Speech

EMBARGOED UNTIL 1:30 p.m. CST Wednesday, March 1, 1995 HOW CAN THE FED INFLUENCE INTEREST RATES AND SUSTAIN GROWTH? Remarks by Thomas C. Melzer President, Federal Reserve Bank of St. Louis Paducah Rotary Club Paducah, Kentucky March 1, 1995 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I am pleased to be here today and welcome the opportunity to discuss a widely misunderstood topic—the Federal Reserve's monetary policy. As most of you know, Federal Reserve Chairman Alan Greenspan testified before Congress last week about the economy and monetary policy. I read one newspaper account that described his remarks as having "raised the tantalizing prospect ... that the central bank will soon stop raising interest rates and may even begin lowering them." Although I am sure he was careful not to make any specific forecasts, as I will be, this account points up how important the prospects for future Fed actions can be at points in time. Indeed, this is one of those times. I guess it's safe to say that, before last week, the line on the Fed was that it had raised interest rates seven times in the past 12 months and was likely to do it again. As usual, the Fed was portrayed as a Scrooge-like figure—raising interest rates, slowing the economy, and fighting an imaginary inflation. Some even accused the Fed of being against economic growth. I can tell you definitively that this characterization pains me. Let me say right from the start that, as a Fed official, I do not like high interest rates, and I certainly am not "anti-growth." Quite the contrary, I seek a monetary policy that fosters a growth rate for our economy that is as high as we can sustain it. Sustainable growth, however, cannot be achieved by manipulating interest rates in an attempt to rev up the economy. Rather, the Fed can best Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 promote low long-term interest rates and sustainable economic growth by pursuing a credible monetary policy designed to achieve stability in prices over time. I will focus my remarks today on three key points: first, the factors that I believe determine economic growth and what the Fed can or cannot do about them; second, how inflation can impede economic growth; and third, the benefits of a credible anti-inflation monetary policy. The way I see it, there are two fundamental determinants of output growth: resources and productivity. By resources I mean labor and capital, and by productivity I mean the efficiency with which resources are used to produce goods and services. Unfortunately, the Fed has no direct influence on either of these things. It cannot raise employment, find new resources or devise ways to increase productivity. Indeed, over time, the Fed doesn't even have much control over the level of interest rates. We can affect growth indirectly, however, by affecting the price level. If our monetary policy causes excessive fluctuations in the price level—either inflation or deflation—we can hinder the working of the market economy and interfere with the allocation of resources to their most productive uses. If our policies limit such fluctuations, we can help the economy grow at the highest rate that it can sustain over the long haul. Now most of us get our news about Fed policies from newspapers, radio or TV. In their attempt to grab our Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3 attention, the mass media typically oversimplifies the way Fed policies work their way through our economic system. I am particularly concerned about what I consider to be an exaggerated picture of the Fed's power over interest rates. Let me explain. In essence, the Fed carries out its monetary policy by buying and selling government securities in the open market. The lingo for this activity is "open market operations." As we buy or sell Treasury securities, the Fed affects the amount of reserves that depository institutions hold to meet their customers' demands. The availability of bank reserves, which is determined by open market operations, plays an important role in influencing banks to lend or invest, thereby creating deposits, the main component of the nation's money supply. Now, I admit that open market operations do affect various interest rates, especially short-term ones like the federal funds rate, which is the interest rate banks charge one another for short-term loans. But keep in mind that markets set these rates, not the Federal Reserve. And, banks base their lending rates on market forces—the supply of reserves and the public's demand for credit. So, while the Fed certainly does influence rates, it does so only indirectly. When you shift the discussion to long-term rates, like those for Treasury bonds or mortgages, Fed actions have almost no immediate influence. One might think that the Fed could push interest rates as low as it wanted simply by increasing the amount of money it Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 supplies to the economy. Indeed, for very brief periods, that can work. But over time, such a policy will backfire. As we have seen many times before in our history, excessive money growth eventually causes prices to rise. And as price hikes become persistent, we have inflation. Sooner or later, the public recognizes that