Mr Ferguson expresses his views on monetary policy and the outlook for the US economy  (Central Bank Articles and Speeches, 15 Jan 99)
Central bank: fed | Type: speech | Date: 1999-01-15

## Mr Ferguson expresses his views on monetary policy and the outlook for the US economyRemarks by Mr Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Fed Reserve System, delivered at the East Hanover Area Chamber of Commerce, East Hanover, N Jersey on 15/1/99.

## The Making of Monetary PolicyThank you for inviting me to share lunch and a few thoughts with you today.

I believe important for the actions of this country's central bank to be as transparent as po therefore I am happy to address this audience on the topic of what the Federal Reserv does and how it does it.

I will also try to give an assessment of the national and issues affecting Federal Reserve policy.I hope that you will conclude from this discussion that, though the process of settin policy is complex, it is nonetheless in many important ways accessible to the average also hope that you will agree that there are really very few secrets; we attempt to be responsible, which is appropriate in a democracy.

## History of the Federal Reserve System and the FOMCThe Federal Reserve was created by an Act of Congress on December 23, 1913.

The Fede Reserve System consists of a seven-member Board of Governors (an independent agency of federal government with headquarters in Washington, DC), plus a nationwide network o Federal Reserve Banks and 25 branches.

Congress established the Federal Reserve Banks operating arms of the nation's central banking system, and they have both public and elements.Neither the Board nor the Reserve Banks receive appropriations from Congress.

Therefore do not operate with tax revenues, but rather pay expenses out of earnings.

Earnings of Reserve Banks are derived primarily from interest received on their holdings of U.S. go securities and the fees they charge to depository institutions for providing services. earnings of the Banks, after expenses, contributions to surplus and payment of other as are aggregated and paid over to the U.S. Treasury.

In 1998, for example, the Federal paid approximately $26.5 billion to the U.S. Treasury.The Federal Open Market Committee, or FOMC, is the most important monetary policy-maki body of the Federal Reserve System.

The FOMC makes the key decisions regarding the con of open market operations (purchases and sales of U.S. government securities) which af cost and availability of money and credit in the U.S.

economy.

The voting members Committee are the members of the Board of Governors and five Reserve Bank presidents. president of the Federal Reserve Bank of New York serves on a continuous basis; the pr of the other Reserve Banks serve one-year terms on a rotating basis, beginning on Jan each year.

All the Reserve Bank presidents participate fully in the various discussions of whether they currently have a vote in the policy decision.

By law, the FOMC must least four times each year in Washington, DC.

Since 1980, eight regularly scheduled m have been held each year.

If circumstances require consultation or consideration of between regularly scheduled meetings, members may be called upon to participate in a meeting or a telephone conference.So what happens at these meetings?

The order and structure of these meetings may chang time, but has been pretty much fixed during my term on the Board.

Before each reg scheduled meeting of the FOMC, System staff members prepare written reports on past prospective economic and financial developments, which are sent to Committee participa the meeting itself, staff members present oral reports on the current and prospectiv situation, conditions in financial markets and international economic and financial dev After these reports, each Committee participant, voting and nonvoting, expresses his or on the current state of the economy and prospects for the future.

After a short coffe have a staff presentation on the alternatives we face in setting monetary policy.

At th Chairman gives his view of the economy and makes a suggestion for the appropriate direc policy.

Each Committee member then responds to the Chairman's suggestion, in the pr setting out a preferred choice for policy.

After this second 'go-around,' we take a for the target federal funds rate for the period until the next meeting.

At this point, the voting members, who, as I noted, include all of the Governors and five of the 12 Pr Generally, an announcement of a change in interest rates, if any, is made at about 2 afternoon.

A full set of meeting minutes is made available after the subsequent meetingLet me turn now to a discussion of monetary policy and the outlook for the U.S. econo course, the views I shall be expressing are my own and are not necessarily shared by t or the Board of Governors.

## The Goals of Monetary PolicyFederal law establishes the goals of monetary policy.

The Federal Reserve and the FOMC promote effectively the goals of maximum employment, stable prices, and moderate long interest rates'.

Many analysts believe that achieving price stability should be the pri a central bank because a stable level of prices appears to be the condition most co maximum sustained output and employment, and to moderate long-term interest rates. presumably is because in times of price stability the prices of goods, materials and undistorted by inflation and thus can serve as clearer signals and guides for th allocation of resources.

Also, a background of stable prices is thought to encoura formation because it reduces the distortion created by a tax system that is only partly inflation.

Some would argue that the remarkable period of growth that we are experienci in no small measure to the low rate of inflation that has prevailed for some time.The problem with the rather neat formulation that I have just given is that it does no element of time.

