speeches · July 30, 2007

Speech

William Poole · President

Milton and Money Stock Control MiltonFriedmanLuncheon Co-sponsoredbytheDepartmentofEconomics,UniversityofMissouri, theEconomicandPolicyAnalysisResearchCenter,andtheShow-MeInstitute UniversityofMissouri–Columbia Columbia,Missouri July31,2007 We are here today on Milton Beforeproceeding,Iwanttoemphasizethat Friedman’s birthday to remember theviewsIexpressherearemineanddonot him and his enormous contribu- necessarilyreflectofficialpositionsoftheFederal tions. Those of us who studied ReserveSystem.Ithankmycolleaguesatthe under him are extraordinarily fortunate. Most of FederalReserveBankofSt.Louisfortheircom- us were able to maintain contact with him for ments,butIretainfullresponsibilityforerrors. the years between our studies and his death. IfMiltonwereheretodaythereisnothinghe wouldenjoymorethanalivelyseminaronsome THE CASE FOR MONEY STOCK aspectofeconomics.AlivelyseminariswhatI CONTROL intendtooffer.I’mprettysurethatwhatI’mgoing Asacard-carryingmonetarist,Iarguedthe tosaywouldhaveprovokedhimandthatIwould steadymoneygrowthcasevigorouslyinyears havelearnedalotfromhearinghimcommenton past,anditisstillmyconvictionthatacentral myanalysis. bankignoresmoneygrowthatitsperil.Milton OfthemonetaryeconomicsbattlesMilton andhisco-authors,especiallyAnnaSchwartz, foughtinthe1960sand1970s,hispolicyprescrip- providedampleevidencethatvariationsinmoney tionforsteadymoneygrowthatalowrateisthe growthwerehighlycorrelatedwiththebusiness onlyimportantissuewherehefailedtocarrythe cycle,andhearguedthatsteadymoneygrowth profession.Mainstreammacroeconomicsaccepts wouldreducetheamplitudeandfrequencyof hisviewthatthelong-runPhillipscurveisverti- recessions.Healsoarguedthatsustainedinfla- cal,thatweneedtofocusonreal,ratherthan tionwouldbeimpossiblewithoutsustained nominal,interestrates,thatlowinflationiscentral moneygrowthinexcessoftheeconomy’slong- toeconomicstabilityandthatfiscalpolicyhas runrealrateofgrowth. littletodowithshort-runfluctuationsinemploy- Miltonfavoredsteadymoneygrowthbecause mentandoutput.Butfeweconomistsstillsupport hedidnotbelievethatcentralbankerswerewise moneygrowthtargeting. enoughtoimproveontheoutcomesthatwould AlthoughMilton’smoney-growthpolicy flowfromsteadymoneygrowth.Withevidence prescriptiondidnotwinout,Ibelievethathis fromtheGreenspanera,Miltonchangedhisview analysisjustifyingthisprescriptionhashadmuch abit,butwasnotconvincedthatGreenspan’s moreinfluencethanmanyrealize.I’llreviewhis successinadjustingthestanceofmonetarypolicy caseforthisrecommendationandthendiscuss waslikelytobereplicatedbyfutureFedchairmen. howthiscaserelatestocurrentcentralbank Thecaseforcontrollingthemoneystockalso practice. restedonthedangersofcontrollinginterestrates. 1 MONETARYPOLICYANDINFLATION Apolicyinterestrateheldtoolowsetinmotion bankallowsexpectationstobecomeunanchored, acumulativeprocessoflargerandlargerinfla- theninterest-ratecontrolbecomesadangerous tionarydisequilibrium;withapeggednominal andpotentiallydestabilizingpolicy.Butshould rateofinterest,risinginflationandinflation thepracticeofmonetarypolicydependonhow expectationswouldlowertherealrateofinterest. wellinflationexpectationsareanchored?Ido Thatwastheoppositeofwhatwouldbeneeded notrecallMiltondiscussingthisquestion,per- toquellinflationaryfires.Theprocesswassym- hapsbecausehebelievedthatthebestwayto metrical;withongoingdeflation,amonetary maintainwell-anchoredexpectationsovertime policyholdinganominalinterestratesteady wasforthecentralbanktocommittosteadyand wouldpromotedeflationandarisingrealrateof lowmoneygrowthunderallcircumstances. interest.Anadjustableinterest-ratepegdoesnot Howdoesacentralbankanchorinflation changetheanalysisinanyfundamentalway; expectations?Oneapproachwouldbeforthe giventhatinflationexpectationsmaybechanging, centralbanktocommittolowandsteadymoney theissueremainswhetherinterest-rateadjust- growthcomewhatmay.Aproblemwiththis