speeches · January 14, 2001

Speech

William Poole · President

Monetary Policy in Uncertain Times MissouriBankersAssociation SeniorBankManagementConference Acapulco,Mexico January15,2001 Press commentary on the state of the FederalReserveBankofSt.Louisfortheircom- U.S. economy has changed dramati- ments,butIretainfullresponsibilityforerrors. cally in recent weeks. Economic data forNovemberandespecially December have come in decidedly weaker than MONETARY POLICY IN THE earlier in theyear2000.Analystshavebeen LONG RUN reducingtheir economic forecasts for 2001, and some have begun to worry about recession. SincecomingtotheSt.LouisFedinMarch Following Federal Reserve policy actions in the of1998,Ihaverepeatedlyemphasizedinmy first week of January, many commentators have speechesthattheFederalReserveisresponsible been discussingtheroleofmonetarypolicyin fortheaveragerateofinflationoverthelongrun. stabilizing the economic situation. TheFedhasstateditsinflationobjectiveasmain- Mypurposetodayistoprovideaperspective tainingalowandstablerateofinflation.The ontheroleofmonetarypolicyintimessuchas reasonforemphasizingthisgoalisthattheecon- these.I’lltalkaboutwhatmonetarypolicycan omy’slong-runeconomicperformanceinterms andcannotdo,andwhatexpectationsaboutpolicy ofemploymentgrowthandeconomicgrowthis arereasonable.I’llbeginbydiscussingmonetary maximizedwhentherateofinflationislowand policyinthelongrun,andbyemphasizingthe stable.Moreover,noothereconomicpolicyauthor- importanceoflong-runconsiderationsandhow itycanachievetheinflationoutcome.Inflation thestrengthofthelong-runoutlookaffectsthe isfundamentallycausedbyexcessivecreationof short-termoutlook.I’llemphasizethebasicprin- money,orliquiditymoregenerally.Controlling ciplethat,overthelong-run,monetarypolicyis thecreationofmoneyistheFed’sresponsibility, responsiblefortherateofinflationbuthasvery andexercisingthatpowerwiselyisthemain littlebearingontheaveragerateofunemployment monetarypolicyfunctionoftheFederalReserve ortherateofeconomicgrowth.I’llthentalkabout System. theshortrunandhowshort-runpolicyadjust- Recentyearshaveprovidedampleevidence mentsfitintothelong-runpolicystance.Finally, ofapropositionthatbecamemainstreaminthe Iwillpayspecialattentiontopolicyleadsand economicsprofession25yearsago—thatitisnot lags.Mypurposehereistoclarifydiscussionabout possibletoreduceunemploymentpermanently howtheeconomyreactstopolicyadjustments byacceptinghigherinflation.Thesecondhalfof andhowthoseeconomicresponsesmightlagthe the1990sshowsconclusivelythattheU.S.econ- policyadjustments. omycanenjoyahighrateofeconomicgrowth Beforeproceeding,Iwanttoemphasizethat anddecliningunemploymentwithoutarising theviewsIexpressherearemineanddonot rateofinflation.Indeed,Iamconvincedthatthe necessarilyreflectofficialpositionsoftheFederal remarkableeconomicperformanceofthelasthalf ReserveSystem.Ithankmycolleaguesatthe dozenyearsorsoowesinparttoadetermined 1 MONETARYPOLICYANDINFLATION FederalReservepolicytokeepinflationlowand Theactualunemploymentratemonthby steady.Participantsinmarketsofallkindshave monthfluctuatesaroundNpercent.Thefluctua- developedconfidenceinthatoutcome,andthat tionsaroundNpercentmaybequitepersistent— confidencehasbeenimportantinunleashingthe theunemploymentratemightremainaboveor inherentvitalityandinventivenessoftheU.S. belowNpercentformonthsorevenmanyquarters economytoachieveremarkablegainsinproduc- atatime. tivityandemployment. Economichistoriansstudyingmonetarypolicy