Alan Greenspan: Risk and uncertainty in monetary policy
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the meetings of the American Economic Association, San Diego, 3 January 2004.
* * *
This morning I plan to sketch the key developments of the past decade and a half of monetary policy
in the United States from the perspective of someone who has been in the policy trenches. I will offer
some conclusions about what I believe has been learned thus far, though I suspect, as is so often the
case, the passing of time, further study, and reflection will deepen our understanding of these
developments. This is a personal statement; I am not speaking for my current colleagues on the
Federal Open Market Committee (FOMC) or the many others with whom I have served over these
many years.1
* * *
The tightening of monetary policy by the Federal Reserve in 1979, then led by my predecessor
Paul Volcker, ultimately broke the back of price acceleration in the United States, ushering in a
two-decade long decline in inflation that eventually brought us to the current state of price stability.
The fall in inflation over this period has been global in scope, and arguably beyond the expectations of
even the most optimistic inflation fighters. I have little doubt that an unrelenting focus of monetary
policy on achieving price stability has been the principal contributor to disinflation. Indeed, the notion,
advanced by Milton Friedman more than thirty years ago, that inflation is everywhere and always a
monetary phenomenon is no longer a controversial proposition in the profession. But the size and
geographic extent of the decline in inflation raises the question of whether other forces have been at
work as well.
I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been
operating in an environment particularly conducive to the pursuit of price stability. The principal
features of this environment included (1) increased political support for stable prices, which was the
consequence of, and reaction to, the unprecedented peacetime inflation in the 1970s,
(2) globalization, which unleashed powerful new forces of competition, and (3) an acceleration of
productivity, which at least for a time held down cost pressures.
I believe we at the Fed, to our credit, did gradually come to recognize the structural economic changes
that we were living through and accordingly altered our understanding of the key parameters of the
economic system and our policy stance. The central banks of other industrialized countries have
grappled with many of the same issues.
But as we lived through it, there was much uncertainty about the evolving structure of the economy
and about the influence of monetary policy. Despite those uncertainties, the trauma of the 1970s was
still so vivid throughout the 1980s that preventing a return to accelerating prices was the unvarying
focus of our efforts during those years.
In recognition of the lag in monetary policy's impact on economic activity, a preemptive response to
the potential for building inflationary pressures was made an important feature of policy. As a
consequence, this approach elevated forecasting to an even more prominent place in policy
deliberations.
* * *
After an almost uninterrupted stint of easing from the summer of 1984 through the spring of 1987, the
Fed again began to lean against increasing inflationary pressures, which were in part the indirect
result of rapidly rising stock prices. We had recognized the risk of an adverse reaction in a stock
market that had recently experienced a steep run-up - indeed, we actively engaged in contingency
planning against that possibility.
In the event, the crash in October 1987 was far more traumatic than any of the possible scenarios we
had identified. Previous planning was only marginally useful in that episode. We operated essentially
in a crisis mode, responding with an immediate and massive injection of liquidity to help stabilize
highly volatile financial markets. However, most of our stabilization efforts were directed at keeping the
payments system functioning and markets open. The concern over the possible fallout on economic
activity from so sharp a stock price decline kept us easing into early 1988. But the economy weathered
that shock reasonably well, and our easing extended perhaps longer than hindsight has indicated was
necessary.
That period was followed by a preemptive tightening that brought the federal funds rate close to
10 percent by early 1989. In the summer of that year, we sensed enough softening of activity to
warrant beginning a series of rate reductions. However, the weakening of demand already under way,
some pullback of credit by lenders, and the spike in oil prices associated with Iraq's invasion of Kuwait
were sufficient to produce a marked contraction of activity in the fall of 1990. But perhaps aided by our
preemptive action, the recession was, to then, the mildest in postwar history.
However, the recovery also was more modest than usual, in large measure because of the notable
financial "headwinds" that confronted businesses. Those headwinds were primarily generated by the
constriction of credit in response to major losses at banks, associated with real-estate and foreign
lending, coupled with a crisis in the savings and loan industry that had its origins in a serious maturity
mismatch as interest rates rose. With their access to managed funds threatened and the quality of
their loan portfolio - and hence their capital - uncertain, these depositories were most reluctant to lend.
Policy eased gradually but persistently to counter the effects of these developments, with the funds
rate falling to 3 percent by September 1992, its lowest level since the early 1960s. The uptilt to the
term structure of interest rates in a generally low interest rate environment restored bank profitability
and, eventually, bank capital. The credit crunch slowly lifted.