mentsareadequatetomovetherealrateofinter- approachisthatitmaynotappearcredibleto estintheappropriatedirection.Steadymoney themarketswhenfinancialinstabilityand/or growth,ontheotherhand,wasinherentlystabi- recessionoccurs.Ifapolicyofsteadymoney lizingastherealrateofinterestwouldtendtorise growthhasexceptions,cantheexceptionsbe duringaninflationandfallduringadeflation. definedinsuchawaytoretainanchoredinfla- Miltonalsoarguedforsteadymoneygrowth tionexpectations? onpoliticalgrounds.Acommitmenttosteady Anecessaryandsufficientconditionfor moneygrowthwouldreflectaruleoflawrather anchoringisthatthecentralbankactvigorously thanofmen.Hedidnottrustthelegislatureto toresistinflationordeflationwheneveritbecomes runmonetarypolicyinanonpoliticalway,nor evidentandparticularlywheninflationexpecta- didhetrust“unaccountablebureaucrats,”ashe tionschange,upordown,inanunwelcomeway. mightputit,appointedforlongtermstoconduct Ifthecentralbankiswillingtopushashardasit adiscretionarymonetarypolicy.Hisviewwas takes,regardlessofshort-runconsequencesto shapedbytheFed’spoorperformanceintheearly unemploymentandespeciallytothebondand yearsoftheGreatDepressionandbythefactthat stockmarkets,thenmarketparticipantswill atthattimepressurefromCongress,whenitwas developfirmviewsonthelikelyrateofinflation insession,didpushtheFedabitinthecorrect inthefuture.TheFedmustconvincemarket direction. participantswhobetagainstitthattheywill Thisbackgroundisallfamiliarground;I regrettheirbets. reviewittointroducemycommentsoncurrent Itishighlydesirablethatthecentralbank centralbankpractice. behaveinarule-likeway,bothforthepolitical objectiveoftheruleoflawratherthantheruleof menandbecausepredictablepolicypromotes CONSEQUENCES OF moreefficientdecisionsintheprivatesector.To themaximumpossibleextent,wedesireanequi- CONTROLLING THE FEDERAL libriuminwhichthemarketsbehaveasthecentral FUNDS RATE bankexpectsandthecentralbankbehavesasthe EverythingMiltonarguedaboutmoneystock marketsexpect.Centralbankbehaviortoanchor controlistrue,buttheeffectofinflationexpecta- expectationsoflowandstableinflationisthe tionsonthepracticeofmonetarypolicyitself singlemostimportantaspectofpolicypredictabil- was,Ibelieve,amissingelementintheanalysis. ity.IbelievethattheFedhascomealongwayin Theeconomyfunctionsdifferentlywheninflation thatdirectionthough,obviously,therearecer- expectationsarefirmlyanchored.Ifacentral tainlyopportunitiesfortheFedtorefineitspolicy 2 MiltonandMoneyStockControl rule.Inthiscontext,by“rule”Isimplymeanthat thoseinterestrateswereheldfixedbymonetary theFed’spolicyactionsaresystematicandhighly policy.IftheFedhadbeenpegginglongrates,the predictableresponsestonewinformation. flighttoqualitylastweekwouldhaverequired Steadymoneygrowthwouldalsobehighly theFedtotakefundsoutofthemarket.That predictable,butIbelievethattheFed’sactual wouldhavebeenadestabilizingresponseto adjustmentsofitsfederalfundsratetargethave marketfearsconcerninghousingandthesub- yieldedsuperioroutcomessince1982towhat primemortgagemarket.NorwouldtheFedhave wewouldhaveobservedundersteadymoney beeninagoodplaceifithadtomakeadecision growth.Ialsobelievethatadvancesinknowledge astojusthowfaritshouldadjustapeggedlong permitustosaywithsomeconfidencethatthese interestrate.Thisisthekindofjudgmentbest gainsarenotjustanaccidentofAlanGreenspan’s lefttothemarket. specialskillsandintuition. Whatouranalysismissedagenerationago So,theFedhaspushedhardatcertaintimes, wasthatthetypicalmodelwithonlyoneinter- andkeptitsfederalfundstargetunchangedat estratecouldnotpossiblyallowforstabilizing othertimes,withtheresultthatinflationexpec- marketresponsesinlongrateswhenthecentral tationsarenowquitewellanchoredandpolicy banksettheshortrate.Ofcourse,macroecono- adjustmentsarenotthemselvesdisturbancesto metricmodelsdidhavebothshortandlong themarket.Withinflationexpectationsanchored, rates,butthestructureofthemodelsdidnotper- changesinthenominalfederalfundsratereliably