intheUnitedStatesandothercountrieshave argued—Ithinkconvincingly—thatcentralbanks MONETARY POLICY IN THE havefromtimetotimemadeseriousmistakes thatincreasedratherthanreducedfluctuations SHORT RUN intheunemploymentrate.Certainly,thefirst IftheFed’slong-runpolicyistomaintain obligationofacentralbankistodonoharm.Over lowandstableinflation,andifthatoutcomehas thelast40yearsorso,advancesineconomists’ littleornoinfluenceontheaveragerateofunem- understandingofmacroeconomicsandmonetary ploymentandeconomicgrowth,whatroleisthere policyhaveledtoimprovementsinmonetary forshort-runmonetarypolicy? policy.TheFederalReservehasbeenabletoavoid Policyinthelongrunisthesumofallthe repeatingpastmistakesandhas,Ibelieve,not short-runpolicyadjustments.Clearly,then,any addedtoemploymentinstabilitysinceinflation short-runpolicyadjustmentsforthepurposeof camedownintheearly1980s. short-runeconomicstabilizationmustbepursued Question:Canmonetarypolicydomorethan inamannerthatisconsistentwithlong-runpolicy. simplyavoidcontributingtoemploymentinsta- Forexample,iftemporaryconditionscallfor bility?Thatis,cantheFedmakeapositivecon- extramonetarystimulus,thenthatextrastimulus tributiontokeepingthefluctuationsinthe unemploymentratesmall,therebykeepingthe mustbewithdrawninfutureyearssoasnotto actualunemploymentrateclosetoNpercent?I createhigherinflationinthelongrun.Wecould thinktheanswerisyes,atleasttosomedegree. puttheargumenttheotherwayaroundaswell; Adjustingmonetarypolicytolimitfluctua- ifextrapolicyrestraintisinordersomeparticular tionsintheunemploymentrateisnoteasy.Ido year,thatpolicyrestraintmustbeundoneinfuture notcountmyselfinthegroupofeconomists yearstoremainonthecorrectlong-termcourse. whobelievethatthereisareliablerelationship Imaginelookingatachartoftheunemploy- betweentheinflationrate,orthechangeinthe mentratespanningseveraldecades.Let’sassume inflationrate,andtheunemploymentgap,where thatthereisalong-termequilibriumunemploy- thegapisdefinedastheactualrateofunemploy- mentratearoundwhichtheactualunemployment mentlesstheestimatedvalueofthenaturalrate ratefluctuates.Thelong–runequilibriumunem- ofunemployment.Oneveryseriousproblemis ploymentrate,whichIwillassumeisNpercent thatnoonehasareliableestimateofthenumerical ofthelaborforce,maychangegraduallyover valueofthenaturalrateorhowitmaybechang- timeforavarietyofreasons.However,Iwantto ing.IdonotbelievethattheFederalReserve assumethattheunemploymentrateNisnot shouldthinkoftheunemploymentrateasadevice affectedbymonetarypolicy,exceptperhapsthat tocontrolinflationbecauseIdonotbelievethat Ncanbealittlelowerwhentheinflationrateis thereisareliablerelationshipbetweeninflation lowandsteady.Incidentally,Ichoosetheletter andtheestimatedunemploymentgap.Although Ntorefertothelong-runequilibriumrateof allofuswanttheactualunemploymentrateto unemploymentbecauseMiltonFriedmancalled settleataslowalevelaspossible,wemustrecog- thisratethe“naturalrate”ofunemploymentin nizethatsometimes—notinvariably,butsome- hisseminalpaperonthissubject. times—actionsnecessarytocontroltherateof 2 MonetaryPolicyinUncertainTimes inflationmayhaveanadverseshort-runeffect processasbeingoneofmaintainingafirmcon- onunemployment.Recognitionofthatfactis victionaboutlong-runpolicy—thatis,thecritical nothingmorethanarestatementofthewell- importanceofachievinglowandsteadyinflation establishedpropositionthatthecentralbank ontheaverage—andbeingasnimbleaspossible cannotlowertheaveragerateofunemployment inmakingshort-runadjustments. byacceptingmoreinflation.Weknowfrompainful