Timothy F Geithner: Uncertainty and transparency in the conduct of monetary
policy
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Financial Services Leadership Forum Breakfast, New York City, 31 May
2006.
* * *
At the Jackson Hole Symposium in 2003, Alan Greenspan remarked that "uncertainty is not just an
important feature of the monetary policy landscape; it is the defining characteristic of that landscape."
Historically, this pervasive uncertainty was associated with a tendency toward opacity on the part of
central bankers. But in recent years we've seen a rather dramatic reversal in this tendency as central
bankers have come to recognize the potentially valuable role that communication with financial
markets and the general public can play in the achievement of monetary policy goals.
While transparency has emerged as one of the hallmarks of modern central banking, so too has an
appreciation for the challenge of communicating about policy under uncertainty. This challenge can be
substantial. It means conveying not only the most likely trajectory for key economic variables, but also
the uncertainty around that trajectory and perhaps some indication of how policy might react under the
myriad ways that the uncertainty could be resolved. I want to devote my remarks today to exploring
what it means, and what it does not mean, for a central bank to communicate in an effective way about
policy in the face of uncertainty.
The issue of communication is particularly relevant in the current economic environment. For much of
the past three years, financial markets have reflected a high degree of certainty about the near-term
outlook for monetary policy in the United States. Market expectations in the weeks preceding each of
the last 16 Federal Open Market Committee (FOMC) meetings attached a probability close to one that
the FOMC would raise the target for the federal funds rate by 25 basis points. Also, there was very
little probability attached to inter-meeting moves over this period, or to moves in increments larger than
25 basis points. And, although market expectations about how far the FOMC would ultimately move
were revised significantly over the course of this period as the economic outlook was revised, these
changes occurred without the Committee needing to deviate from the near-term path.
This period of unusual certainty in the path of the fed funds rate was the result of a confluence of
factors. When the Committee first moved to tighten policy in June 2004, the fed funds rate was at the
historic low of 1 percent, and it was clear that policy would have to move a substantial distance to get
back within the range of plausible estimates of the neutral rate. Over the course of the following
months the incoming data tended to reinforce the case for a progressive move up in the target rate.
And, the Committee made a conscious decision to signal that in view of the likely path of growth and
inflation further tightening of monetary policy was necessary and could be achieved at a relatively
gradual pace.
We are now in the process of emerging from this rather exceptional period, and this provides us with
an interesting context in which to reflect on uncertainty and how it affects the conduct of monetary
policy and communications about monetary policy.
The degree of confidence in the sign and shape of the near-term path of the fed funds rate we've seen
in recent years is unlikely to be a common feature of monetary policy in the United States or in other
countries. The simple reason for this is that the economic circumstances that precipitated the policy
were also not typical. There are likely to be times when incoming data deviates substantially and
persistently from our forecasts. In those situations, policymakers have to examine whether they have
significantly misestimated certain fundamental features of the economy, such as the NAIRU or the
trend productivity growth rate, that might alter the appropriate course of monetary policy.
Central banks everywhere conduct policy in a state of limited knowledge about the economy and how
best to achieve their objectives. The sources of uncertainty they confront are many and varied.
Sometimes, what we think we know about how the economy works turns out to be wrong, either
because certain features of the economy have changed, or because our understanding was not right
in the first place. It was once widely held that monetary policy could achieve somewhat lower rates of
unemployment by allowing somewhat higher rates of inflation, and that it could do this without risking a
substantial acceleration of inflation. This view proved to be mistaken because it did not correctly
account for the role inflation expectations played in inflation dynamics.
Economic concepts that are critical to our understanding of the economy may be difficult or impossible
to capture in practice. One such concept is the neutral or equilibrium interest rate, which is the rate
that, if sustained over some period of time, is likely to be consistent with an economy growing at
potential with low inflation. Plausible estimates for the prevailing level of this rate have a range of at
least 100 basis points, and the center of the estimates tends to move around quite a bit.
Another concept that is difficult to estimate precisely is the economy's potential, or sustainable, growth
rate. The acceleration in productivity growth in the United States in the late 1990s, for example, led us
to revise our estimates of how fast the economy was likely to be able to grow at that time without
undermining price stability.
We also face considerable ignorance about the precise channels through which policy actions
ultimately affect the economy, as well as how long those effects will take to show up and how large
they will be when they do show up. As you would expect, this makes it difficult to assess in advance,
or even in real time, the amount of loosening or tightening that is likely to be necessary to achieve the
goals of central banks.