mitanalysisofthesortIamdiscussingbecause movetherealfederalfundsrateinthesamedirec- thetypicaltermstructureequationmadethe tionandbyroughlythesameamount.Datafrom longrateadistributedlagontheshortrate.The tradinginindexedTreasurybonds,andfrom model’sshortrate,inturn,wasdeterminedby surveys,allowtheFedtomonitorchangesin monetarypolicymakerssettingitdirectlyorby inflationexpectationscontinuously.Suchmoni- themoneymarketunderapolicydetermining toringhelpstremendouslytoprovideassurance moneygrowth. thattheFedisnotfallingbehindinitspolicy Onceweallowexpectationstouncouplethe adjustments. currentlongratefromthecurrentshortrate,the Inotedthatanattractivepartofthecasefor situationchangesdramatically.Themarketcan steadymoneygrowthwasthatmarket-driven respondtoincominginformationinastabilizing changesininterestrateswouldbeinherently waywithoutthecentralbankhavingtorespond. stabilizing.Interestingly,andIthinksurprisingly, Longbondratescanchange,andchangesubstan- wenowseethesameprocessatworkwithlonger- tially,whilethefederalfundsratetargetremains termbondyields.TheFedadjustsitsfederal constant. fundsratetargetinadiscretionary,thoughhighly Eventually,ofcourse,ifchangedconditions predictable,fashion,butsignificantchangesin persist,thecentralbankwillhavetoadjustthe longratesdooccur.Thoseofyouwhofollowthe policyrateinthedirectionrequiredbythenew marketscloselycouldpointtomanycasesin information.Intheabsenceofsucheventual recentyearsinwhichlongrateshavehelpedto policyadjustment,thedestabilizingeffectsofa stabilizetheeconomywhiletheFedremained constantinterestrateemphasizedintheearlier onthesidelines,holdingthefederalfundsrate literaturewillappear. targetunchanged. Wearewitnessingthisphenomenoncurrently. Puttingasidewhatishappeningtothemarkets THE BOTTOM LINE asIspeak—somethingIobviouslycouldnot incorporateinmywrittentext—thedeclinein Considerwherethisanalysisleavesus. longTreasuryrateslastweeksurelyhelpedto Assumeinflationexpectationsarewellanchored. stabilizemarketsrelativetoasituationinwhich Thecentralbankcanholditspolicyraterelatively 3 MONETARYPOLICYANDINFLATION steadyandrelyonmarketadjustmentsinlong rightquestiontoaskisnotwhetherFedactionin ratestodomuchofthestabilizationwork.When responsetoanycurrentmarketupsetwouldbe newinformationarrives,mostofthetimethe desirablebutratherwhetheritispossibleto centralbankcanwaitformarketresponsesand defineasystematicresponsetomarketupsetsin thepassageoftimetoclarifywhatishappening. generalthatwouldbehelpful.TheanswerIgive Thecurrentsituationisaperfectillustration. isthateffectsontheeconomycanrarelybeunder- TheFeddoesn’tknowandmarketparticipants stoodwithoutpassageoftimeandmoreinforma- donotknoweither,thefullimplicationsoflast tion.Occasionally,thereiscontemporaneous week’sstockmarketdeclinesandincreasesin evidenceofdamagetomarketmechanismsthat riskspreads.Marketreactionslastweekmaybe mightjustifyquickFedaction. overdone,orperhapsnot.Wejustdonotknow. Thekeypointisthat,inthesesituations,the Inasituationliketheterroristattacksof9/11, marketismakingjudgmentsonsecurityprices, theFedknewenoughtobelievethataquickpol- stabilizingtheeconomywithouttheFedhaving icyresponsewouldbehelpfulandunlikelyto toleadtheway.Thisisexactlytheprocessenvi- itselfbedestabilizing. sionedagenerationagobythemonetaristadvo- Atypicalmarketupset,suchaslastweek’s, catesofsteadymoneygrowth.ThisiswhatMilton isnotatalllike9/11.Mostoftheseupsetsstabi- taughtusaboutmarkets,andhewasright. lizeontheirown,butsomedonot.I’mnotsaying Wheninflationexpectationsarefirmly thattheFedshouldignorewhathappenedlast anchored,animportantreasonfortheFedtolet week—weneedtounderstandwhatishappening. marketstaketheleadisthatoveractiveFed However,itisimportantthattheFednotpermit responsestomarketdevelopmentssetprecedents uncertaintyoverpolicytoaddtotheexisting thattendtodestabilizemarketsinthefuture.If uncertainty.Themarketunderstands,Ibelieve, themarketbelievesthattheFedisalwaysprimed