Mr Gramlich gives his views on stabilization policy strategy  (Central Bank Articles and Speeches, 22 Apr 1999)
Central bank: fed | Type: speech | Date: 1999-04-22

## Mr Gramlich gives his views on stabilization policy strategyRemarks by Mr Edward M Gramlich, a member of the Board of Governors of the US Federal Reser System, before the Wharton Public Policy Forum Series in Philadelphia, Pennsylvania on 22 1999. *Former

Federal Reserve Chairman William McChesney Martin had a famous line about how t conduct monetary policy: 'You have to take away the punch bowl when the party is warming up.While that may seem straightforward guidance (if not always easy politically!), it is not practice.

Considering the broader question of stabilization policy, there are two sets of a could take away the punch bowl, monetary policymakers or fiscal policymakers.

Which should, what conditions?

Another question involves the heat - exactly how warm should the party third involves timing - should the bowl be taken away slightly in advance of when the expected to warm up, or once it is clear that the party really has warmed up?Economists and others have debated these questions of stabilization policy strategy for many issues still unresolved.

In this talk I take the opportunity to give my own views.

## Fiscal and Monetary Policy in TheoryIn domestic macroeconomic theory either fiscal or monetary policy can be used to stabilize o employment around their trend levels, and hence prevent booms or recessions from getting hand.

When this domestic model is broadened to open the economy to international trade and flows, this conclusion no longer holds but the results depend on the flexibility of t exchange rate.Suppose first that a nation's exchange rate is flexible, which means that the central ba does not intervene in currency markets and allows private markets to set the value of its response to an incipient recession, expansionary fiscal policy will raise interest r international funds, drive up the value of the nation's currency, and reduce net exports small country model, this process will continue until the fiscal expansion has no impact a nation's output and is ineffective as a stabilization policy measure.

In less strict international link greatly reduces the expansionary impact of the fiscal change and sti generally unproductive to use fiscal policy for stabilization purposes.By contrast, the impact of a monetary expansion is enhanced by flexible exchange rates.

M expansion will lower interest rates, lower the value of the nation's currency, raise net generally have a more stimulatory impact on output and employment than it would have wi changing exchange rates.

In this exchange regime it makes sense for a country to rely on policy as its primary stabilization tool and let fiscal policy influence the nation's overal might seem like this assignment of responsibilities would consign fiscal policy to oblivion not so.

In the long run the most important policy a country has to influence its long standards is fiscal policy, operating through just this influence on national saving.Interestingly, these conclusions are totally inverted if a country is following a fixed policy, which means that its central bank intervenes in markets to set the value of its curr variety of exchange arrangements fall into this category - a gold standard, a currenc dollarization, and exchange rate zones would all be considered as fixed exchange rate re these purposes.

In these cases, central bank policy (if indeed there is a domestic centra must be dedicated to setting the exchange rate and cannot be used to stabilize output and e* Mr Gramlich presented an identical speech at the Jerome Levy Economics Institute, Bard Co Annandale-on-the-Hudson, New York on 23 April 1999.Interest rates cannot deviate from the level necessary to determine the pre-set exchange rate. policy becomes the pre-eminent stabilization tool by necessity.

As expansionary fiscal po threatens to raise interest rates and drive up the exchange rate, the process induces a rise in supply to preserve the fixed interest and exchange rates, accommodating a larger rise in output would be the case in a closed economy.

For this reason the impact of fiscal policy on the econo even greater than it would be in a closed economy.

## Timing IssuesSince stabilization policy is dedicated to mitigating business cycles that can be of relative duration, timing also matters in developing a stabilization strategy.Fiscal policy contains automatic stabilizers - basically tax revenues that rise in booms and recessions, hence stabilizing overall spending demands.

These stabilizers cut the amplitude of in output and employment, but they do not eliminate the cycles.

To eliminate cycles altoget policymakers must act in time for their policies to offset incipient booms or recessions.

The a postwar recession in the United States has been slightly less than a year long, which narrows th horizon for what are known as discretionary policies considerably.Two types of lags can cause problems, inside lags and outside lags.

Inside lags involve the between the need for action and the action, outside lags the time between policy action and its on the economy.An inevitable component of the inside lag is simply the time it takes policymakers, whether on monetary or fiscal side, to recognize shifts in economic indicators.

