Mr. Meyer remarks on the strategy of monetary policy in the United States Text of
the Alan R. Holmes Lecture by Mr. Laurence H. Meyer, a member of the Board of Governors of the US
Federal Reserve System, held at Middlebury College, Middlebury, Vermont on 16/3/98.
When I was asked to deliver the Alan R. Holmes Lecture, it seemed appropriate to focus
on a topic directly related to the interests and contributions of Alan Holmes. It was not hard to find such
a topic, because Alan Holmes served with distinction in a position that was at the very core of monetary
policymaking.
Monetary policy begins with a set of objectives, which identify where policymakers want
the economy to be, a preferred or ideal state of macroeconomic performance. The heart of monetary
policy is about designing and implementing a strategy to guide policymakers in decisions about the
setting of open market operations, the principal instrument of monetary policy, so as to contribute to
achieving the objectives. This is the subject of my lecture today and it was very much the subject of Alan
Holmes' career. He was an economist for 31 years at the Federal Reserve Bank of New York, and for
many years served as Executive Vice President of the Federal Reserve Bank of New York and as
Manager of the System Open Market Account. In that position he was directly responsible for
implementing policies of the Federal Open Market Committee, the FOMC, specifically the day-to-day
decisions about open market operations.
The FOMC consists of the seven members of the Board of Governors and five presidents
of the regional Federal Reserve banks. There is no official operating manual for members of the
committee that identifies the guiding principles, no "official doctrine". While the views I present here are
my own perspectives on strategy, my purpose in this lecture is not to articulate a singular view of the
strategy of monetary policy, but rather to shed light on some of the mystery about monetary policy.
A former Alan Homes Professor of Economics at Middlebury College and good friend,
Dewey Daane, co-edited a book in honor of Alan Holmes, entitled The Art of Monetary Policy. In his
forward to the book, William Simon called Alan Holmes a "monetary policy artist". As I develop my
perspective on monetary policy, I will try to blend the role of art and science, of economic theory and
practical judgments that Alan Holmes so well understood.
Objectives
Monetary policymaking naturally begins with an understanding of the objectives of
policy, because that is what good policy should deliver. It is widely accepted that there are three
fundamental norms of macroeconomic performance, which I summarize as full employment, growth, and
price stability, and these norms are a useful point of departure to thinking about the objectives for
monetary policy.
Full employment can be interpreted as achieving the maximum sustainable level of
employment and production. It basically means avoiding waste, in the sense of failing to use all the
available productive resources. By sustainable, I mean the highest level of output that can be sustained
without imposing unacceptable costs, a consideration I will return to shortly.
By growth, I am referring to the desire to achieve both a high average level and rate of
growth in living standards, on average, over time. We usually measure living standards in terms of real
income per capita. We can be at full employment and yet be poor. We want to be at full employment and
be rich. And we want our living standards to be improving over time. I'll refer to the average rate of
growth in output in the long run as the economy's trend rate of growth.
Price stability refers to the stability of the overall price level, measured, for example, by
the price index for overall output (the chain-weighted price index of GDP) or for consumer goods and
services (the Consumer Price Index). We often satisfy ourselves with the norm of low and stable
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inflation. At any rate, price stability is really more an intermediate goal than an ultimate objective. The
reason we care about price stability is that we believe that it contributes to a high and rising level of
living standards. Indeed, it is viewed as so important in this regard that we identify it as a separate and
free-standing norm. And we will soon see we have particular reason to do so from the perspective of
monetary policy.
Implications of Economic Theory
I am going to assert some conclusions based on economic theory that help to understand
the potential for monetary policy to achieve these objectives and the consistency among them. These
conclusions are widely though not universally shared, but they do guide my views of what monetary
policy can and should do.
First, monetary policy cannot influence real variables -- such as output and
employment -- in the long run (except via the contribution of price stability to living standards). This is
often referred to as the principle of the neutrality of money. This proposition removes "growth" as an
objective for monetary policy and also means that monetary policy cannot materially affect the level of
output or employment corresponding to "full employment".
Second, monetary policy is the principal determinant of inflation in the long run. This
proposition immediately makes price stability (in some shape or form) the direct, unequivocal, and
singular long-term objective of monetary policy. No central bank around the world would argue
otherwise. When it comes to price stability, the buck, literally, stops at the central bank.
Third, because prices in many markets may be slow to adjust to equate supply and
demand, shocks to the economy can lead to persistent departures of the economy from full
employment -- in both directions. This proposition offers at least the potential for monetary policy to
play a role in smoothing out business cycles.