Even if we had precise knowledge of key economic relationships, our ability to assess economic
conditions in real time would be impeded by data limitations. Though most modern central banks
implicitly or explicitly target some measure of inflation, the host of issues surrounding the proper
definition and measurement of inflation for policy purposes is daunting. In general, most economic
data are subject to sampling error and so cannot simply be taken at face value. Also, many of the
series we rely on are subject to revision as more or better information becomes available, and
potentially can even be redefined in a way that makes the history of the series less useful for
interpreting current movements. Finally, data are often reported with a significant enough delay to limit
their use as a read on current conditions.
But, even if we knew the model and data with certainty, it is impossible to perfectly predict the
evolution of factors that are largely beyond the influence of current monetary policy but that would
likely affect our policy today if we knew for sure how they would look tomorrow. One way to say this is
that we simply cannot know what types of "shocks" are likely to hit the economy or when they will hit.
And even as they impact the economy, the appropriate policy response may not be obvious because it
may be difficult to assess in real time the probable duration of the shock and whether it is demand
driven or supply driven.
Even at a one-year horizon, which for policy purposes is not a very long time, there is considerable
uncertainty surrounding forecasts of GDP growth. For example, the Survey of Professional
Forecasters reports that on average 50 economists attach a 90 percent probability to an outcome for
real GDP growth for 2007 that ranges from 1.0 percent to 5.0 percent. The width of this band of
confidence or uncertainty is similar to that in the published forecasts of many central banks.
The types of fundamental uncertainty I just reviewed are always present, but their impact on the
appropriate near-term trajectory of rates, and hence on the degree of confidence the central bank can
convey about that trajectory, may vary substantially over time.
I want to mention a few other concrete examples of the uncertainty we currently face. The latest wave
of global economic integration has influenced inflation and output dynamics around the world in ways
that may be hard to understand fully in real time. Technological progress, along with the transition to
greater labor force participation in emerging and developing economies has probably served to keep
inflation low in many other countries and has served to increase the rate of growth in potential output
globally. But the rapid growth in the market sectors of emerging and developing economies may also
contribute to more rapid growth in global demand and inflation pressures. This changing configuration
of world markets complicates the task of forecasting inflation and output within national economies.
Energy prices have surprised us over the past few years, in terms of the extent of the rise in prices,
the increase in volatility, and the limited negative effects to date on global economic growth. Our
capacity to project future energy prices has proven to be very limited, as has our ability to convincingly
ascertain the extent to which temporary supply factors, rather than an unrecognized strength in global
demand, accounts for the energy price trajectory we've witnessed recently. The consequences of
these limits to our knowledge may be even greater given the extent of the price increases already
experienced.
The unprecedented level of the U.S. current account deficit and dramatic rise in U.S. indebtedness
adds to the normal degree of uncertainty that surrounds any medium-term forecast because of the
dynamics that could accompany the path to a more sustainable pattern of capital flows.
The process of adjustment that appears to be underway in the U.S. housing market, occurring as it is
after a sustained and very substantial decline in the household savings rate, provides more than the
usual challenge in predicting the future strength of consumer spending.
It is also hard to assess the degree to which the current constellation of global monetary conditions
has influenced the behavior of long-term interest rates. This makes it harder to assess the
appropriateness of the current stance of monetary policy. And it may also mask some of the pressures
on risk premiums we might expect to see given the deterioration of the U.S. long-term fiscal situation
and the magnitude of the U.S. current account imbalance.
In reviewing these dimensions of uncertainty, I want to emphasize that the fundamental conditions of
the U.S. economy, and much of the world economy, are very strong today. But these aspects of
uncertainly help illustrate what makes monetary policy interesting, and they help explain why central
banks may confront wide bands of uncertainty around even a strong central outlook. They also
emphasize the importance of the process we use to make decisions about policy in a state of limited
knowledge.
Policymakers can use a range of approaches to deal with uncertainty. In addition to making a very
substantial investment in trying to capture changes in economic activity that may not be fully evident in
the national data, we typically spend a lot of time looking at the assumptions that underpin the central
forecast, and the sensitivity of that forecast to the possibility that those assumptions prove wrong.
We regularly and systematically examine a range of alternative scenarios that attempt to capture a
broad range of different paths for the main forces operating on the economy. These scenarios include
those that seem highly implausible but might prove very damaging, as well as those that seem more
plausible but might alter the outlook less. To complement this, we look at the implications for monetary
policy of alternative scenarios for the outlook-what should we do if the world moves in a different
direction. And we also look at the impact on the outlook for growth and inflation of different paths for
the fed funds rate.