thattheFedwillactinduetime,ifandwhen toadjustpolicy,thenmarketparticipantswill evidenceaccumulatesthatactionwouldbeappro- spendmoretimetryingtosecond-guesstheFed priate.Thatiswhytradinginthefederalfunds thantryingtounderstandwhatishappeningto futuresmarketreflectschangedoddsfromtwo businessandhouseholdbehavior.AsIempha- weeksagoonapolicyadjustmentlaterthisyear. sizedearlier,agoodmarketequilibriumrequires Iflastweek’seventsdonotturnouttochange thattheFedbehaveasthemarketexpects.When theprobablecourseofeconomicgrowthand therearewidelyvaryinginterpretationsinthe inflation,thenthefedfundsfuturesmarketwill marketaboutwhatishappening,itisimpossible reversecourseandtheexpectedpolicyeasing fortheFedtobehaveasthemarketexpects willdisappear.Or,ifevidenceaccumulatesthat becausethereisnounifiedviewinthemarket theinflationpictureremainsbenignbuttheout- aboutwhatishappening.Atanygiventime,it lookfortheeconomynextyearappearslikelyto maybeimpossibleforthemarkettocometoa besignificantlyweakerthanthecurrentbest unifiedviewaboutwhatishappening,simply guess,thenthemarketwilldeepenitsconviction becauseofincompleteknowledgeanddifferent thattheFedwillbecuttingitsfedfundstarget. professionaljudgmentsbythosebestinformed. TheregularityofFedbehaviorIespouseis Still,thereneedbelittleornouncertainlyabout thattheFedshouldrespondtomarketupsets FedbehaviorthedaybeforeanFOMCmeeting. onlywhenithasbecomeclearthattheythreaten Fedactionsatfuturemeetingsmonthsahead toundermineachievementoffundamentalobjec- willremainuncertain,toboththemarketand tivesofpricestabilityandhighemployment,or theFOMCitself,becausethefutureinformation whenfinancial-marketdevelopmentsthreaten setisuncertain. marketprocessesthemselves.TheFedshouldnot Inthemeantime,thecentraltendencyof trytosubstituteitsjudgmentsforthemarket’s marketviewsonwhatishappeningwillcontrol judgmentonappropriatesecurityprices.The thelongbondrateandsecuritypricesmoregen- 4 MiltonandMoneyStockControl erally.Differencesinmarketviewsastowhatis happeningwilldeterminewhoislongandwho isshortinthemarket.Eventually,asnewinfor- mationclarifiesthesituation,thevarianceof viewsaroundthecentraltendencywillfalland morenormalmarketconditionswillreemerge. Asforthepoliticsofmonetarypolicy,I believethereisextremelywidesupportfora totallyapoliticalFed.Thereisaconsensuson thedesirabilityoflowinflationandthattheFed shoulddowhatitcantostabilizetheunemploy- mentrateatthelowestrateconsistentwithsus- tainednon-inflationaryeconomicgrowth.The marketandmostpoliticalleadersbelievethat theFedisapolitical.Themarkettrustsus,and we,inturn,workhardtoretainthistrust.When Isay“we”IreallymeantheFedasaninstitution. Fedofficials,staffandReservebankdirectors haveadeepunderstandingoftheimportanceof apoliticalmonetarypolicy.Thisunderstanding goesfartowardmakingFedactionsreflectarule oflawratherthanaruleoftheindividualsmaking thedecisions.Theclosestanalogy,perhaps,is thatweworkasfiduciaries.Idonotdenythatit wouldbedesirablefortheFederalReserveAct tobeclearerabouttheobjectivestheFedshould pursue.Still,theFedasaninstitutionhasgonea longwaytomakeitspolicyactionsrule-likein theirregularity.Iftheinstitutionisstrongand incorruptible,asIbelieveitis,thenweprobably haveasmuchassuranceinademocraticsociety aswearelikelytoget. AlthoughMiltondidnotprevailinhisquest tohavetheFedmaintainaconstantmoneygrowth rate,hedidprevailinhisinsistencethatpolicy beapoliticalandrelytothemaximumpossible extentonmarketjudgments.Helostabattlebut trulydidwinthewar. 5

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APA

William Poole (2007, July 30). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20070731_poole

BibTeX

@misc{wtfs_speech_20070731_poole,
  author = {William Poole},
  title = {Speech},
  year = {2007},
  month = {Jul},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20070731_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}