Fourth, full employment and price stability are compatible. Now, by full employment I
do not mean literally zero unemployment. Instead full employment is better thought of as the lowest
possible rate of unemployment that can be sustained without rising inflation. If unemployment remains,
on average, at this level, inflation tends to remain constant. This rate -- which is often called the
non-accelerating inflation rate of unemployment (or NAIRU) -- is a fact of life outside the control of the
FOMC. This definition of full employment insures that the two objectives left for monetary policy -- full
employment and price stability -- are compatible in the long run.
Fifth, inflation pressures arise, in large part, in response to departures of the economy
from full employment. If the economy moves below full employment, for example, the resulting slack
results in disinflation, that is, downward pressure on inflation. When the economy moves above this
threshold there is continuing upward pressure on inflation. This implies that the two objectives of price
stability and full employment can conflict in the short run.
This leaves us with dual objectives for monetary policy: short-run stabilization of output
relative to potential and long-run price stability. Fortunately, this is also the legislative mandate Congress
has set for monetary policy in the Full Employment and Balanced Growth Act of 1978, often referred to
as the Humphrey-Hawkins Act, at least by my interpretation.
There are many interesting issues and controversies related to the choice and definition of
objectives. These include the definition of an inflation target that corresponds to price stability and the
estimate of the unemployment threshold that corresponds to full employment. I'll assume that the
inflation target is set to reflect the expected bias in inflation measurement or to be slightly above this
estimate. Many commentators view a 2% inflation rate as a reasonable inflation objective and many
countries with explicit inflation targets use a 1% - 3% range. As for the definition of full employment,
I'll use a consensus estimate of the unemployment threshold, which is currently around 51⁄2%. I might
add that there is considerable uncertainty about this estimate, particularly in light of the consistent
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surprise of declining inflation even as the unemployment rate has fallen well below this threshold. I have
focused a number of my speeches on this very topic, but, for today, it is mainly a reminder of the
uncertainty that monetary policymakers face about the structure of the economy, especially when the
structure changes over time.
Instruments
The next step is to identify the instruments through which monetary policy influences the
economy. While there are, in principle, three instruments through which monetary policy affects the
macroeconomy -- open market operations, the discount rate, and the reserve requirement ratio -- as Alan
Holmes certainly appreciated, open market operations are the principal instrument of monetary policy,
and so I will focus on open market operations.
The Federal Reserve holds a portfolio of government securities. It injects or withdraws
reserves by buying for or selling from this portfolio. When it purchases securities from the private sector,
it injects reserves and normally puts downward pressure on short-term market interest rates. So open
market operations can be viewed as implementing either a path of reserves or achieving a level of
short-term interest rates. In practice, nearly all central banks target a short-term interest rate rather than
reserves with their open market operations. This is because reserves are most useful for close control of
the money supply and money supplies have proven to have only a loose, long-term relationship to the
objectives of monetary policy.
Natural Hurdles
If we knew precisely where we were, understood precisely the relationship between our
instruments and macroeconomic performance, had a single objective, and could instantly affect the
variable or variables associated with our target(s), implementing policy would be easy. Indeed, this
lecture would be nearly over, because we would not have to worry about a strategy for monetary policy.
It is precisely because none of these preconditions hold that monetary policy is so difficult and principles
are needed to guide its implementation.
First, it is clearly important to know where you are in relation to where you want to be.
But we do not have timely and accurate information about where we are. The data trickles in with a lag,
often involves considerable noise, and is subject to revision, even after which it may remain less precise
than we would prefer. Because of the noise in economic measures, considerable effort is needed to
extract the meaningful signal from the data.
Second, we are working with a caricature of the economy in the form of our empirical
models that guide both forecasting and policy decisions. The models reflect our imperfect state of
knowledge about how the economy works. In addition, as I just noted, the relationships among the
variables in the economy shift over time and we only gradually learn and adjust to such structural
changes.
Third, monetary policy affects aggregate demand and inflation with a lag. The major
effect of a policy action today is not felt until about a year from now. Therefore, when we are thinking
about affecting inflation, we better be thinking about affecting inflation next year, rather than tomorrow.
One implication of lags is that policy has to be forward looking. If we want to affect inflation next year,
we have to act today. We therefore have to try to anticipate problems rather than simply react to them.
That means that forecasting is an inherent part of the policy process and policy has to have a pre-emptive
quality.
