Mr. Ferguson gives his views on exercising caution and vigilance in monetary policy in the United States  (Central Bank Articles and Speeches, 9 Jul 98)
Central bank: fed | Type: speech | Date: 1998-07-09

Mr. Ferguson gives his views on exercising caution and vigilance in monetar policy in the United States Remarks by Mr. Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, on the occasion of the Distinguished Speaker Series, held at the Federal Reserve Bank of Atlanta on 9/7/98.

## IntroductionThese

are fascinating times for monetary policy.

As we progress through eighth year of the current economic expansion, economic growth has continued at a robu with unemployment reaching a 28-year low, while inflation has remained remarkably sub To be sure, not all recent developments have been altogether positive, especially consi current situation in Asia.

Nonetheless, the performance of the American economy in rece has exceeded expectations in a rather extraordinary fashion.But recent developments have challenged our understanding of the workings the macroeconomy.

Although the recent surprises of both low unemployment and well-beha inflation have been quite favorable, they have been surprises nonetheless and no reconcilable with each other based on old relationships and our earlier assessmen economy's potential.These developments have increased the uncertainty about the economic outl and about the appropriate response of monetary policy in general to new developments.

I take this opportunity to discuss some implications of this increased uncertainty for th monetary policy.Before starting, let me remind you that these views are personal and d necessarily reflect the views of other members of the FOMC or the Board of Governors.

## Objectives and Strategy for Monetary PolicyTo evaluate the proper strategy for monetary policy, we must first underst Federal

Reserve's policy objectives and then recognize the parameters within which operates in attaining these objectives.The long-run goal of monetary policy is straightforward.

The Federal Reserv mandates that we promote price stability and maximum employment.

Sometimes this du objective is misunderstood, with the misconception that these inflation and employmen cannot be attained simultaneously -- that there is a tradeoff in the long run between other.

It is worthwhile repeating what I am sure all of you already understand well: t goals of price stability and maximum employment are not mutually exclusive.

Not so lon mainstream macroeconomists thought that employment and growth were by and larg independent of inflation in the long run.

But the evidence accumulating in the 1990s suggest that low inflation contributes to real economic performance in ways not fully a before.

If anything, our approach to price stability, by reducing uncertainty and makin savings and investment decisions easier, seems to have enhanced the growth of productiv GDP, and employment.This indirect benefit, of course, reinforces the price stability goal.

It inflation that monetary policy determines in the long run, and this means that price s straightforward way is elevated to the status of the primary long-run goal of monetary pWhere a tradeoff can appear, and this I think is the source of occasional co is over shorter periods.

In the shorter run, inflation may rise and fall depending o economy is operating relative to its potential.

When the economy has become overextende output exceeding the economy's potential, employment beyond sustainable norms, production surpassing normal capacity limits, then prices have tended to increase a faster rate.

Likewise, when aggregate demand has fallen short of the economy's po inflation has tended to fall.And this is where the short-run setting of monetary policy comes into pl moving short-term interest rates, monetary policy can affect other financial condition up exerting a substantial influence on aggregate demand.

Decisions by businesses investment and by households about housing and consumption are altered by changes in i rates and other credit conditions.

Monetary policy also can indirectly impinge up components of aggregate demand.

As a result, in the shorter run, monetary policy can important role in stabilizing the economy from undesired fluctuations in economic act inflation.

The strategy for monetary policy geared towards these shorter-run concern briefly described.

It is to restrict monetary conditions when the economy seems on th becoming overheated and inflation is threatening and ease monetary conditions when si weakness in demand appear on the horizon.

But it is important that we pursue these s goals keeping in mind our primary long-run goal of price stability.Of course, other forces besides the state of the economy relative to its can influence inflation in the short run.

Even prior to the anomalous experience of re which I will discuss later in detail, supply shocks, such as a sudden hike in oil dramatically affected inflation.

Such forces can also cause short-term fluctuations in t that are, at least in part, beyond the control of monetary policy.