Policymakers can rel forecasting models, but these can be sufficiently wide of the mark that policymakers often pref see real world data before they act.

In most countries first reports on economic data come out a month after the quarter or month for which the data are reported, but these first reports are s considerable short run noise, often revised substantially, and in fact are themselves often lit than forecasts.

If there were a sharp but unexpected change in the pace of activity, policym would probably not have a good statistical idea of this change until a month or more after the faThe other component of the inside lag is the time between recognition and action.

For monet policy this time period is usually relatively short.

Central bank monetary policy committees gen meet at two to six weeks' intervals throughout the year.

Normally these committees respond changes in economic information at the first meeting after the fact, sometimes the second.

I change were to be extreme, most committees have the ability to make inter-meeting changes in poli Summing the two components, for monetary policy the inside lag is probably on the order of quarter, less if the monetary authorities are prepared to act on the basis of forecasts.For fiscal policy, the time between recognition and action is long in parliamentary count seemingly interminable in the United States.

In the U.S. if the need for action is recognized in of the year, the President's budget message can reflect that.

But the budget message, which come in early February, lays the groundwork for Congressional debate on the budget, which most of time is not quite completed by the time the fiscal year starts in October.

Hence, at best this co of the inside lag for U.S. discretionary fiscal policy is about a year, already longer than th recession, and the lag can be substantially longer than that if the relevant action is at all co In parliamentary countries it is possible to act faster, but even in these countries there substantial procedural bottlenecks to altering a budget that has already been submitted.

Most time even parliamentary countries will wait for the next budget cycle to incorporate new discreti fiscal policies.The second lag is what is known as the outside lag - the time between the action being taken and observable impact on the real economy.

For monetary policy this lag was formerly thought to be l- on the order of nine months to a year in most developed countries.

Monetary polic traditionally operated through changes in short term interest rates, which then change long with some lag, and real spending with some further lag.

But there are reasons why this lag speeded up in recent years - credit markets have now become more forward-looking and asset v have a sizeable and relatively quick impact on spending through the wealth effect.

For fis tax changes that alter withholding probably operate within a quarter or two, though those spending such as for construction can take many years to plan routes, purchase land, let co the like.The upshot of all of this is that it does seem possible to use monetary policy as a stabilization instrument.

Because of its relatively short inside lag and possibly reduced monetary actions are likely to have some effects within a half-year of the recognition of th change, perhaps even faster when authorities act on the basis of forecasts.

But what is monetary policy seems basically impossible for discretionary fiscal policy.

When the extra piece of the inside lag is added on, it is hard to escape the conclusion that fiscal policy for stabilization purposes only in the deepest and longest of recessions.

If an economy h exchange rates, no harm is done by this conclusion, because the economics of flexible excha suggest that monetary policy is best used for stabilization and fiscal policy for long-ter any case.

If the economy operates under fixed exchange rates, the lesson here is that di fiscal policy should generally only be used to deal with long run needs.

The only stabilization force in these economies is then the automatic fiscal stabilizers - indeed, t potential problem for countries on fixed exchange rates.

## Fiscal Policy in the United StatesTurning now from the general to the specific, I examine these issues in more detail for States.

The first point to make is that for nearly three decades the U.S. has operated u exchange rates.

Neither the Federal Reserve nor the Treasury typically intervenes in markets to try to influence exchange rates.

This means both that monetary policy is free to stabilization needs, and should be able to do that effectively.

Fiscal policy, on the othe devoted to longer run considerations.The second salient point is that for two decades American fiscal policy has been hamstrun national saving rates.

Much attention lately has been devoted to the low rate of personal s United States - the rate that just recently dipped below zero.

But while personal savi important component of national saving, it is only one component.

A country with high b and/or government saving can provide plenty of resources for new capital investment, even personal saving.

The overall national saving rate, based on a summation of saving in all se economy, is the key indicator of how much a country is providing for its future.