Mydiscussionsofarhasignoredakeypart experienceinthe1970sthatanefforttopursue ofthisprocess—theinteractionofFedpolicy expansionarymonetarypolicytoholddown andmarketexpectations.TheFed’smainpolicy unemploymentisdoomedtofailureifthatpolicy instrumentistheintendedlevelforthefederal yieldsrisinginflation. fundsrate—theinterestrateonovernightbank ThewayIviewmonetarypolicyisthatIfocus loansofreservesondepositatFederalReserve abovealloninflationandthenfeelmywaygin- Banks.TheFederalReservedoesnothaveany gerlyontheunemploymentfront.WhatImean directinfluenceonlong-terminterestratessuch by“feelmywaygingerly”isthatthroughexten- asthatonhomemortgages.Thefederalfundsrate siveexperienceIhavedevelopedasenseofwhen affectsthemortgagerateentirelythrougheffects businessconditionsaremovingquicklyinone onmarketexpectations.A1-weekinterestrate directionoranother.AyearagoIhadthesense reflectsexpectationsabouttheovernightfederal thatdemandpressuresweresimplytoostrongto fundsrateforthenextweek;the1-monthrate besustainedovertheindefinitefuturewithout reflectsexpectationsaboutthenextfour1-week generatingsubstantialriskofhigherinflation. rates;the1-yearratereflectsexpectationsabout Overthelastcoupleofmonths,demandpressures, thenext12one-monthratesanda30-yearbond asmeasuredbyawidevarietyofindicatorsamply ratereflectsexpectationsaboutthenext301-year commentedoninthepress,havebeensubstan- rates.Alloftheseexpectationsareformedinthe tiallylessrobust.Thisisnotamatterofhardsci- marketplace.Theseinterestrateexpectations encebyanymeans;informingmysenseofcurrent reflecttheinterplayofmarketexpectationsabout businessconditions,Irelyonformalstatistics, futureeconomicdevelopmentsandfutureFederal businesscontacts,pressreportsaboutthestate Reservepolicyadjustments,whichofcourse ofbusiness,andexpertstaffinput.Thebest interact. analogyIcanofferisthatwhendrivingmycarI Themarketclearlymovesinterestratesin haveasenseoftheappropriatespeed.Thatspeed anticipationoffuturedevelopments.Thisfact dependsuponthenatureoftheroad,myfamiliar- allowsmetobemuchmorepreciseaboutwhatI itywithit,trafficconditions,weather,theangle meanwhenIsaythattheFederalReserveneeds ofthesun,thetypeofcarIamdriving,andso tobepreparedtoactnimbly.TheFeddoesnot forth.Atanygiventime,differentskilleddrivers havetobe,andshouldnotbe,hyperactive.Given canhaveadifferentsenseofthesafeandreason- thatthemarketunderstandswellhowthisprocess ablespeed,andbothcanbecorrect.Whenitcomes works,theFederalReserveoftencanholdasteady tomonetarypolicy,thoseofusdirectlyresponsi- federalfundsratetargetwhilewaitingforthesit- bleforpolicydecisionssitaroundthetableand uationtoclarify.Marketinterestratesfluctuate offerourobservationsandjudgments.Iknowthat readilyupanddownasnewinformationarrives. thepolicydiscussionsatmeetingsoftheFederal Thispointisnicelyillustratedbyexperience OpenMarketCommitteedohelpmetobecome overthelastyear. betterinformedanddoaffectmyviews. Letmeillustratethisprocessbyreferringto Differentviews,orviewswithdifferent the10-yearTreasurybondyield.InJanuaryof nuances,areperfectlynaturalgiventhestateof lastyearthatratereachedamonthlypeakof6.7 knowledge.Atthesametime,itisclearthatevery- percent.Meanwhile,theFedwasraisingthe oneinthisbusinesswillbesurprisedfromtime intendedfederalfundsrate,whichreacheda totimebytheactualoutcome.Ithinkofthis peakof6.5percentinMay.Overthesecondhalf 3 MONETARYPOLICYANDINFLATION oflastyear,somecombinationoflowercredit abletopursuemonetarypolicybysomemecha- demandsandthemarket’sinterpretationofthe