However, active s policy may still have a role to play as a buffer, helping the economy to absorb such d in the short run, while counteracting any persistent deviations from price stability.But monetary policy operates with a long lag, with a policy change exhib material effects on the economy (excluding the immediate impact on financial markets several quarters after its implementation.

By some estimates it may be almost a year brunt of the effect of an interest rate change is felt on aggregate demand, although t appears sooner in some sectors of the economy than in others.

And it may generally tak still for a policy change to alter the course of inflation.Consequently, active stabilization policy is most successful when pre-emptive, responding to early warning signals or forecasts of unfavorable developm the inflation and employment fronts.

In this regard, by identifying past regul relationships among economic variables and understanding their conceptual underpinning can use the most recent economic data to update forecasts of where the economy is Based on these forecasts we can then take steps to adjust the stance of monetary necessary, in accordance with our objectives.

## Uncertainties: Old and newTo be useful for monetary policy, forecasts of the future health of the e need to be reasonably reliable.

Good forecasts rest on theories about empirical regul can be confidently relied upon to provide guidance.Regrettably, accepted theories are found lacking at times, empirical models down, and forecasts based on them prove unusually inaccurate.

If monetary policy were to follow guidelines based on past regularities that are increasingly failing to reflect it would unintentionally introduce undesirable gyrations in the economy.

Thus, hei uncertainties regarding the workings of the economy pose an additional source of stress design.To ascertain the appropriate framework for policy analysis we must first be of some key sources of uncertainty.

In recent years, traditional views of the econom have been most challenged by the phenomenon of declining inflation despite increasing t in labor markets as evidenced by reductions in the unemployment rate to its lowest almost three decades.

Many believe that there is an unemployment rate, the non-acce inflation rate of unemployment (the 'NAIRU'), that would be consistent with a stable i rate, once other short-run influences on inflation dissipate.

To these economists, pressures tend to increase when unemployment remains below the NAIRU and tend to decre when unemployment stays above the NAIRU.

For many years proponents of this view considered 6 percent a reasonable estimate of the NAIRU.

Since 1995, however, unemployment rate has been below this level, and substantially below of late, while inf continued to progress toward our price-stability objective.

In response, over the past many observers have revised their estimates of the NAIRU down by half a percentage po more.

Yet considerable uncertainty remains about the confidence with which the new est can be relied upon for evaluating inflationary pressures.The NAIRU never was measured with precision; statistical inference has alw provided a distribution of likely values around a point estimate.

And several factors, the demographic composition of the labor force, have long been known to introduce syst variation in its value over time.

Nonetheless, the uncertainties about how structural be changing the NAIRU seem unusually large at present and cannot be ignored.

And for the present uncertainties have called into further question the basic usefulness of th at least of a point estimate held with any confidence.A related uncertainty concerns the underlying trend growth of labor produc Until fairly recently, this trend had seemed to have been about constant since the mid there are many that believe that a pickup may have occurred in the last few years, an productivity trend would help to explain the unexpectedly favorable econ growth-unemployment-inflation nexus in recent years.

Unfortunately, much as with the NA our understanding of the forces that drive the productivity trend is less than perfect. investment boom of the current expansion has raised the amount of capital for each wor contributed to an increase in labor productivity, and it may be that advancing tech making the capital stock and workforce more productive.

However, some of the recent pic productivity is the normal response to the faster output growth of late, so the degr there is a new higher trend remains an open question.Another difficulty in assessing the current amount of slack in the economy, third uncertainty, concerns the divergent patterns in alternative measures of exces Capacity utilization in manufacturing and the rate of unemployment have historically together over the cycle.

Unexpectedly, they have diverged in the current expansion, in surge in investment has kept capacity utilization in the manufacturing sector near i average while labor markets have become tighter and tighter.Recent developments in South-East Asia also have contributed to uncerta about the current monetary policy environment.

One place where the effect of the crisi felt is in the prices of primary commodities.

Since such commodities are traded o markets, lower demand from Asia is reflected in lower prices world-wide, which bene producers that use commodities as inputs.