Thr accounting identity, it can be shown that this overall national saving rate equals output and public consumption, perhaps an easier way to think about the concept.This overall rate of net national saving in the United States averaged 11.4 percent of product from 1950 to 1970, but then fell to 6.1 percent in the 1980s and to 5.2 percent in the long run this drop is bound to show up in a reduced growth path for per capita output. the United States is on the verge of a dramatic rise in potential entitlement spendin particularly poor time for such a sharp drop.But national saving is a long run concept, and the fact that the U.S. rate has fallen does make for economic problems.

Indeed, Alan Greenspan has recently attributed much favorable economic performance to significant capital gains on wealth.

These wealth gains are not c income from production but they raise consumption, implying a drop in national saving.

Th can raise investment, implying an investment boom financed by the saving of foreigners.

O the current account balance of payments deficit implied by the rise in investment and dropmay not be sustainable.

Nor might the capital gains persist.

If a nation could consistently co large-scale capital gains and foreign capital inflows, it would not need as much saving.

But c gains come and go, and inflows may not be sustainable.

To provide a strong and consistent basis future growth, a developed nation will generally need to do its own saving.While there are a number of policy changes that could in principle raise national saving, the tr true method is through contractionary fiscal policy.

Higher budget surpluses imply lower pub and/or private consumption and permit more funds to be devoted to capital investment.

Making t same point from another perspective, higher surpluses retire some of the outstanding public deb free up more funds for investment.

In this regard, the recent return of overall budget surpluses welcome, and it has already begun to raise national saving.

The overall net national saving rate budget surplus year of 1998 was 7.5 percent, significantly above the decade average for the 19 despite the fact that the personal saving rate fell.Since contractionary fiscal policy is at the heart of the national saving issue, it is natural budget procedures that promote saving.

One, used by many national governments and most American states, is the convention of separating accounts into a current and capital budget.

There normally be restrictions against borrowing on current account, but not against borrowing to fi capital investment.

While there have been arguments that the U.S. federal government should us capital budget, such a change is unlikely to help promote saving in the present environment. problem is that the federal government does remarkably little direct investment spending, so current budget deficit or surplus would differ little from the overall deficit or surplus.

An present time the main policy issue is that the current budget is likely to run a surplus, in w restrictions against current deficit spending would be irrelevant.Countries that have come upon large petroleum resources have hit on another contractionary budg procedure.

They have often devoted the resources to a special trust fund, insuring that the income does not translate to a rise in consumption.

For many years the United States has ha budgetary device that operates in a similar manner, involving its Social Security trust fund. generally considered within the federal budget, Social Security has operated as a budget with budget - being financed so that current and future payroll tax revenues are sufficient to cove current and future benefits scheduled under present law, looking ahead for the next 75 years.

S times in the past two decades this long run actuarial budget constraint for Social Security ha responsible for cuts in future benefits to bring the forward-looking Social Security budget in term actuarial balance.

Many have argued for strengthening this separation by removing Soci Security altogether from the federal government's budget.In his proposed budget for year 2000 and beyond, President Clinton came up with another way t promote national saving, ironically by reducing the segmentation between Social Security and the of the budget.

He proposed making general revenue transfers out of the anticipated general bu surplus and to the Social Security trust fund.

The idea is similar to the special trust fund emp oil producing countries.

While such a move may make for more responsible general budgets, one wonders what happens on the other side of the transfer.

Since Social Security's long term bu constraint has been responsible for significant forward benefit cuts, it may not be as feasibl easy, to make these cuts in future benefits if there is now the tradition of making general transfers to fill Social Security's revenue gaps.

What may encourage national saving in one bu may discourage it in another.While these budget structures are interesting and potentially worth exploring, my own view is they are not likely to work in the United States.

To me, a capital budget is unlikely to so problems and the arrangements involving the Social Security trust fund are best left alone.

In t I believe that the way to promote the desirable fiscal goal of raising national saving is simply for it.

Paying down the national debt reduces interest costs and adds to long term fiscal fle The implicit rise in saving also generates new funds for raising investment, adding skilled joraising living standards in the long run.

One would hope that these benefits could be defen own right.

## Monetary PolicyPreviously

we saw that it often makes sense to use monetary policy for stabilization Precisely how is this to be done?The textbook way of thinking about monetary policy still runs in terms of quantities.

The c operates so that some measure of the money stock or liquidity grows in some relation to th growth in real output.

