Speech

WHAT WE CAN LEARN FROM THE PAST Address by Lawrence K. Roos President Federal Reserve Bank of St. Louis Before The Economic Club of Pittsburgh Pittsburgh Hilton Hotel Pittsburgh, Pennsylvania November 9, 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis When I listen to discussions about the current state of the economy, I am reminded of A Tale of.Two Cities which begins "It was the best of times, it was the worst of times." Those who fear the worst point to high unemployment, a stagnant economy, and few signs of real recovery. On the other hand, the optimists concentrate on the continuing decline in inflation, recent reductions in interest rates, and the sharp upswing in financial markets. Now, obviously, it is an exaggeration to call present circumstances either the worst or the best; we have faced worse times and we will certainly achieve better ones. But it is no exaggeration to view monetary policy decisions now being made as having the potential for profoundly influencing the economy for some time to come. To paraphrase Dickens, now is the most critical of times for monetary policy. Unfortunately, it is also the most puzzling of times for those who are trying to decipher what is happening. For in spite of the fact that perceptions of policy actions are crucial in determining the actual future course of economic events, there seems to be serious confusion in the public mind as to the current thrust and direction of monetary policy. Much of that confusion arises from a misinterpretation in some quarters of the meaning of the Federal Reserve's recent announcement that it is temporarily reducing the emphasis it places on its narrow monetary aggregate (Ml) target, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 2 - instead, for a time, will be focusing increased attention on movements in the broader aggregates (M2 and M3) and the federal funds rate. Actually what is being done is perfectly understandable. It was induced by possible temporary distortions in the measurement of Ml and by possible temporary shifts in the relationship of Ml to economic activity. There is concern that funds moving out of maturing all-saver certificates may be temporarily "parked1' in checkable accounts, thereby distorting the Ml measure. Moreover, it is felt that the passage of the Garn-St. Germain Depository Institutions Act of 1982, authorizing financial institutions to create deposits that will directly compete with money market mutual funds, might also V temporarily distort Ml growth. Thus, it is reasonable to expect that targeting on Ml might be subject to unusual uncertainty during a short period of adjustment to these events. Although the Fed's announcement carefully stated that this temporary change in policy emphasis does not constitute, in any way, an underlying change in policy, the announcement has been interpreted by some as being, in fact, a major departure from the Fed's post-1979 policy of targeting primarily on monetary aggregates. Typical of such misinterpretation is a recent column in the Wall Street Journal which read: "It is a great relief that Mr. Volcker has ditched the monetarists and has opted for a new, less restrictive monetary policy. . . The Fed will [now] be looking at real interest rates, at relative strength or weakness of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 3 - dollar in international currency markets, at the price of commodities (including gold) and at nominal GNP." In a similar vein, the New York Times proclaimed that the "United States appears to be at the end of a three-year experiment" with monetary aggregate targeting and that policy is giving way "to a more pragmatic approach." Forbes Magazine goes even farther in saying "The deterioration of the economy has given the Federal Reserve the courage to do what it should have done months ago: abandon its disastrous experiment with monetarism." Now, comments such as these would not be disturbing were it not for the fact that such statements by respected financial journals tend to confuse the public in general and financial markets in particular. There is a world of difference between temporarily abandoning Ml as a target and permanently replacing it with something else. This distinction is fundamental to an understanding of what is really happening, and I would like to spend the next few minutes discussing why it is so important that we interpret the recent change by the Fed in its true context and not as a permanent departure from monetary aggregate targeting. It is important to keep in mind that monetary policy targets, whether they are interest rates, monetary aggregates or credit aggregates, are not the ultimate goals of policy and should never be confused with them. The ultimate goal of policy is the attainment of optimal economic growth under conditions of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 4 - price stability. Targets are merely short-run indicators of what is happening to current spending in the economy; they represent only one aspect of the "link" between policy actions and our economic goals. As such, it is essential that they be predictably related both to the growth of GNP and to our monetary policy actions—which consist primarily of changes in reserves or changes in the monetary base. If a target does not satisfy these two requirements, it should be replaced with one that does. Worse, if a target becomes, for some reason, a goal in itself, as interest rates frequently did in the past, monetary policy becomes a destabilizing, rather than a stabilizing force in the economy. This can be seen by comparing three periods of post-World War II history when policy was conducted in markedly different ways. The first period, from 1951 to 1965, was one in which interest rates were the most frequently used monetary target, with several other variables being used as well. Normally, this could have been expected to produce considerable economic instability. However, in spite of interest rate targeting, this period was actually one of relatively slow money growth, low inflation and low interest rates. What prevented interest rate stabilization from producing undesired results? Throughout this period, the U.S. monetary system was still connected, albeit loosely, to an international gold exchange standard. Attempts to manipulate interest rates were constrained by the possibility of gold flows. The international gold exchange standard served to confine U.S. policy actions and, in essence, produced the same Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 5 - noninflationary impact that direct targeting on Ml could have achieved. Thus, despite the potential for less desirable results normally associated with interest rate targeting, slow monetary growth prevailed during this period and the U.S. experienced substantial increases in output and real per capita income with remarkable price level stability. In the early 1960s, however, the influence of the gold standard on policy actions began to wane. Economic priorities both in the United States and elsewhere shifted from the objective of maintaining price level stability to attempts to protect individual sectors and groups in the society from the vagaries of economic change. The linkage to gold eroded as a constraint on monetary policy. The