This development serves as a short-run b positive supply shock, to the US economy, one that also helps contain inflationary pre does the more general decline in import prices as the US dollar appreciates.But the Asian crisis can be expected to continue to have an adverse impa trade-sensitive industries.

Some evidence of a deterioration of our trade balance with economies has already appeared.

With little historical guidance to draw from, h considerable uncertainty prevails regarding the extent to which the present Asian situ contribute to slower US growth as well as the timing of such a slowdown.

For instance, expectations that the crisis would have contributed to a slowdown in economic activit this year, the economy's growth in the first quarter of this year exceeded even the performance of 1997.

However, more recent data reflecting developments in the second q including survey information, do give some evidence of a slowing in the overall ec especially the manufacturing sector, perhaps due to Asian financial turmoil.

As yo suspect, we will continue to watch incoming data quite closely as the year progresses better handle on this situation.To be sure, uncertainties such as these have loomed large at times in the p we can learn much from those experiences.

The uncertainties faced by policymakers duri 1970s about the economy's potential provide an enlightening perspective on the p situation.Following a period of rapid productivity gains during the 1950s and 1960s economy's performance during the 1970s appeared out of line with previous experience.

S in 1973, in particular, inflation rose more than expected, at times considerably' economic growth tended to disappoint expectations for a number of years.

At first, it reasonable to assume that the observed productivity'slowdown was temporary.

Reflectin assumption, for instance, the Council of Economic Advisors gave a 4 percent estim potential output growth in the 1974 Economic Report of the President, as would hav consistent with the earlier trends.Increased uncertainty regarding this estimate was evident in the 1975 and Reports, but not until 1977 was the point estimate of potential output growth revised to 3.6 percent.

As the economy's performance continued to disappoint, further dow revisions followed, to 3 percent in 1979 and to 2.5 percent to close the decade in 1 several years after the fact was a trend break in productivity recognized as likely to h in 1973.

And even today our understanding of the forces contributing to the slowdown entirely satisfactory.As inflation accelerated as the 1970s continued, critics blamed the F Reserve's operating procedures for placing too little weight on money growth and too m interest rates in the conduct of policy.

In response, the Federal Reserve in late 197 emphasis on monetary growth targets.

But the FOMC abandoned the strict regime of targ M1 through reserve quantities in 1982 once evidence accumulated that the character demand had been altered by the spread of interest-bearing NOW accounts.

Later, the brea behavior of M2 velocity during the early 1990s from its earlier historical pattern u indicator properties of that aggregate as well.

In 1993, the FOMC de-emphasized the ro broader aggregates in policymaking.

Despite recent tentative signs that the relationsh M2 velocity and the cost of holding M2 assets may be returning to its earlier histori uncertainty persists regarding the continued stability of this relationship.In terms of the performance of inflation and unemployment, the experience o past few years has not been unlike a mirror image of the 1970s.

While the consequences more pleasant, unexpectedly low inflation and unemployment do raise some complicated i for monetary policy.

## Strategy in Uncertain Times: Caution and VigilanceThis account of the sources of uncertainty that we face in designing the course of monetary policy should not leave the impression that our task is so dauntin policy waters are unnavigable.

But such an account does serve a valuable purpose in re us that in designing policy we should recognize our ignorance as well as trust our knowlFor instance, we need to recognize the difficulties of inferring the true s the economy by interpreting incoming data.

How do we know whether unexpected developmen are just temporary moves away from stable longer-run relationships or are manifesta changes in the underlying economic structure?

In many cases this judgment is difficult with much confidence until considerably after the fact.

In the meantime, we must bear that the statistical relationships we work with are only loose approximations of u reality, which is constantly evolving, at least to some extent, in response to technology, consumer preferences, and government policies.

Our vision is always obstru some haze.

But sometimes the picture is clearer than at other times.Because of these difficulties in assessing the situation, a balanced jud required in evaluating whether historical regularities are indeed changing significan not just subject to temporary aberrations.