But the sharp changes in money velocity in the early 1990s have chan economists and central bankers from being money quantity watchers to being interest rate w Rather than trying to guess the optimal rate of monetary expansion, many analysts now focus on interest rates - should they be lower, higher, or the same?John Taylor has worked out a simple way of thinking about this question.

Under what is know Taylor Rule, monetary authorities first determine an equilibrium level of a target interest real federal funds rate.

The authorities can then adjust the actual funds rate relative to rate depending on inflation relative to its target, and unemployment relative to its t example, inflation were above its target and unemployment were close to its target, authorities would raise the real funds rate above its equilibrium value.While Taylor's Rule provides a useful framework for policymakers to think about policy, operating rule it too is beginning to encounter empirical difficulties.

The Taylor Rule req point estimates of the equilibrium real funds rate and targets for inflation and unemployme these estimates is easily come by.

The equilibrium real funds rate is difficult to estim change with productivity growth and national saving rates.

On the inflation side, there are different price indices, any of which could be used as a target.

All of these indices can stories about whether or not inflation is heating up, and there are a number of measurement with the Consumer Price Index, the most widely watched of these measures.

On the unemploy side, the fear that inflation will accelerate if unemployment drops below an estimated natu at this point proven groundless - inflation has not accelerated when unemployment has rema a zone that would have been felt to be well below the estimated natural rate.

Over this r the Taylor Rule would have called for higher federal funds rates to raise unemployment, change that may well prove to be unwarranted when the final history is written.One ad hoc remedy would be to drop the unemployment term, the one that seems to be giving t from the Taylor Rule.

Less drastically, the policy weight on the inflation term might be rai on the unemployment term lowered.

In these cases the Taylor Rule comes very close to an in targeting rule, which indeed many economists have also advocated.But there is uncertainty about more than the unemployment target, and there may be an eve way to modify the Taylor Rule.

Whenever there is doubt about the point estimates of the eq funds rate, the inflation target, or the unemployment target, the Taylor Rule can be con change rule.

If levels of inflation and unemployment seem to be at least within their tar not at unknown point estimates of the target, monetary policy can just try to keep inf unemployment in these desirable bands.

Policy would respond only when movements in the econ threaten to take inflation and/or unemployment out of their preferred bands.

Solving a stan of the macro-economy, such a policy would effectively convert monetary policy into what mi called 'speed limit' form, where policy tries to insure that aggregate demand grows at r expected rate of increase of aggregate supply, which increase can be more easily predicted.This version of the Taylor Rule goes back to the spirit of Martin's initial remark, where t authority is happy with the cocktail party temperature at present but moves against anyincreases its warmth.

Should demand growth threaten to outrun supply growth (the party to warm up the seeds of accelerating inflation may be planted and monetary policy should curb the growth demand by raising interest rates.

Should demand growth threaten to fall behind supply growth, ri unemployment is probably in the works, and monetary policy should try to boost the growth i demand by lowering interest rates.

As long as inflation and unemployment remain in the acceptab band, this change version of the rule simply tries to maintain a good thing, without requiring quantification of inflation and unemployment policy goals.This approach has not addressed the question of supply shocks, which are dealt with in the gen formulation of Taylor's Rule.

But one can incorporate supply shocks into the change rule as wel there are temporary supply shocks that do not seem likely to be incorporated into the broader inf process, they should be ignored.

If there are positive or negative shocks that do seem likely incorporated, the change rule may not work well, and one may have to go back to the general form the rule.

## Policy StrategiesThis

all amounts to what might be considered a stabilization policy strategy.

Given the fle exchange rate regime, fiscal policy should be used to influence overall national saving, which lower than it has been for most of the postwar period for the United States.

I personally would for a rise in national saving, especially in view of the likely increase in future government en spending.

But I would not argue for any of the recently suggested changes in budget procedures are alleged to help in this process.On the monetary side, authorities should try to stabilize the economy without anticipating help fiscal policy.

Generally this would involve following the dictates of the Taylor Rule, assumin one can choose the equilibrium real funds rate and target values for inflation and unemploymen not, and if both inflation and unemployment seem to be safely within their target bands, this could be simplified to a change form - in which interest rates are used to keep the growth aggregate demand near the more easily predictable growth in aggregate supply.