the Fed is pursuing an inflationary policy and demands higher nominal interest rates to compensate themselves for higher inflation. In this way, inflation acts like a tax, eroding the purchasing power of those who save or invest. The principal way monetary policy can hold down long-term interest rates is thus by holding down expectations of future inflation. A policy that is strongly committed to maintaining stable prices over time will minimize expected inflation and produce lower long-term interest rates. Keep inflation down, and long-term interest rates will be low. Of course, interest rates will always rise and fall to some extent—even when there is no inflation—but overall, rates will be lower in the absence of inflation than they will be if prices are rising. Unfortunately, the bad news about inflation does not end here, with high interest rates. Inflation has several other, equally unattractive side effects. The first is that it tends to be quite variable from one year to the next. Think about the problems that variable inflation might cause you in trying to plan your business investments and expenditures. Let's say the owner of a construction firm notices a rise in the price of lumber. Should he switch to a cheaper material? Maybe Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 5 so, if the price hike is confined to the lumber industry. But if prices are rising across the board, as happens when you have inflation, his decision may be to stick with lumber—or, perhaps, to get out of the construction business altogether. My point is, that inflation camouflages the real signals given by changes in relative prices. Thus, the construction firm runs the risk—whatever its decision—of allocating its resources inefficiently, leading to lower profits. For the economy as a whole, inefficient resource allocation means slower growth. High and unstable inflation also encourages people to divert resources away from productive investment and into inflation hedges or speculative ventures. We saw this happen in the late '70s and early '80s in the commercial real estate market, which overbuilt dramatically, and in the metals and commodity markets, which went through a speculative frenzy. This behavior on the part of investors reflected expectations of continuing price increases, not fundamental values. With inflation running fairly consistently in the 3 percent area for some time now, investors like those who are financing Paducah's Information Age Park have likely put up their money because of the prospects for a real return, not simply as an inflation hedge. Another of inflation7 s side effects is that it promotes borrowing and consumption. As prices continue to rise, people realize that any debts they incur will be repaid with dollars that will buy less than they do today. You7!! Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 recall that just a few years ago, all consumer interest payments were deductible from your taxable income. This made borrowing more attractive when inflation was high. Meanwhile, savers were taxed on their nominal incomes, not their inflation-adjusted incomes. It was not uncommon in the '70s for savers to lose wealth on their financial investments in real terms, despite having a nominal gain and an income tax liability. Not surprisingly, people expend considerable resources trying to forecast inflation and find inflation hedges. In the absence of inflation, these resources could be allocated to more productive uses. So we have seen how inflation can hinder economic performance. What can a credible commitment to low inflation do for us? It's simple. When the public believes that the Fed is committed to stability in prices, the inflation premium in interest rates and the allocation of resource toward inflation hedges will be minimized. In addition, the meaning of individual price and wage signals will be clearer. Let me give you a few examples of the value of a credible anti-inflation policy. In 1993, the United States and Argentina had similar rates of inflation—about 3 percent in the U.S. and 3.5 percent in Argentina. Investors, however, were willing to buy U.S. government securities that yielded 8 percent, but required a return of 16 percent on Argentinean government securities. Why was that? Some of the difference in yields might be explained by political risk, or by the relative difficulty of obtaining information about securities Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7 in Argentina. But surely another reason has to do with inflation. Even though the inflation rates were roughly the same in both countries, our inflation histories were far different. For many years, Argentina had high inflation—at times well over 100 percent. Such rates penalized those who saved. Compared to Argentina, inflation has been relatively low over time in the U.S.