I believe that one should guard against hol truths that may no longer be valid, but one should also be cautious about decla permanent changes have occurred, for there are too many examples of proclaimed 'new that did not in fact come to pass.

Erroneously dismissing the continued validity of could result in bad policy just as easily as failing to correctly recognize new re change occurs.What should be done when uncertainties seem particularly acute?

When w suspect that our understanding of the macroeconomic environment has deteriorated appre as evidenced by strings of surprises difficult to reconcile with our earlier beliefs, appropriate response is to rely less upon the future predicted by the increasingly un gauges and more upon inferences from the more recent past, weighing incoming data heavily relative to more distant data in trying to discern the new environment.Even for those of us who take this more pragmatic approach, there are chall Recent data, on which our understanding of the new reality is based, are subject to r more reliable or more complete sources become available.

Moreover, there are often indices for measuring underlying economic circumstances, requiring one to consider measures simultaneously.In the current context, the considerable uncertainty regarding our pr estimates of the capacity of the economy and its sustainable rate of growth in my suggest the need to downplay forecasts of inflation based on those earlier assessm necessity, I believe heightened reliance needs to be placed on more recent observa inflation and costs for inferring future inflationary pressures.

We are not precluded pre-emptively if new information were to tip the balance of risks in the outlook towa inflation, but are naturally a little more cautious in acting on forecasts as long uncertainty persists.As a consequence, the lead times for pre-emptive action are likely to be And, in my judgment, we may have to rely more on measures other than apparent excess de to get reliable indications of pending changes in inflationary pressures.

For instance costs may have to be watched especially closely, and the rate of unemployment perha closely than we are used to.

But a pattern of unsustainable growth characterize continuously declining unemployment rate still may increasingly suggest greater infla Even if the limits of the economy's growth potential have moved, there are still limit to be respected.The increased uncertainty also implies that continued strong economic gr with low inflation is not outside the realm of possibility, and by adopting a caut posture we may learn more clearly if that possibility is likely or remote.

It should be creation of new jobs, by itself, is a welcomed development.

There are benefits to al skill building that occurs on the job.

It is important, however, that these jobs be sustainable growth, and not the result of excesses and imbalances.However, caution can be excessive, running the risk that inflation may i reappear and require a more wrenching readjustment than if it had been anticipated.

Un should not induce paralysis.

We need to be willing to move, even if cautiously, knowing may have to reverse our action if subsequent developments differ from our expect Moreover, we must be willing to act forcefully if information suggesting a threat to o price stability becomes available.

Inflation is an insidious tax on all of our citi impacting low and moderate-income citizens more than others because there are fewer available to them to protect their income and their assets against an erosion of purcha If evidence of an incipient rise in inflation were to appear, decisive action would counterweight to minimize the building of a temporary inflationary aberration into expectations, which could be disruptive.

And this is why caution and vigilance go hand under these circumstances of increased uncertainty.Moreover, it is at uncertain times such as these that the wisdom underlyi institutional structure of the FOMC becomes most apparent.

A committee with br representation can bring a variety of perspectives and analyses to bear on difficul problems.

In addition, the real-time reports the presidents of the Federal Reserve B from their districts are especially valuable in the decision-making process at times because they afford a contemporaneous sense of what is going on in the economy.

Such diof information sources becomes particularly useful when our earlier assessment of the e potential has been drawn into question by surprises, even pleasant ones.

## ConclusionA string of favorable surprises yielding strong growth, high employment an inflation is by far the most pleasant environment under which to come to the realizati understanding of the workings of our complex economy is not infallible.

A sound economy subdued inflation makes dealing with the greater uncertainty much easier indeed!The Federal Reserve has an important trust to help safeguard the health United States economy.

What we should do in the face of some uncertainty is to act ca while remaining vigilant, to take measured steps when necessary, and to adjust to the unforeseen change.

In this way we will raise the odds of achieving our goals of stable maximum employment, not only providing benefits to Americans, but also a stable anchor volatile world economy.