By early 1994, as the headwinds of financial restraint abated, it became clear that underlying price
pressures were again building. If we had left those pressures unchecked, we would have put at risk
some of the hard-won gains that had been achieved over the preceding decade and a half. So,
starting from a real federal funds rate that was close to zero, a preemptive tightening was initiated. The
resulting rise in the funds rate of 300 basis points over twelve months apparently defused those
nascent inflationary pressures.
Though economic activity hesitated in early 1995, it soon steadied, confirming the achievement of a
historically elusive soft landing. The success of that period set up two powerful expectations that were
to influence developments over the subsequent decade. One was the expectation that inflation could
be controlled over the business cycle and that price stability was an achievable objective. The second
expectation, in part a consequence of more stable inflation, was that overall economic volatility had
been reduced and would likely remain lower than it had previously.
Of course, these new developments brought new challenges. In particular, the prospect that a
necessary cyclical adjustment was now behind us fostered increasing levels of optimism, which were
manifested in a fall in bond risk spreads and a rise in stock prices. The associated decline in the cost
of equity capital further spurred already developing increases in capital investment and productivity
growth, both of which broadened impressively in the latter part of the 1990s.
The rise in structural productivity growth was not obvious in the official data on gross product per hour
worked until later in the decade, but precursors had emerged earlier. The pickup in new bookings and
order backlogs for high-tech capital goods in 1993 seemed incongruous given the sluggish economic
environment at the time. Plant managers apparently were reacting to what they perceived to be
elevated prospective rates of return on the newer technologies, a judgment that was confirmed as
orders and profits continued to increase through 1994 and 1995. Moreover, even though hourly labor
compensation and profit margins were rising, prices were being contained, implying increasing growth
in output per hour.2
As a consequence of the improving trend in structural productivity growth that was apparent from 1995
forward, we at the Fed were able to be much more accommodative to the rise in economic growth
than our past experiences would have deemed prudent. We were motivated, in part, by the view that
the evident structural economic changes rendered suspect, at best, the prevailing notion in the early
1990s of an elevated and reasonably stable NAIRU. Those views were reinforced as inflation
continued to fall in the context of a declining unemployment rate that by 2000 had dipped below
4 percent in the United States for the first time in three decades.
Notions that prevailed for a time in the 1970s and early 1980s that even high single-digit inflation did
not measurably impede economic growth were gradually abandoned as the evidence of significant
benefits of low inflation became increasingly persuasive. Moreover, the variance of GDP growth
markedly lessened as inflation tumbled from its double-digit high in the early 1980s. To preserve these
benefits, we engaged in our most recent preemptive tightening in early 1999 that brought the funds
rate to 6-1/2 percent by May 2000.
Our goal of price stability was achieved by most analysts' definition by mid-2003. Unstinting and
largely preemptive efforts over two decades had finally paid off. Throughout the period, a key objective
has been to ensure that our response to incipient changes in inflation was forceful enough. As John
Taylor has emphasized, in the face of an incipient increase in inflation, nominal interest rates must
move up more than one-for-one.3
* * *
Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation
may well have contributed to the stock price bubble of the latter part of the 1990s.4 Looking back on
those years, it is evident that technology-driven increases in productivity growth imparted significant
upward momentum to expectations of earnings growth and, accordingly, to stock prices.5 At the same
time, an environment of increasing macroeconomic stability reduced perceptions of risk. In any event,
Fed policymakers were confronted with forces that none of us had previously encountered. Aside from
the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate
stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were,
thus, an especial challenge to the Federal Reserve.
It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a
substantial economic contraction and possible financial destabilization - the very outcomes we would
be seeking to avoid.
In fact, our experience over the past two decades suggests that a moderate monetary tightening that
deflates stock prices without substantial effect on economic activity has often been associated with
increases
subsequent in the level of stock prices.6 Arguably, markets that pass that type of stress test
are presumed particularly resilient. The notion that a well-timed incremental tightening could have
3
See, for example, "A Half-Century of Changes in Monetary Policy," John B. Taylor, remarks delivered at the conference in
honor of Milton Friedman, November 8, 2002, pp 9-10, manuscript, Department of the Treasury.
4
It is notable, that in the United States, surges in price-earnings ratios, a presumed essential characteristic of an equity price
bubble, are not observed with elevated inflation expectations.
5
But, as the Federal Reserve indicated in congressional testimony in July 1999, "... productivity acceleration does not ensure
that equity prices are not overextended. There can be little doubt that if the nation's productivity growth has stepped up, the
level of profits and their future potential would be elevated. That prospect has supported higher stock prices. The danger is
that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to
levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could
create problems for our economy when the inevitable adjustment occurs." Testimony of Alan Greenspan before the
Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1999.