In the long run, I have no doubt that price stability underpins effor maximum output and employment.

But, in the short run, some tensions can arise between e to reduce inflation and efforts to maximize employment and output.

For example, the e may at times be faced with adverse developments affecting supply, such as a bad agri harvest or a disruption in the supply of oil, which put upward pressure on prices and pressure on output and employment.

In these circumstances, makers of monetary policy decide the extent to which we should focus on defusing price pressures or on cushioning of output and employment in the short run, in the context of our long-term objectives times, policy-makers may be concerned that expectations of inflation will get built int about wages and prices, become a self-fulfilling prophecy, and result in temporary output and employment.

Countering this threat of inflation with a more restrictive policy could risk small losses of output and employment in the short run but might possible to avoid larger losses later should expectations of higher inflation become e the economy.The press tries to categorize FOMC members as 'hawks' and 'doves.' These labels are an to simplify, in fact oversimplify, the complex choices that each member of the FOMC mus in deciding how to trade off the risk that action, or inaction, on our part will lea heating up to unacceptable levels, as opposed to having an inadequate creation of jo believe that all members of the Committee recognize that the major contribution the Reserve can make to higher standards of living over time is to promote price stability.It is generally thought that monetary policy takes many months to have most of its growth and employment, while of course it has an immediate impact on financial mar Because of the long time frame for effect on the real economy, I believe that it is i policy to look ahead one to two years as it aims at promoting stable prices and a susta growth path, along which the economy is at full potential.

Given that we need to be looking, or 'preemptive,' as it is often put, one potentially important element monetary policy is the forecast or likely outlook for economic growth, unemployment a price level for the next year or two.

Fortunately, as we make monetary policy we h advantage of several forecasts.

The staff of the Board of Governors, private sector and the staffs of the Federal Reserve Banks all make forecasts.

Some individual Govern Reserve Bank Presidents also have considerable experience and expertise in forecasting.To be useful for monetary policy, forecasts of the future health of the economy ne reasonably reliable.

Good forecasts rest on the identification of empirical regularitie confidently relied upon to provide guidance.

Regrettably, some previously reliable e relations have not proven so of late.

As one example, the failure of price inflation t labor markets have become tighter is not consistent with older empirical observations. factors outside of economists' models have provided some surprises, such as the Asian e and financial turmoil and the collapse of oil prices.If forecast relationships are less certain, it becomes more challenging to be 'pree these circumstances, I believe, it is appropriate to put greater weight on incomi determine whether the stance of monetary policy should be changed.

Some of the var relevant in this regard are: 1) the level of unemployment and the rate of job creation of change in wages or prices or early signs of emerging inflation; 3) the rate and com GDP growth (inventory, trade flows, consumption, investment, residential and comme construction, etc.); and 4) international developments.

Economists refer to these va being from the 'real' side of the economy.

Another set of variables to be considered i monetary policy are financial variables, such as money supply, interest rates, excha credit flows and conditions in bank lending or in the debt and equity markets.The last two years, 1997 and 1998, gave an interesting case study of the interplay bet different variables and the degree of forward-looking behavior in the making of monetar From March of 1997 through much of 1998, pleasant surprises in the performance of inf and the general absence of early signs of inflation, and uncertainty about the rela inflation to changes in the level of production, kept the FOMC from tightening.

We tighten despite the economy being beyond most estimates of its potential and despi forecasts of rising inflation.

Put another way, the FOMC could have 'preemptively' ti monetary policy, based on forecasts, but, recognizing the uncertainties about e relationships, chose not to do so.But in the fall of 1998, you may recall, there was concern regarding the performance o markets, especially the bond market and market for commercial paper.

These concerns centered around the fact that corporate borrowers could no longer raise funds in thcommercial paper markets at reasonable prices or, at some times and for some borrowers In this case, we were reasonably confident that constraints on the ability of corp borrow would eventually have a negative effect on their willingness to invest in p capacity and therefore on their ability to provide goods and services and to create job concern was that weakened foreign economies might have adverse consequences for fu domestic activity.

Under those circumstances, the FOMC thought it appropriate to ease a likely significant impact on future domestic spending and growth.Finally, no discussion of monetary policy and financial markets would be complete w reference to the equity markets.

I believe that the Fed cannot target specific leve markets.

However, equity markets have spillover effects into the real economy and hen important signals to policy-makers.

As you know, economists often speak of the 'wealth and econometric modeling indicates that consumers tend to raise the level of their about 2 -to 4 percent of incremental wealth, after two or three years.

Through the wealth effect, equity valuations can and do have an effect on consumption an macroeconomic performance.

Additionally, equity markets are a source of investment ca and valuations in the stock market are one determinant of the cost of capital for Therefore, equity prices have an influence on business fixed investment, alon consumption, the major drivers of our economy.