—hence, the public has more confidence in the future value of the dollar than it has in the Argentinean peso. Simply put, interest rates are lower in the United States in part because our central bank has more credibility at controlling inflation. Among the world's industrial countries, the differences in government bond yields are less stark than our U.S./Argentina example. Still, during 1994, long-term government bond yields in the G-10 countries ranged from a bit over 3 percent in Japan to nearly 9 percent in Italy. More often than not, countries that have had a history of relatively high inflation, like Italy, have higher long-term interest rates than historically low inflation countries, like Japan. This relationship holds true even for countries with similar current rates of inflation. I interpret these numbers as saying that the more successful a country has been at controlling inflation in the past, the lower long-term interest rates will be today, irrespective of the current year's inflation. Although credibility takes time to build, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 we see that it does produce real benefits in terms of lower long-term interest rates. Let's talk about long-term rates in this country. Keep in mind, as I mentioned earlier, that the Federal Reserve affects the volume of bank reserves and the money supply. Fed actions have little direct influence on interest rates, which are instead determined by supply and demand. Long-term rates rose in 1994, particularly in the first half of the year. Several factors may have contributed to this increase, but I believe that one reason was the expectation of rising inflation. From 1991 to 1993, the Fed pursued an aggressively stimulative monetary policy. Bank reserves and the Ml measure of the money supply grew very rapidly. Meanwhile, proposals were floating in Congress to limit the Fed's independence. Because inflation results primarily from excessive money supply growth, and because it tends to be high in countries where the central bank is more directly under the control of politicians, I believe that doubts were raised in the public's mind about the Fed's commitment to controlling inflation. Although interest rates tended to fall during this period, much of the decline was relegated to short-term rates. As the Fed began to tighten policy in early 1994, long- term rates increased in tandem with short rates. By mid-year, however, this pattern had largely ended, and further increases in short-term interest rates were not matched by increases in long rates. In fact, when short-term rates increased by 75 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 basis points in November, long-term rates actually fell. The same thing happened when short rates increased by 50 basis points in January. Long rates are now more than a half of a percentage point below their peak in November, though short rates have increased one and a quarter percentage points. The experience of 1994 demonstrates how fragile credibility can be. It also shows how increasing public confidence in the willingness of monetary policymakers to hold the line on inflation can help reduce long-term interest rates. In other words, by establishing a credible anti- inflation policy, the Fed can lessen the inflation premium and encourage long-term investment. Such a policy also limits confusion over the meaning of individual prices changes and minimizes the unproductive use of resources in the search for inflation hedges. To conclude, let me restate the question posed in the title of my talk: "How can the Fed influence interest rates and sustain economic growth?" Some would have us adopt highly stimulatively monetary policies to push interest rates lower and speed up the economy. We see no signs of inflation right now, so let's lower interest rates to propel growth. We can always reverse our policy later if inflation accelerates, so the script reads. We have seen, however, that such a prescription for monetary policy is short-sighted. Do we want a monetary policy that reacts to each and every piece of economic news, or that floors the economic accelerator one year, then slams Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 on the brakes the next? I think not. Such a policy places too great a burden on the marketplace and causes the public to waste time and resources trying to figure out how they and their businesses will be affected. Any gains in production or employment that may come from adopting a highly stimulative monetary policy tend to dissipate after a brief time. However, the inflation generated by this policy lingers, ultimately requiring painful measures to restrain it. Eventually, excessive monetary stimulus results only in inflation, not gains in production or employment. Our own experience, as well as that of other countries, has taught us that monetary policy can best promote low long-term interest rates and sustainable economic growth only when it is oriented toward controlling inflation. Low inflation and sustainable growth are thus not incompatible. In fact, one requires the other. A monetary policy that is strongly committed to keeping prices stable and inflation low is a pro-growth policy. That's what the historical record supports and what I believe is the appropriate goal of a pro-growth monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Thomas C. Melzer (1995, February 28). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19950301_melzer

@misc{wtfs_speech_19950301_melzer,
  author = {Thomas C. Melzer},
  title = {Speech},
  year = {1995},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19950301_melzer},
  note = {Retrieved via When the Fed Speaks corpus}
}