6
For example, stock prices rose following the completion of the more than 300 basis point rise in the federal funds rate in the
twelve months ending in February 1989. And during the year beginning in February 1994, when the Federal Reserve again
raised the federal funds target 300 basis points, stock prices initially flattened. But as soon as that round of tightening was
completed, prices resumed their marked upward advance. From mid-1999 through May 2000, the federal funds rate was
raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in
retrospect, was the exhausted tail of a bull market. Stock prices peaked in March 2000, but the market basically moved
sideways until September of that year.
Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic
retrenchment with all its attendant risks is sufficient to check a nascent bubble. Certainly, 300 basis points proved
inadequate to even dent stock prices in 1994.
BIS Review 1/2004
been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely
an illusion.7
Instead of trying to contain a putative bubble by drastic actions with largely unpredictable
consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies
"to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."8
* * *
During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September
2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis
points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years.
We were able to be unusually aggressive in the initial stages of the recession of 2001 because both
inflation and inflation expectations were low and stable. We thought we needed to be, and could be,
forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided
for the first time in forty years.
There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing
the bubble's consequences rather than the bubble itself has been successful. Despite the stock
market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we
experienced an exceptionally mild recession - even milder than that of a decade earlier. As I discuss
later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from
notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a
significant contributor to stability.9
* * *
The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just
a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape.
The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the
probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is
delimited by a known probability distribution. In practice, one is never quite sure what type of
uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from
well-defined risks to the truly unknown.
As a consequence, the conduct of monetary policy in the United States has come to involve, at its
core, crucial elements of risk management. This conceptual framework emphasizes understanding as
much as possible the many sources of risk and uncertainty that policymakers face, quantifying those
7
Some have asserted that the Federal Reserve can deflate a stock-price bubble - rather painlessly - by boosting margin
requirements. The evidence suggests otherwise. First, the amount of margin debt is small, having never amounted to more
than about 1-3/4 percent of the market value of equities; moreover, even this figure overstates the amount of margin debt
used to purchase stock, as such debt also finances short sales of equity and transactions in non-equity securities. Second,
investors need not rely on margin debt to take a leveraged position in equities. They can borrow from other sources to buy
stock. Or, they can purchase options, which will affect stock prices given the linkages across markets.
Thus, not surprisingly, the preponderance of research suggests that changes in margins are not an effective tool for
reducing stock market volatility. It is possible that margin requirements inhibit very small investors whose access to other
forms of credit is limited. If so, the only effect of increasing margin requirements is to price out of the market the very small
investor without addressing the broader issue of stock price bubbles.
If a change in margin requirements were taken by investors as a signal that the central bank would soon tighten monetary
policy enough to burst a bubble, then there might be the appearance of a causal effect. But it is the prospect of monetary
policy action, not the margin increase, that should be viewed as the trigger. In a similar manner, history tells us that
"jawboning" asset markets will be ineffective unless backed by action.
8
Op. cit.
9
Some have argued that, as a consequence of the 1995-2000 speculative episode, long-term imbalances remain, having
been only partly addressed since early 2001, the peak of the post-bubble business cycle. For example, large residues of
household and external debt are perceived as barriers to future growth. But in the past, imbalances that led to business
contractions were rarely fully reversed before the subsequent economic upturn began. Presumably they were fully reversed
in later periods, or they continued to fester, but not by enough to halt economic growth.
Even if imbalances still persist in our current environment, the business decline that began in March 2001 came to an end in
November of that year, according to the National Bureau of Economic Research. We experienced tepid recovery until the
second half of last year, when GDP accelerated considerably. Hence, when the next recession arrives, as it inevitably will, it
will be a stretch to attribute it to speculative imbalances of many years earlier.
BIS Review 1/2004
risks when possible, and assessing the costs associated with each of the risks. In essence, the risk
management approach to monetary policymaking is an application of Bayesian decisionmaking.
This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing
the probabilities of achieving over time our goals of price stability and the maximum sustainable
economic growth that we associate with it. In designing strategies to meet our policy objectives, we
have drawn on the work of analysts, both inside and outside the Fed, who over the past half century
have devoted much effort to improving our understanding of the economy and its monetary
transmission mechanism. A critical result has been the identification of a relatively small set of key
relationships that, taken together, provide a useful approximation of our economy's dynamics. Such an
approximation underlies the statistical models that we at the Federal Reserve employ to assess the
likely influence of our policy decisions.
However, despite extensive efforts to capture and quantify what we perceive as the key
macroeconomic relationships, our knowledge about many of the important linkages is far from
complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well
designed, conceptually and empirically, is a vastly simplified representation of the world that we
experience with all its intricacies on a day-to-day basis.
Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy
and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to
consider not only the most likely future path for the economy but also the distribution of possible
outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities,
costs, and benefits of the various possible outcomes under alternative choices for policy.
A policy action that is calculated to be optimal based on a simulation of one particular model may not,
in fact, be optimal once the full extent of the risks surrounding the most likely path is taken into
account. In general, different policies will exhibit different degrees of robustness with respect to the
true underlying structure of the economy.
For example, policy A might be judged as best advancing the policymakers' objectives, conditional on
a particular model of the economy, but might also be seen as having relatively severe adverse
consequences if the true structure of the economy turns out to be other than the one assumed. On the
other hand, policy B might be somewhat less effective in advancing the policy objectives under the
assumed baseline model but might be relatively benign in the event that the structure of the economy
turns out to differ from the baseline. A year ago, these considerations inclined Federal Reserve
policymakers toward an easier stance of policy aimed at limiting the risk of deflation even though
baseline forecasts from most conventional models at that time did not project deflation; that is, we
chose a policy that, in a world of perfect certainty, would have been judged to be too loose.
As this episode illustrates, policy practitioners operating under a risk-management paradigm may, at
times, be led to undertake actions intended to provide insurance against especially adverse outcomes.
Following the Russian debt default in the autumn of 1998, for example, the FOMC eased policy
despite our perception that the economy was expanding at a satisfactory pace and that, even without
a policy initiative, it was likely to continue doing so.10 We eased policy because we were concerned
about the low-probability risk that the default might trigger events that would severely disrupt domestic
and international financial markets, with outsized adverse feedback to the performance of the U.S.
economy.
The product of a low-probability event and a potentially severe outcome was judged a more serious
threat to economic performance than the higher inflation that might ensue in the more probable
scenario. That possibility of higher inflation caused us little concern at the time, largely because
increased productivity growth was resulting in only limited increases in unit labor costs and heightened
competition, driven by globalization, was thwarting employers' ability to pass through those limited cost
increases into prices. Given the potential consequences of the Russian default, the benefits of the
unusual policy action were judged to outweigh its costs.
Such a cost-benefit analysis is an ongoing part of monetary policy decisionmaking and causes us to
tip more toward monetary ease when a contractionary event, such as the Russian default, seems
especially likely or the costs associated with it seem especially high.
The 1998 liquidity crisis and the crises associated with the stock market crash of 1987 and the
terrorism of September 2001 prompted the type of massive ease that has been the historic mandate of
a central bank. Such crises are precipitated by the efforts of market participants to convert illiquid
assets into cash. When confronted with uncertainty, especially Knightian uncertainty, human beings
invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity.
Because economies, of necessity, are net long - that is, have net real assets - attempts to flee these
assets cause prices of equity assets to fall, in some cases dramatically. In the crisis that emerged in
the autumn of 1998, pressures extended beyond equity markets. Credit-risk spreads widened
materially and investors put a particularly high value on liquidity, as evidenced by the extraordinarily
wide yield gaps that emerged between on-the-run and off-the-run U.S. Treasuries.
The immediate response on the part of the central bank to such financial implosions must be to inject
large quantities of liquidity - or as Walter Bagehot put it, describing such policies of the Bank of
England more than a century ago, in a panic the Bank should lend at very high rates of interest "to all
that bring good securities quickly, freely, and readily."11 This was perhaps an early articulation of a
crisis risk management policy for a central bank.
* * *
The economic world in which we function is best described by a structure whose parameters are
continuously changing. The channels of monetary policy, consequently, are changing in tandem. An
ongoing challenge for the Federal Reserve - indeed, for any central bank - is to operate in a way that
does not depend on a fixed economic structure based on historically average coefficients. We often fit
simple models only because we cannot estimate a continuously changing set of parameters without
vastly more observations than are currently available to us. Moreover, we recognize that the simple
linear functions underlying most of our econometric structures may not hold outside the range in which
adequate economic observations exist. For example, it is difficult to have much confidence in the
ability of models fit to the data of the moderate inflations of the postwar period to accurately predict
what the behavior of the economy would be in an environment of aggregate price deflation.
In pursuing a risk-management approach to policy, we must confront the fact that only a limited
number of risks can be quantified with any confidence. And even these risks are generally quantifiable
only if we accept the assumption that the future will, at least in some important respects, resemble the
past. Policymakers often have to act, or choose not to act, even though we may not fully understand
the full range of possible outcomes, let alone each possible outcome's likelihood. As a result, risk
management often involves significant judgment as we evaluate the risks of different events and the
probability that our actions will alter those risks.