period from 1965-1979, the second period I shall describe, was one in which U.S. monetary policy continued to be dominated by the use of interest rates as targets, but the constraining influence of Bretton Woods was gone. As the years passed, two major problems associated with interest rate targeting became apparent. First, manipulation of interest rates proved to be poorly related to changes in the price level and changes in economic activity. In other words, it became increasingly evident that interest rates were poor targets for monetary policy. What was worse, however, was that, for a variety of reasons, policymakers made a significant error in their policy calculations; they confused the target of policy with the goals of policy. Policy actions frequently degenerated into attempts Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 6 - to stabilize interest rates with associated undesired economic results. During economic expansions when rising credit demands put upward pressure on interest rates, attempts to resist such upward pressure resulted in accelerated monetary growth. The immediate result was an overheated economy; the ultimate result was increased inflation. Similarly, in periods of economic weakness, attempts to prevent interest rates from falling "too quickly" led to accentuated monetary restraint and a much weaker economy than would otherwise have occurred. As a consequence, the 1965-1979 period was characterized by accelerating money growth, rising inflation, rising interest rates, declining capital formation, declining productivity and a reduced international value of the dollar. That record provides clear evidence that unconstrained interest rate targeting, the kind that many today seem once again to be advocating, is counterproductive and extremely destabilizing to the economy. A return to interest rate targeting now would simply produce a "rerun" of the inflationary problems which resulted from interest rate targeting during the 1965-1979 period. The failure of policy to constrain inflation during the 1970s undoubtedly contributed to the Federal Reserve's decision on October 6, 1979 to place more emphasis on monetary aggregate targets, particularly Ml. This policy direction has now lasted slightly more than three years. But already, there are those who are calling the 1979 change a mistake and are advocating its abandonment. Before we terminate that "experiment," however, we should carefully review what the new policy perspective has Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 7 - achieved over the past three years. I would be the first to acknowledge that the 1979 change did not work miracles overnight. It could not have been expected to, for movements in prices and interest rates over much of 1980 and 1981 continued to be dominated by the momentum of prior inflationary policy actions. Despite a reduction in monetary growth, inflation continued to increase, inflationary expectations did not abate, and interest rates continued to rise. This year, however, it has become increasingly clear that reduced monetary growth is producing its expected results. Growth in consumer prices has receded from double-digit figures in 1979 to its current annual rate of approximately 5 percent. Inflationary expectations are receding because the public has begun at long last to recognize that the Fed intends to stick to its anti-inflationary policy. As a result, interest rates have declined significantly. It is also clear that there has been adverse real sector performance over the past three years. Output growth has been virtually nil since 1979 and the unemployment rate now exceeds ten percent. It was not unexpected that a gradual reduction in money growth would reduce output growth temporarily below its long-term trend and, consequently, cause a temporary increase in unemployment. But the extent of the downturn over the past three years has exceeded expectations. Two factors, in particular, in addition to slow money growth, have contributed to the severity of the downturn and have indirectly led to a lessening of public support for anti-inflationary monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 8 - First, 15 years of inflation induced and masked declining productivity in our heavy industries and eliminated the competitive edge that we have so long enjoyed in international markets. Much of the current decline in output and a significant part of the increase in unemployment can be attributed to this factor. Second, the decline in money growth over the past three years did not occur in a steady and predictable fashion that would have minimized its negative effect on output. Instead, the erratic behavior of short-run money growth contributed both to economic instability and to the public's uncertainty about future policy prospects. It was not targeting on monetary aggregates per se that was responsible for the somewhat erratic pattern of short-run money growth; it was rather the manner in which the new procedure was introduced. Like the launching of any new ship, some problems during the shakedown cruise were to be expected, and some occurred. These problems should now be largely eliminated. I have taken you through this brief 30-year history of monetary policy to demonstrate that the only way we can be sure of containing interest rates, assuring price stability, and proaucing long-term economic growth, is to continue to focus our policy emphasis and attention primarily on the behavior of Ml. In doing so, there will be times when it will be necessary to redefine the Ml measure to adjust for innovations. This was done in February 1980 to accommodate the advent of NOW accounts. We are again in the midst of such a period, and we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 9 - are again taking appropriate temporary action. What is important is that the duration of any such "detours" be kept to a minimum and that the public be reassured that policymakers have not abandoned their anti-inflation policies. If there is anything that we have learned from the experience of the past few years, it is that public confidence in monetary policy is of enormous importance. Credibility is difficult to come by and easy to lose. Any hint that monetary policy has permanently shifted back to interest rate stabilization would send interest rates skyrocketing and undo all that has been accomplished. History has demonstrated that interest rate targeting inevitably produces an inflationary bias, and that targeting on multiple targets makes consistency in monetary policy difficult to achieve. That leaves us with the need for one reliable monetary target. Since Ml has been performing better than all others, and since the results of Ml targeting have finally produced confidence in our ability to control inflation, I fervently hope that we will continue to use it. In the words of a well-known pundit, "If it ain't broke, don't fix it!" Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Lawrence K. Roos (1982, November 8). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19821109_roos

@misc{wtfs_speech_19821109_roos,
  author = {Lawrence K. Roos},
  title = {Speech},
  year = {1982},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19821109_roos},
  note = {Retrieved via When the Fed Speaks corpus}
}