speeches · September 15, 1998

Speech

William Poole · President

A Policymaker Confronts Uncertainty St.LouisGatewayChapteroftheNationalAssociationforBusinessEconomics St.Louis,Missouri September16,1998 PublishedintheFederalReserveBankofSt.LouisReview,September/October1998,80(5),pp.3-8 When, in August, I chose a title for toFedpolicy;and5)marketanticipationsofFed these remarks I thought my policy.Letmetalkbrieflyabouteachoftheseand approach would be academic in thenturntoapolicyframeworkfordealingwith tone. Little did I guess that the uncertainties. topic would be immediate and obvious because of the press of events, both abroad and at home. Data Uncertainties abound in today’s environment. I Economicsisanempiricalscience,andthe must say, though, that the uncertainties we face lifebloodofeveryempiricalscienceisthedata have been in the background all along. What is necessarytoconfirmtheoreticalpropositionsand differentatthemoment,andworthremembering, toestablishtheregularitiesuponwhichscientific is that the uncertainties are simply very obvious inferencedepends.U.S.dataareprettygood,but right now. weareconstantlyfindinggapsandquestionable Ihavelongbeeninterestedintheanalysisof areasinourbaseofempiricalknowledge.Dayin monetarypolicyunderuncertainty.Theproblems anddayoutwestruggletointerprettheflowof arisefromwhatwedonotknow;wemustdeal currentinformationandmustalwaysbealertto withtheuncertaintyfromthebaseofwhatwe variouspossibleanomaliesandbiases.Letme doknow.Thegeneralpublicseemstohavea providejustoneexamplethathasbeenofinterest vastlyunrealisticviewofhowmuchtheFed inrecentquarters. knows,andsometimesassumesthattheproblem Measuringwageinflationisoftremendous issimplythattheissuesaresocomplicatedthat importanceintryingtounderstandwhether onlytheexpertscanunderstandthem.Infact, unexpectedlyrobustgrowthinnominaldemand thebasicissuesofuncertaintycanbeexplained isfeedingthroughnotonlytolowerunemploy- quitereadily. mentbutalsotohigherthandesiredincreasesin Iwill,shortly,talkmorepreciselyaboutthe wages.Fortrackingwages,Irelyheavilyonthe currentpolicysituationfacingtheFed,butbefore EmploymentCostIndex(ECI),forthatindexis gettingintocurrentissues,Idowanttoindulge constructedtoprovidethebestpossiblemeasure myacademicproclivitiesbyprovidinganoutline ofincreasesinlaborcompensation.Akeyfeature ofthesourcesofuncertaintyweface. oftheindexisthatittrackscompensationchanges occupationbyoccupation,positionbyposition, andismeanttobefreeofdistortionsthatarise SOURCES OF UNCERTAINTY fromchangesintheindustrycompositionof Idividethesourcesofuncertaintyfacingthe employmentandthepercentageofovertimein monetarypolicymakerintofivecategories:1)the totalemployment.Thequestionthatanalysts data;2)futureevents,shocksanddisturbances; mustdealwithnowiswhetherwageinflation 3)howtheeconomyworks;4)marketreactions maybetakingtheformofpromotionstohigher 1 MONETARYPOLICYANDINFLATION gradesinfirms’employmentladders.Thattype Market Reactions to Fed Policy ofwageinflationwouldnotshowupintheECI, Theeconomy’sresponsetoaFedpolicy whichtrackschangesincompensationgradeby adjustmentwilldependimportantlyonwhether grade. themarketbelievesthepolicyadjustmentis temporary,permanent,orthefirstofaseriesof Future Events policyadjustmentsinthesamedirection.Iwant Thecourseoftheeconomywillobviously toseparatethisdiscussionfromtheimmediate dependonthingsthathappeninthefuture. policysituation,solet’sthinkbacktoayearago Becauseofthelagsintheeffectsofpolicychanges, (beforeIarrivedattheSt.LouisFed).Atthattime, IwanttheFedtoactaheadoffutureeventsthat theeconomywasgrowingrobustly,andthere wouldrequirepolicyadjustments.Yet,mycrystal werepossiblesignsofoverheating.Supposethat ballislittlebetterthananyoneelse’s.Theprivate lastfalltheFedhadraisedthefederalfundsrate marketdidnotforeseetheseverityofdevelop- by25basispoints.Theeconomy’sresponsewould