These approaches help illustrate the size and sources of uncertainty we live with at any moment. They
do not give us the capacity to attach precise probabilities to alternative scenarios or to quantify with
precision the implications, but they help frame a discussion of the material risks to the outlook and the
potential consequences of different types of policy mistakes. And they can help inform choices about
how central banks should affect expectations about future interest rates.
Along with these analytical tools, many central banks have adopted a decisionmaking structure that is
designed to bring a diversity of independent perspectives to the table. Although the FOMC's
discussions begin with the presentation of a forecast prepared by the staff of the Federal Reserve
Board, the committee members bring to the discussion substantial information based on independent
efforts to understand the underlying dynamics of demand and inflation and their implications for
monetary policy. This can provide a stronger foundation for decisions, particularly where uncertainty is
inherently great.
Central banks have adopted different approaches to this challenge, even as there has been broad
convergence toward the model of independent central banks, with explicit mandates that include price
stability and greater disclosure and transparency.
The central banks that publish quantitative forecasts for growth and inflation now typically show the
confidence bands around their forecasts. In some cases, these forecasts use, as a conditioning
assumption, financial market expectations for the path of short-term interest rates. In others, the
central bank publishes a forecast that includes the central bank's assessment at that time of the likely
path of monetary policy over some horizon. In the former case, the implications of the forecast for
monetary policy are left implicit. In the latter case, the likely path of monetary policy is made explicit,
but that path is heavily qualified or conditioned to make it clear that that expected path of short-term
interest rates will change as conditions change.
The FOMC's approach to communication differs in interesting and important ways from these other
models. Although the Committee has introduced a gradual but marked increase in the degree of
communication over the past two decades, it provides information about its forecast in quantitative
terms less frequently and with less detail than has become typical of many other central banks. And
yet, because of the unique circumstances over the past two to three years, it has provided more
information about the near-term path for monetary policy than has been the practice of many of our
counterparts.
These differences in approaches to communication do not seem to reflect fundamental differences in
perceptions of the degree or nature of uncertainty. The proponents of the regimes with the most
explicit forecasts and greater disclosure about the future path of interest rates do not claim to have
greater confidence in their ability to forecast. They do express, however, greater comfort with some of
the potentially adverse consequences of such approaches, the tendency, for example, for observers to
gravitate toward the central tendency of the forecast and to look past the uncertainty bands and
qualifications. And they express less concern that these approaches to communication will end up
limiting the flexibility of central banks to react as circumstances change without inducing damaging
volatility into markets.
And so, even as central banks have moved in varying degrees toward greater clarity about their goals,
forecasts and policy decisions, they have also moved to being more explicit about uncertainty and
about the need for flexibility in how policy should adjust over time.
This reflects an evolving appreciation that there are limits to transparency. Transparency in monetary
policy cannot mean that the central bank conveys more confidence in the outlook for growth and
inflation than it can reasonably have, and it cannot provide more assurance about the likely future
course of policy than it actually has.
This seems self evident. And yet as central banks have moved to communicating more and disclosing
more about monetary policy, transparency in monetary policy has been associated with rising
expectations for clarity about the path of target interest rates over time. It might seem desirable in an
ideal state of the world for expectations in financial markets about the future course of policy to closely
track in real time those of the central bank. But given the degree of uncertainty that surrounds
monetary policy making, this is unlikely to be possible, except in special circumstances.
There will be circumstances when it is appropriate for the central bank to send a signal about the
target rate that extends well beyond the immediate horizon. These circumstances are not likely to
arise frequently, and will be appropriate in particular conditions when the benefits afforded by the
effect on expectations clearly outweigh the cost imposed by the loss to flexibility.
Central banks should be clear about what they are trying to achieve. They should be open with the
knowledge and insight they possess. And they should provide the public with clarity where it is
attainable. But they also need to convey the limits to their knowledge and avoid providing a sense of
certainty they do not, or cannot, possess.
Uncertainty strengthens the case for being open about what we do not know, and exploring the
robustness of our decisions to a range of alternative scenarios. But uncertainty also reinforces the
case for clarity in communications about the objectives that guide policy and the rationale for our
decisions. Perhaps most crucially, this means preserving confidence in our commitment to keep
underlying inflation low over time, and for retaining the capacity to respond with flexibility to the
challenges we face in this uncertain world.
Thank you.