Finally, equity markets are of interest makers because we have a responsibility for macro-stability.

We have seen in other ec that bubbles and busts in financial markets can create unsettled conditions that i economic activity.

Therefore, while it would be incorrect to say that policy-makers equity markets or that market concerns 'tie the hands' of the Fed, the markets are an consideration in macroeconomic analysis.These are just some of the factors that might go into making monetary policy.

The in part of the job is that the relative importance of these factors - forecasts, current m conditions, financial market conditions and others - is often in flux.

For those w monitor our actions, the good news is that through a reading of FOMC announcements minutes, speeches by Governors and Presidents, and interviews, an observer can get good handle on which variables are uppermost in each policy-maker's mind at any given Often, however, many factors are relevant, and we cannot indicate precisely the relati the FOMC may be applying to them in making policy.

After all, the economy is influenced of the factors I have outlined, and the FOMC's emphasis on specific factors varies ove economic conditions change.

## Outlook for 1999With this general statement of the factors that go into setting monetary policy, let m outlook for 1999.

Recent economic data have been stronger than many had expected.

I appears to many forecasters that real GDP growth for 1998 was 3.5 percent or more on a quarter-to-fourth-quarter basis.

The consensus, as represented by the most recent B Economic Indicators, is that real growth in 1999 will moderate, perhaps to slightl percent, again on a fourth-quarter-to-fourth-quarter basis (nearly 2.5 percent on a ye basis).

This consensus outlook, if accurate, would eventually produce a 'soft landi growth near the economy's potential and inflation remaining low.

The range of foreca compose this so-called consensus is large, perhaps indicating that forecasters are cogn fact that it's not hard to imagine risks to both sides of this scenario.

I should also a repeat of earlier forecasts that growth will moderate, and the economy has surpri forecasters with its resilience.

I can see that 1999 will require a continued high leve for policy-makers.Not surprisingly, many of the forces and uncertainties that seemed to shape so much year's discussion are present in the outlook.

Tight labor markets are putting pressure but competitive markets are limiting pricing leverage and causing profits to be squeez these circumstances, will businesses become more cautious in their spending and hirin Rising stock prices continue to point to strong consumer demand, but valuations are historical standards and one wonders whether this stimulus will remain so strong.

The d in some of the troubled economies of Asia seem to be bottoming out, at least outside but the risk of spreading distress in Latin America creates another element of int uncertainty.Recent events in Brazil have made this concern more evident.

It is now even more import Brazil move as quickly as possible to implement a clearly sustainable fiscal position the confidence of international markets and investors.

The Federal Reserve will con monitor closely international developments and their potential effect on domestic activAt the same time, U.S.

inflation has been contained, at least until recently, by a factors, such as a rising exchange rate for the U.S.

dollar through much of last contained health care costs, and declining prices for oil and other commodities, which to be short-lived.

The ability of businesses to pass on price increases has been con part, by international competition.

Will the restraint on pricing power remain as weaken?

If the latter, at what pace?

Will the special factors I mentioned above co mitigate inflationary pressures arising from labor markets?

Are there other, longer-ter work damping price pressures that we have not yet identified?A new factor that I find most interesting as we start this year is the likely impact of century date change.

As you may know, I am Chairman of the Joint Year 2000 Council, whi a group of financial regulators that has spent the last nine months focusing on the computer problem.

In an international context, the Year 2000 is likely to have differi across different regions.

Here in the United States, my colleague Governor Mike Kel stated that we are likely to see some disruptions to economic activity because of Y problems but the effects are likely to be temporary and quickly reversed.

This outc seems likely to me.

Overseas, the early signs are that Europe has successfully conv computer systems to the euro, but there were some periods early in the transition settlement of some cross-border transactions in Europe did experience end-of-day glitc now important for senior management of major European institutions to turn their atte preparations for the Year 2000.

Asian financial and other business firms, too, sho energy on preparing for the Year 2000 even as they are restoring fundamental fi soundness.

Indeed, the events of the last 18 months have probably distracted their atte this problem.

It is in everyone's interest that we not become complacent as we enter th months before the start of the new millennium.

## ConclusionThe Federal Reserve has an important role to play in our economy.

However, our role economy should be kept in perspective.

We control just a few of the levers that d economy.

We observe consumption, investment and labor market decisions and try to a monetary policy to the signals that we receive so that our nation's economic welfar threatened by inflation or by growth that is below the economy's potential.

However, decisions and actions that you take as consumers and business managers that ult determine the health of the United States economy.

Despite difficult periods, 1998 turbe a very good year because of a mix of private action and economic policy.

I hope that be as good to us all.