mentsinAsia,nordidI.Obviously,everyfore- presumablyhavebeenminimalifthemarket casterdoestheverybesthecanatforecasting anticipatedthattheFedwasgoingtobringthe thefuture,but,withoutquestion,thedifference fundsratebackto51/2percentinamatterofa betweenwhatactuallyhappensandtheforecast fewmonths.Or,theeconomy’sresponsewould canbeverylargeindeed. besomewhatgreaterifthemarketbelievedthat the25-basis-pointincreasewaslikelytoremain How the Economy Works ineffectfor,say,ayear.Theeffectontheecon- omywouldhavebeenevenlargerifthemarket Theinterplayofdevelopmentsineconomic viewedthefundsrateasthefirstofaseriesof theoryandempiricalobservationhasenormously increases. improvedourunderstandingofthemacroecon- Everyone,bothinsidetheFedandout,is omyoverthelast50years.Yet,thereareextremely wellawareofthisargument.Butatthetimethe importantareassubjecttowidedispute.Akey Fedisconsideringapolicychange,Ihavelittle areatoday,andmuchinthenews,isthemagni- insightintohowthemarketwillactuallyreactto tudeofthewealtheffectonhouseholdspending. apolicychangeof25basispointsinthefundsrate. Therecentdeclineinthestockmarketmay Tosomeextent,theFedcanshapethisreaction depressconsumptionspendingsubstantially, bywhatitsays,butIamnotmyselfconfident ormaybeitwon’t.Inrecentyears,consumption spendinghasbeenhighrelativetothecurrent thatIcanpredictthereaction. flowofdisposableincome.Itiscertainlyconsistent Moreover,uncertaintyabouthowthemarket withthehypothesisofasubstantialwealtheffect willreactisbynomeanstheendofthematter.If toobservethislowsavingrateoutofcurrent aFedpolicyadjustmenttakesthemarketlargely income.Householdshavebeenrelyingonthe bysurprise,aswasthecasewiththeincreasein appreciationinthestockmarkettoincrease thefundsrateinFebruary1994,themarketreac- wealth,andhave,therefore,feltcomfortablein tionmaybeoneofwholesalerevisionofexpecta- spendingalargefractionofcurrentdisposable tionsaboutthestateoftheeconomy.Ifthemarket income.Underthisargument,thedeclineinthe believestheinflationenvironmentisbenign,for stockmarketshouldindeedbeexpectedtoreduce example,andtheFedtightenspolicy,themarket consumption.However,theeffectsmaycome maythensuddenlydevelopacaseofinflation aboutwithalonglag,andthereareotherpossible jitterssimplybecauseitbelievesthattheFedhas hypothesestoexplainthehighlevelofconsump- acaseofinflationjitters.(Ofcourse,theFednever tioninrecentyears.Thefactofthematteristhat has“jitters,”only“concerns.”)Still,thisproblem Ireallyamnotconfidentaboutthesizeofthe ofmakingthemarket’sjudgmentscoincidewith wealtheffect. theFed’sjudgmentsisanextremelydifficultpart 2 APolicymakerConfrontsUncertainty ofthepolicyproblemtheFedfaces.Oneofthe cessfulinkeepingtherateofinflationlowand biggestriskswefaceisagapbetweenthemarket’s stableif,roughlyspeaking,theeconomyenjoys expectationofFedpolicyandwhattheFedactu- sustainedpricestability,thentheFedwillhave allydoes. doneitsjobanddoneitwell.Pricestabilityaids theefficiencyoftheeconomyandfromrecent Market Anticipations of Fed Policy evidenceitalsoappearstobehelpfulinholding downtheaveragelevelofunemployment.But Closelyrelatedtotheproblemofuncertainty withonepolicyinstrument,theFedcannotaim overmarketreactionstoFedpolicyistheuncer- directlyateconomicgrowth,theunemployment taintyofmarketanticipationsofFedpolicy.The rate,thelevelofthestockandbondmarkets,the difficultyhereisthattheFedshouldnotadjust policysimplybecausethemarketexpectsit.That exchangerate,thegrowthoftheJapaneseecon- said,mistakendecisionsinprivatemarketsmay omy,andsoforthandsoon.Touseasimple ariseifFederalReservepolicydoesnotmatch analogy,whendrivingacarweneedasteering theanticipatedpolicy. wheeltocontroldirection,anacceleratorand braketocontrolspeed,andatransmissionto controlforwardorreverse.Iftheonlycontrol DEALING WITH UNCERTAINTY instrumentavailablewerethesteeringwheel,at bestwecouldcontroldirection.Therewouldbe