nismotherthanbysettingtheintendedlevelof flowofnewinformationbroughtthe10-yearbond thefederalfundsrate.Thatis,supposeallinter- ratedowninirregularfashion.ByAugust,that estrates,includingthefederalfundsrate,were ratewasdownto5.8percentandbyDecemberit freetofluctuatefreelyinthemarket.Assumealso wasdownto5.2percent.Earlierthismonththe thattheFedweresuccessfulinmaintaininglow FOMCdecidedtoreducetheintendedratefrom andstableinflationonaverageandinoffsetting 6.5to6.0percent.However,ascanbeseenfrom somepartofshort-runeconomicdisturbances, thedataonthe10-yearbondrateI’vejustdis- thoughnotall.Then,wewouldobserveinterest cussed,financialconditionseasedwellbefore ratesfluctuatingupanddownaspressuresin theFOMCchangedpolicy.Examinationofthe thefinancialmarketsroseandfell.Theseinterest Aaacorporatebondrateyieldsthesameconclu- ratefluctuationswouldnotbeadirectconsequence sion.Usingmonthlyaveragedata,thatratereached ofFederalReservepolicybutoftheworkingsof apeakof8.0percentinMayoflastyearandby themarketeconomy.AlthoughtheFedinfact Decemberwasdownto7.2percent. setstheintendedrateonfederalfunds,oneway Thefactthatmarketinterestratesmoved oflookingatwhattheFeddoesisthatittries aheadoftheFOMCdoesnotmeanthattheFed moreorlesstoreplicatetheinterestratefluctua- gotbehind.Infact,inrecentyears,themarkethas tionsthatwouldoccurinthepolicymodeljust typicallymovedaheadoftheFed.Thecorrect described.Thatis,interestrateswouldneedto interpretation,inmyview,isthatmarketpartici- fluctuateinresponsetotheebbsandflowsof pantshavegreatconfidenceinandunderstanding creditmarketconditionsasnecessarytomaintain ofFederalReservepolicy.Becausethemarkets theeconomy’sequilibriumclosetofullemploy- understandtheFed,theFedcanaffordtoholda mentandwithanongoinginflationratethatis steadysettingontheintendedfederalfundsrate lowandsteady.AlthoughtheFedinfactsetsthe untiltheevidencebecomesclearthatapolicy intendedfederalfundsrate,ithasrelativelylit- adjustmentisappropriate. tlefreedomyear-by-yearastowhatleveltosetif Letmenowrecapthisargument,pullingits itwantstobesuccessfulinachievingitspolicy variousthreadstogether.First,theFederal objectives. Reserveiscommittedtoalong-termpolicythat maintainsalowandstablerateofinflation. Second,theFederalReservecan,inmyview, POLICY LEADS AND LAGS makeshort-runpolicyadjustmentsasappropriate toreducefluctuationsinemploymentandeco- I’veemphasizedthebroadoutlinesofhow nomicactivityaroundtheirlong-runtrends, policyworksandnowwanttosayjustafewwords whicharedeterminedbynon-monetaryfactors. aboutatopicmuchinthenewsrecently.Many ThemarketunderstandstheFed’sroleandcan observershaveexpressedconcernoverweakness typicallyanticipateFedpolicyadjustments. insomeoftheeconomicstatistics.Atthesame MyargumentthattheFedcancushionshort- time,theyoftenremarkthataFederalReserve runfluctuationsinemploymentandeconomic policyresponseisunlikelytohavemucheffect activitymostdefinitelydoesnotimplythatwe forsixtoninemonthsorperhapslonger.The caneliminateallsuchfluctuations.Alongwith argumentis,implicitly,thattheFedispowerless privatebusinessanalysts,weareoftentakenby todomuchtostemeconomicweaknessinthe surprisebycurrenteconomicdevelopments.We nearterm. arenobetterthananyoneelseatforecastingthe Theconclusionisinonerespectcorrectbut unforecastable. thereasonhasnothingtodowiththeasserted Letmementiononeotheraspectofthissitu- policylags.I’vealreadyemphasizedthatinterest ation.Let’ssupposethattheFederalReservewere ratesfellsubstantiallyoverthesecondhalfof 