the subject matter and for bringing to the foreground the key issues involved. By sweeping away the "clutter", they often separate real issues from pseudo ones. Second, they usually generate the latest empirical evidence relating both to problems and to suggested solutions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 2 - By so doing, they provide policymakers with information that, given the usual publishing lags, might otherwise not be available for several months or years. Then, too, in attending conferences such as this, it is possible to judge, by observing the extent of the disagreements, disputes, and debates among participants, whether there really are substantive differences of opinion and analysis among the "experts." When ancient mapmakers disagreed about what dangers lay in unexplored territory, they labeled those parts of their maps with the warning "Dragons live here." Policymakers too need to know where dragons are lurking. Finally, on rare occasions, answers to specific issues or problems actually emerge at conferences. When this occurs, it can be counted upon to produce a state of "nirvana" in policymakers. At least that's what I've been told; it has never actually happened at one that I've attended—at least, up to now. While I really don't expect to achieve nirvana at this conference, I am here to observe and to learn, from the papers and discussions, how much you believe that financial innovations have affected monetary policy and financial markets. Your conclusions will be of value even if you haven't been able to uncover all the answers by noon tomorrow. Given the policymaking process, every bit of available information helps. With the time constraints policymakers face, we cannot always wait until the definitive study has been completed, the final regression has been run and the ultimate Nobel Prize for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 3 - Economics has been awarded. We must make decisions now, using our best judgement about the relationships between instruments, targets, and goals, realizing, at the same time, that the world is an uncertain place and that "truth" is a highly elusive commodity. Now, you are probably wondering why I am up here giving this luncheon talk. I assure you that it is not because Ted Balbach knows, from long experience, that when three or more people are gathered together to give speeches at the St. Louis Fed, all hell breaks loose if Roos isn't on the program. That's not so. It's rather that I believe it might put the policy aspects of the problem in perspective if you know how at least one policymaker views the issue. In approaching policy decisions, I have always felt that policymakers should have some consistent framework of analysis to guide their decisions. Otherwise they are likely to suffer the same fate as a captain whose ship is adrift in a fog- shrouded ocean without compass or other navigational aid. Three years ago, at a conference similar to this one at this bank, I described several concepts or navigational aids that I find useful in assessing the consequences of monetary policy actions on the economy. Briefly stated, they are: 1. that inflation is fundamentally a monetary phenomenon; 2. that abrupt and substantial changes in the growth of money, if sufficiently prolonged, have dramatic and usually unfortunate consequences for the economy, and; 3. that the growth of money can best be controlled by controlling the growth of the monetary base. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 4 - Now, despite what you may have heard to the contrary, these are not necessarily viewed by the St. Louis Fed as the "Three Commandments of Monetary Policy." Nor do we think of them as "The Gospel according to St. Louis," even though a fair amount of the research done over the years supporting their validity has been done at this Bank. I view these concepts only as a frame of reference in arriving at decisions. It is this framework that has influenced my initial point of view concerning the impacts of innovation on monetary policy, and I would like to offer a few tentative "speculations" on the impact of innovations in light of these concepts. First, I have not found that recent innovations have had a noticeable impact on relationship of trend money growth to inflation. Prior to the end of 1979, both trend money growth and inflation were clearly accelerating. In part, this pattern was responsible for the Fed's October 6, 1979 policy change. Since October 1979, there has been a marked decline in the trend rate of growth in Ml, and rates of inflation have slowed considerably as well. It even appears that the relationship between the measured rate of inflation and trend Ml growth has narrowed. I will certainly admit that this observation is based on a very simple comparison and that full investigation requires extensive statistical and econometric analysis. Still, the simple comparison does not suggest that there is a problem in continued use of the trend money growth-inflation relationship for policy purposes. Now, what about the second concept—-that excessively Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 5 - erratic short-run money growth can produce short-run swings in real economic activity? At least at first glance, short-run monetary impulses seem to have had essentially the same impacts on the.economy in recent years as they did previously. For example, as many of you know, we have had several short-run periods of widely diverse money growth. In particular, from November 1979 to May 1980 and from April 1981 to October 1981, we had two extended periods when Ml growth was essentially zero. In both cases, these protracted slowdowns in Ml growth were associated with sharp reductions in nominal GNP growth and declines in real GNP. Again, this comparison is just a simple juxtaposition of short-run money growth and movements in real economic activity—not a sophisticated and detailed analysis. But, once again, the comparison points out something that I find interesting—namely that the expected happened] Real output growth declined significantly when there were sizable reductions in money growth that persisted for more than six months. Strangely enough for those who argue that the world has changed, the second concept still seems to possess some validity. Also, the third concept—that the growth of money is closely related to the growth of the monetary base—seems to be surviving as well. Since the fourth quarter of 1979, the monetary base and Ml have grown at average annual rates of 7 percent and 6.3 percent respectively. Not only are both rates of growth down sharply from what they were over the prior four Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 6 - years, it turns out that the reduction in money growth is virtually identical to the drop in the growth of the adjusted monetary base. As far as I can tell, a similar, though somewhat noisier relationship still continues to exist, as well, between short-run base growth and short-run money growth. Thus, after viewing what has occurred since 1979, albeit in a simple fashion, I am hard-pressed to find any convincing evidence that financial innovations have had significant impacts either on the monetary base—money growth relationship or on the relationship between measures of monetary impulses and the economy. Since this impression conflicts directly with those of others, I must conclude either that I have somehow overlooked some important evidence or that, at least for the present, the impressions of others who feel differently about the effect of innovations are in error. This puzzle is one that I hope will be resolved by the papers and discussion to follow. As I see it, if financial innovations have significantly distorted the relationships between monetary base growth, money growth and the economy, then some of the concepts that have helped me to make policy decisions in the past are no longer valid. If, on the other hand, these relationships have been essentially unaffected by innovations that have occurred over the past several years, then they still provide useful information to guide policy actions. If this is indeed the case, then the recent financial innovations can be ignored by policymakers until such time as they do, in fact, affect policy outcomes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Lawrence K. Roos (1982, September 30). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19821001_roos

@misc{wtfs_speech_19821001_roos,
  author = {Lawrence K. Roos},
  title = {Speech},
  year = {1982},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19821001_roos},
  note = {Retrieved via When the Fed Speaks corpus}
}