So,whatdowedo?Attheoutset,weneedto nouseinalsotryingtocontrolspeed. beclearaboutseveralthings.Firstofall,atany Thispoint,whichissoobvioustoprofessional giventimetheFedreceivesanampleamountof economists,isextremelyimportantinthecurrent advicefromeverydirectionand,therefore,after environment.ManyarecallingontheFedto thefactsomeoneorotherwillalwayshavehad reduceinterestratestocalmthemarket.Some thingspeggedbetterthantheFeddid.Butthatis arguethatcuttingratesintheUnitedStateswill nottherightcriterionforjudgingthewisdomof promoteamorehealthyfinancialandgrowth policydecisions.Wemustmakethejudgments environmentabroad,willeasethepressingfinan- onthebasisofexanteconsiderations—youpay cialproblemsinRussia,andsoforthandsoon. yourmoneyandmakeyourbetsbeforethegame Thefactofthematteristhatwithonepolicy isplayed.TheissueisalwayswhethertheFedis instrumenttheFederalReservecannotdoallof makingamistakethatispredictableatthetime thesethings.Anattempttopursueotherobjectives thedecisionisbeingmade.Withalloftheuncer- thatinfactdamagedthepursuitofpricestability taintiesintheenvironment,itisrarelythecase intheUnitedStateswouldonlyaddtoworld thattheFedmakeobviousexantemistakes.Or financialproblems.Themostimportantcontribu- atleastsoitseemstomeinrecentyears. tiontheFederalReservecanmakeistomaintain Second,weshouldalwayskeepinmindthat theFederalReservehasessentiallyonlyonepolicy pricestabilityathome,andtheeconomicstability instrument.Iliketothinkofthatinstrumentas thataccompaniesachievementofthatgoal.Do theamountofmoneytheFedcreates,butforthose notmisinterpretme;improvinggrowthprospects whoprefertoconcentrateonthefederalfundsrate, inJapanandelsewherearoundtheworldisan theissueisexactlythesame.Howeveryouput importantobjective.Itisjustthat,inmyjudgment, it,theFedcontrolsjustonepolicyinstrument— theFederalReservedoesnothavepolicyinstru- moneygrowthorthefundsrate. mentstofurtherthisobjective.Ofcourse,iffinan- Withonepolicyinstrument,theFedcan cialturmoilintheworldthreatenstodepressthe achieveatbestonepolicygoal.Myconviction, U.S.economy,thenadjustmentofU.S.monetary whichIbelieveistheoverwhelmingviewinthe policyisappropriate,andIhavenodoubtthat economicsprofession,isthatthegoalmustbe theFedwillmakethatadjustmentwhenthecase therateofinflation.IftheFederalReserveissuc- foritisclear. 3 MONETARYPOLICYANDINFLATION Asecondimportantpolicyprinciplefordeal- shortrun,itappearsthatabuilt-instabilizing ingwithuncertaintyisthatweneedtominimize mechanism,amechanismnotanticipatedinthe errorsinthemarket’sexpectationofwhatthe policydebatesofthe1960sand1970s,doesoper- FederalReserveisgoingtodo.Theseerrorscan ate.Themarketmoveslonger-terminterestrates neveraltogetherbeeliminated,becausewhatthe bysubstantialamountsgiventhebaseofthefed- FederalReservewilldodependsingoodmeasure eralfundsrateandgivenmarketconfidencein oneventsthatnoonecanforecast.Butwhatthe continuedlowinflation.Thefederalfundsratehas Fedcandoistoreiterateitsconvictionthatmain- beenconstantat51/2percentfromMarchoflast yeartothetimeofthiswriting.Overthisperiod, tainingpricestabilityistheprimary,indeed long-terminterestratesfluctuatedverysubstan- almostexclusiveinmyview,goalofmonetary tially.Thewaytheprocessseemstobeworking policy.Ibelievethatthemarketinrecentyears isthatthemarkethasincreasinglybecomecon- hasinfactcometointerprettheFed’sactionsand vincedoftheFederalReserve’sobjectiveofmain- analyseswithinthatcontext.TheFederalReserve tainingpricestabilityandhasbeenadjusting shouldalsoshareitsviewswiththemarketsand longer-terminterestratesonthebasisofthose explainthereasonsforitspolicydecisions.Thisis firmlow-inflationexpectations.Asmarketrates notbyanymeansaneasyjob,becauseindividual fluctuate,theincentivesforbusinessesandhouse- FOMCmembersmaydifferontherationalefora holdstospendoncapitalgoodsandconsumer givenpolicychange.Thatis,itistypicallythe