For such judgment, policymakers have needed to reach beyond models to broader - though less
mathematically precise - hypotheses about how the world works. For example, inferences about how
market participants and, hence, the economy might respond to a monetary policy initiative may need
to be drawn from evidence about past behavior during a period only roughly comparable to the current
situation.
Some critics have argued that such an approach to policy is too undisciplined - judgmental, seemingly
discretionary, and difficult to explain. The Federal Reserve, they conclude, should attempt to be more
formal in its operations by tying its actions solely, or in the weaker paradigm, largely, to the
prescriptions of a simple policy rule. Indeed, rules that relate the setting of the federal funds rate to the
deviations of output and inflation from their respective targets, in some configurations, do seem to
capture the broad contours of what we did over the past decade and a half. And the prescriptions of
formal rules can, in fact, serve as helpful adjuncts to policy, as many of the proponents of these rules
have suggested. But at crucial points, like those in our recent policy history - the stock market crash of
1987, the crises of 1997-98, and the events that followed September 2001 - simple rules will be
inadequate as either descriptions or prescriptions for policy. Moreover, such rules suffer from much of
the same fixed-coefficient difficulties we have with our large-scale models.
To be sure, sensible policymaking can be accomplished only with the aid of a rigorous analytic
structure. A rule does provide a benchmark against which to assess emerging developments.
However, any rule capable of encompassing every possible contingency would lose a key aspect of its
attractiveness: simplicity. On the other hand, no simple rule could possibly describe the policy action to
be taken in every contingency and thus provide a satisfactory substitute for an approach based on the
principles of risk management.
As I indicated earlier, policy has worked off a risk-management paradigm in which the risk and
costbenefit analyses depend on forecasts of probabilities developed from large macromodels, numerous
submodels, and judgments based on less mathematically precise regimens. Such judgments, by their
nature, are based on bits and pieces of history that cannot formally be associated with an analysis of
variance.
Yet, there is information in those bits and pieces. For example, while we have been unable to readily
construct a variable that captures the apparent increased degree of flexibility in the United States or
the global economy, there has been too much circumstantial evidence of this critically important trend
to ignore its existence. Increased flexibility is a likely source of changing structural coefficients.
Our problem is not, as is sometimes alleged, the complexity of our policymaking process, but the far
greater complexity of a world economy whose underlying linkages appear to be continuously evolving.
Our response to that continuous evolution has been disciplined by the Bayesian type of
decisionmaking in which we have engaged.
* * *
While all, no doubt, would prefer that it were otherwise, there is no way to dismiss what has to be
obvious to every monetary policymaker: The success of monetary policy depends importantly on the
quality of forecasting. The ability to gauge risks implies some judgment about how current economic
imbalances will ultimately play out.
Thus, both econometric and qualitative models need to be continually tested. The first signs that a
relationship may have changed is usually the emergence of events that seem inconsistent with our
hypotheses of the way the economic world is supposed to behave. The anomalous rise in high-tech
capital goods orders in 1993, to which I alluded earlier, is one such example. The credit crunch of the
early 1990s is another.
The emergence of inflation targeting in recent years is an interesting development in this regard. As
practiced, it emphasizes forecasts, but within a more rule-like structure that skews monetary policy
toward inflation containment as the primary goal. Indeed, its early applications were in high-inflation
countries where discretionary monetary policy fell into disrepute.
Inflation targeting often originated as a fairly simple structure concentrating solely on inflation
outcomes, but it has evolved into more-discretionary forms requiring complex judgments for
implementation. Indeed, this evolution has gone so far that the actual practice of monetary policy by
inflation-targeting central banks now closely resembles the practice of those central banks, such as
the European Central Bank, the Bank of Japan, and the Federal Reserve, that have not chosen to
adopt that paradigm.
In practice, most central banks, at least those not bound by an exchange rate peg, behave in roughly
the same way. They seek price stability as their long-term goal and, accounting for the lag in monetary
policy, calibrate the setting of the policy rate accordingly. Central banks generally appear to have
embraced a common model of the channels through which monetary policy functions, although the
specifics and emphasis given to those channels vary according to our particular circumstances. All
banks ease when economic conditions ease and tighten when economic conditions tighten, even if in
differing degrees, regardless of whether they are guided by formal or informal inflation targets.
As yet unresolved is whether the mere announcement that a central bank intends to engage in
inflation targeting increases the credibility of the central bank's inclination to maintain price stability
and, hence, assists in the anchoring of inflation expectations. The Bank of England's recent
experiences