4 MonetaryPolicyinUncertainTimes lastyear,anticipatingFederalReserveactionby accuracy.Whatwecandoistorespondsensibly manymonths.Themarketcouldnotpredictthe tocurrentdevelopments,makingsurethatwe timingoftherecentFedpolicyeasing,butitdid keepinmindthelong-termpolicygoalsandnot predictthefactofeasingatsomepoint.Ifinterest overreacttoshort-rundisturbancesonwhichwe ratesdeclineinanticipationofFedactions,then canhavelittleeffect. thepolicylagshouldbemeasuredfromthedecline MybottomlineontheoutlookfortheU.S. inmarketinterestratesandnotfromthedateof economythisyearmatchesthatofprivatefore- Fedactionanticipatedbymarketinterestrates. casters.Thebestguessofprivateforecastersat InMayoflastyear,atthetimetheFedlasttight- thistimeisthattheeconomywillcontinueto enedpolicy,the10-yearbondratewas6.4percent. grow,butmoreslowlythanlastyear.Thereisa Usingmonthlyaveragedata,the10-yearbond rangeofpossibleoutcomesaroundthatbestguess; ratefelleverymonththereafter.Someofthesame thatrangedoesincludearecessionoutcome, observerscontendingthattheeconomy’sresponse althoughprivateeconomicforecastersdonot willlagFedactionnotethathousinghasheldup viewthatoutcomeashighlylikelyatthistime. prettywellinrecentmonths.Surelythereason Theeconomyalsohasthepotentialtoperform inpartisthatmortgagerateshavebeencoming betterthanthebestguess. down,alongwithotherrates.Lastyear,the30- Yourreactiontomyfearlessforecastmaybe, yearconventionalmortgageratefellfrom8.5 “so,whatelseisnew?”Theansweristhatthe percentinMayto7.4percentinDecember. situationtodayisnotunusual,exceptforthose Theseobservationsmakeclearthattheques- withmemoriesthatgobackonlyfiveyearsorso. tionofthelengthofthelagfromtheFed’spolicy Ifweconsideragainthetitleofmytalktoday, actionearlierthismonthisnotwelldefined, “MonetaryPolicyinUncertainTimes,”mymes- becausethemarketgraduallyeasedrateslast sageisthatthesetimesseemmuchmoreuncer- yearinanticipationofeventualFedaction.The tainthantheyreallyare.Yes,arecessionisinthe marketsandtheFedhaveacommoninterestin realmofpossibility,butitisnotabestguessat understandinghowtheeconomyisevolving. thistime.Nothinghashappenedtochangethe WhethertheFedcanensurethattheeconomy appropriateassessmentoftheeconomy’slong-run willnotfallintoarecessionthisyearisreallyan potential.Thefactthatexcessivelyoptimistic issueofwhetherthemarketsandtheFedtogether long-rungrowthforecasts—“excessivelyexuber- cananticipate,andoffset,developmentsthat ant”isthephraseI’msearchingforbutdarenot couldleadtoarecession.Thereisnoguarantee use!—havedisappearedspeakstothoseforecast- astotheoutcome. ersandnottotheeconomy’sgrowthpotential. Mypersonaleconomicforecastiscompletely Growthprospectsremainexcellent.Theinflation consistentwiththemainstreamofprivatefore- outlookforthenextcoupleofyearsandlong-term casters,forIknowthatIhavenocomparative inflationexpectationsremainlow. advantageinproducingasuperiorforecast. Insum,thenear-termoutlookhaschanged— NeithertheFederalReservenorprivatebusiness butitisalwayschanginginsomerespectorother— firmscanforeseefuturedevelopmentswithgreat andthelong-runfundamentalsaresound. 5

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APA

William Poole (2001, January 14). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20010115_poole

BibTeX

@misc{wtfs_speech_20010115_poole,
  author = {William Poole},
  title = {Speech},
  year = {2001},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20010115_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}