durablesriseandfall.Ofcourse,thisprocesscan casethatFOMCmemberscanagreeonwhattodo workonlyiftheFederalReservedoesinfactadjust withoutbeingabletoagreewithgreatprecision thefundsrateinduetime,asrequiredbyemerg- onexactlywhytheactionisappropriate.Different ingeconomicconditions.Andthat,Ibelieve,is economists,quitenaturally,havedifferentviews exactlywhattheFederalReservehasdonetothe onwhatthemostcompellingcircumstancesare bestofitsability. inanygivensituation. IfIamcorrectwiththisanalysis,thenthe Anotherimportantprincipleisthatweshould marketshouldhaveconfidencethattheFederal relyonbuilt-inmarketstabilizerstothemaximum Reservewilladjustthefederalfundsrateupor possibleextent.Letmeprovideaverybriefback- downasrequiredbyemergingdevelopmentsto groundonthisimportanttopic,whichisbyno keeptheeconomyatlowinflation.Theredoes meansfullyexploredorunderstoodatthelevel seemtobeasubstantialamountofroomtotime oftheprofessionaljournalliterature.Chicago- theseadjustmentssoastofurthertheobjective schooleconomistshavelongarguedthatasteady ofstabilityingrowthandemployment.Butthe rateofmoneygrowthwouldsetafirmbasisfor keytothisprocessisthatthemarketmustbelieve themarkettoformexpectationsaboutthelong- thattheFed’slong-termgoalis(afterallowingfor runcourseofmonetarypolicy.Givenconfidence thebiasesinbroadpriceindexes)truepricesta- inpricestability,marketscouldthenrespondto bility—neitherinflationnordeflation. currentinformationandcurrenteconomiccon- Insettinginterestrates,themarketshould ditionsbyadjustinginterestratestoequilibrate alwaysconcentrateonthefundamentalsofthe savingandinvestmentatfullemployment.This situation,ratherthanontryingtoguesswhatthe visionofmonetarypolicydidnotultimately FederalReserveisgoingtodonext.TheFedis prevail,mostlikelybecauseofthedisturbances concentratingonthefundamentals;ifthemarket causedbyunpredictablechangesinmoney iscorrectinjudgingthatthefundamentalswill demandintheshortrun.Still,theprincipleof requireaninterestrateadjustment,thenasthedata relyingonmarketmechanismstoequilibratemar- arriveandfutureprospectschangetheFederal ketstothemaximumpossibleextentstillholds. Reservewillindeedchangeinterestratesinthe UndertheFed’soperatingprocedureoffixing anticipateddirection.However,undercurrent thefederalfundsrateinanarrowrangeinthe circumstances,theFederalReservedoeshavethe 4 APolicymakerConfrontsUncertainty luxuryofwaitingtobesurethatthefundamentals Letmefinishwithabriefwordaboutthesec- doindeedpointinaparticulardirection.That ondgreatprincipleofmonetarypolicy:theneed luxuryisanextremelyimportantgainfromthe fortheFederalReservetoactunderextraordinary Fed’sinvestmentinpolicycredibility.Because circumstancestoprovideextraliquiditytothe themarkettruststheFedtokeepinflationlowand marketplace.Everynowandthen,acrisiserupts stable,wedonothavelargechangesininflation inwhichthemarketmechanismitselfbreaks expectationscomplicatingourpolicydecisions. down.Thesearerareoccurrences,asevidenced bythelistofeventsinrecentyearsthathave requiredextraordinaryliquidityprovision.(The THE POLICY ENVIRONMENT mostfamousrecentcaseisthestockmarketcrash of1987,duringwhichthemarketmechanismfor TODAY tradingequitieswasunderextraordinarystress Applyingthesecommentstotoday’scircum- asevidencedbytradingvolumeoutrunningthe stances,itisobvioustoeveryonewhowatchesthe capacityofthemarketplace,thepanicconditions, marketsthatthelevelofinterestrateshasdeclined andtheconcernsovertheviabilityofseveralsecu- inanticipationofaFedeasingofthefederalfunds ritiesfirms.)Inthiscircumstance,theFedacted ratesometimewithinthenextfewmonthsorfew vigorouslytoprovideextrafundstothemarket quarters.Icanbequitevagueaboutthetiming untilconditionsquietedandthepanicsubsided. becausethetimingdoesn’treallymattervery Anothercircumstancewasthenearfailureof muchtoaholderofa30-yearbond.Ifthefunda- ContinentalIllinoisBankin1984,duringwhich mentalsdocomeinasthemarketanticipates,and themarketmechanismforlarge-bankCDswas letmereiteratetheimportanceofthatconditional severelystrainedandspreadswidenedasinvestors word“if,”thenofcoursetheFedwillact.How- developedgreatuncertaintiesabouttheentireCD ever,thepossiblefutureeventsarebynomeans market.TheFedintervenedtosmoothoverthat one-sided.Ifthesituationwereperfectlyclear,the marketupset.AnothercasewasthePennCentral FederalReservewouldalreadyhaveadjustedrates. Railroadbankruptcyin1970.Inthiscase,the Iam,Ihope,onlysayingveryobviousthings, marketforcommercialpaperwasdisrupted. butitisextremelyimportantthatwebeclear Theseinfrequenteventsrequirepromptand abouttheseobviousthingstoavoidmisinterpre- vigorousFederalReserveactionstoprovideextra tationoftheFed’spolicyandwhatIamsaying liquidityandreassurancetothemarket.The aboutit.Ifitturnsoutthattheeconomyremains essentialfeatureoftheseperiodsisnotonlythat muchmorebuoyantthanthemarketseemsto marketpricesaremoving,butalsothatthemarket anticipateatthistime,andespeciallyifitturns mechanismitselfisbreakingdowninsomeway. outthatweseeinflationarypressuresrising,then RememberonceagainthattheFederalReserve thenextadjustmentininterestratescouldbeup, hasonlyonepolicyinstrument.Wecannotsimul- ratherthandown.Mostoftheadjustmentwould taneouslyachieveourgoalofpricestabilityand beinmarketrates,asnewinformationchanges providesupporttoeachindividualmarketinthe marketperceptionsaboutthelikelycourseof economy.TheFed’sday-inandday-outpolicy events.Intime,theFedmightwanttomovethe mustbeconcernedwithpricestability.Asanation fundsrateupunderthesecircumstances,but werelyonmanydifferentmechanismsforkeep- analystsshouldnotunderestimatetheimportance ingtheeconomyhummingalongsmoothlyand ofthebuilt-instabilizingeffectsfrommarket efficiently.Werelyonprivatemarketswithdeci- adjustmentsofinterestrates. sionsmadebymillionsofindividualparticipants MydiscussionsofarhasbeenaboutwhatIcall tosolveproblemsinthedistributionofgoods thefirstgreatprincipleofmonetarypolicy—the andinthedeterminationofsecuritiesprices.We pursuitdayinanddayoutofpricestabilityinan relyonthemechanismsofgovernmentspending environmentinherentlyriddledwithuncertainties. andtaxesandregulationtosolvemanyother 5 MONETARYPOLICYANDINFLATION allocationanddistributionproblemsinourecon- omy.TheFederalReserve’sroleisakeyone,but itisjustpartofthesociety’smechanismforpro- ducinggoodoutcomesforthelongrun. SUMMARY I’llfinishwithaverybriefsummaryofmy analysis.TheFedfacesmanyuncertainties,and mustadjustitsonepolicyinstrumenttonavigate asbestitcanthisseaofuncertainty.Thefunda- mentalprincipleisthattheFedshouldusethat onepolicyinstrumenttoachievelong-runprice stability.TheFed,bymakingcleartoeveryoneits commitmenttothatgoal,isabletorelyincreas- inglyonmarketadjustmentsofinterestratesto equilibratetheeconomy.TheFedneedstoadjust thefundsratetargetfromtimetotime,butnot dayinanddayout.Thesecondgreatprinciple ofmonetarypolicyisthattheFedshouldstand readytoprovideextraliquiditytostabilizemarkets inthoserarecircumstancesthatpanicisbreaking downthemarketmechanismitself.BecauseU.S. marketsworksowell,extraordinarypolicyinter- ventionisfortunatelyextraordinarilyrare.My bottomlineisthatmarketparticipantsshould concentrateonthefundamentals,andsoshould theFed.Withsuccessinmaintainingpricestabil- ity,theFedwillneedtoadjustitspolicyinstru- mentfromtimetotime,butifthebondtraders cangetitrightthey’lldomuchofthestabilization work.WeattheFedcanthensitbackandenjoy life. 6

Cite this document

APA

William Poole (1998, September 15). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19980916_poole

BibTeX

@misc{wtfs_speech_19980916_poole,
  author = {William Poole},
  title = {Speech},
  year = {1998},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19980916_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}