Fourth, we have multiple objectives, but only a single instrument. Simple models of
policy normally imply that to achieve two objectives simultaneously, you need two instruments. How
can we therefore juggle our dual targets? Fortunately, theory and evidence suggest, as I noted earlier, that
the objectives of full employment and price stability are consistent in the long run. Short-run conflicts
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between the targets arise in one of two circumstances. A conflict arises if we begin with inflation above
our objective. Unfortunately, monetary policy can reduce inflation only by temporarily imposing some
slack in the economy. In this case, lowering inflation would mean departing for a while from full
employment. Once inflation had fallen to its target level, the economy could return to full employment
and enjoy the consistency of the two objectives. A second source of conflict arises in response to a
supply shock, such as an increase in oil prices. Assume we begin with full employment and price
stability and there is a sharp rise in oil prices. This will tend to both raise inflation in the short run and
depress output. What should monetary policy do? Tighten to unwind the increase in inflation? Or loosen
to counter the increase in unemployment?
The natural hurdles make monetary policy a challenging task, requiring the application of
both good judgment and appropriate models, art and science.
Operating Strategies and the FOMC Meeting
Now that we appreciate the challenging nature of monetary policy, we are ready to
develop a strategy for implementing open market operations. The first question we ask is whether policy
should be carried out according to some well-defined and precise formula, or rule, or whether it should be
implemented judgmentally. My point here is not to recall the longstanding debate about rules vs.
discretion, but to emphasize that good policy should be systematic or rule-like, even when it is not
formally tied to a specific rule. In addition, we can learn a lot about principles for guiding discretionary
policy by examining rules that can be shown to have effective stabilizing properties in our models.
As I noted earlier, monetary policy is implemented in the United States, as in most
central banks, through the control of interest rates. At each meeting, the FOMC sets an intended federal
funds rate target. The federal funds rate is the interest rate on overnight loans in the inter-bank market. It
is therefore the rate paid when reserves are borrowed and lent among banks. And it is a natural target to
achieve via open market operations since these operations in effect inject or withdraw reserves.
The federal funds rate is currently 5.5%. The FOMC announces any change in this target
immediately following the conclusion of its meetings. It also explicitly incorporates this target funds rate
in a "directive" to the Manager of the System Open Market Account, the position Alan Holmes held at
the Federal Reserve Bank of New York. This directive instructs the Manager to implement open market
operations during the period between this and the next FOMC meeting so as to maintain the federal funds
rate as close as possible to the intended rate.
Point of Departure: Constant Money Growth Rule
Given that the Federal Reserve, like most other central bank today, operates by setting a
near-term interest rate target, my focus is on developing some guiding principles for setting the interest
rate target, more precisely, for adjusting the interest rate target in response to changing economic
conditions. I have found it useful to begin this search, perhaps surprisingly, by developing the properties
of a constant money supply growth rule. This both helps to identify some of the essential properties of a
monetary policy strategy, which will apply to interest rate targeting as well, and highlights the practical
difficulties in carrying out monetary policy using money supply targets.
Another reason for starting with a monetary aggregate strategy is that monetary
aggregates played a more significant role in the implementation of monetary policy during Holmes'
service as Manager of the System Open Market Account. The directive to the Manager from the FOMC
during this period was often specified in terms of maintaining or changing "money market conditions" (a
code for the federal funds rate), unless growth in the monetary aggregates departed significantly from the
midpoints of their specified ranges. Sometimes the directive was specified directly in terms of the desired
course of the monetary aggregates, in this case typically subject to an acceptable range for the federal
funds rate. This gave money growth a more direct role in the conduct of policy than it has today.
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Let's now see why money growth might be a useful target for implementing monetary
policy. Economic theory suggests that, if the demand for money is stable, the rate of money growth will
pin down the rate of growth in nominal income. Under reasonable assumptions, a constant rate of money
growth will yield growth of nominal income, on average, at the same rate. The rate of money growth
should be set to achieve a rate of nominal income growth that just equals the rate of trend growth in real
output and the rate of inflation consistent with the policy objective. On average and in the long run, this
rate of money growth will achieve the Fed's inflation objective.
So the first proposition is that a money growth target provides a nominal anchor which
pins down the long-run inflation rate. This strategy immediately allows a translation of the long-run price
stability objective into a more near-term money supply growth target. And, by implication, any monetary
policy strategy must mimic the nominal anchor property of a money supply target, if it is to be consistent
with the Federal Reserve's mandate for price stability.
Next, let's ask what would happen if the economy was subject to a shock that moved it
away from price stability and full employment. If real output increases faster than trend and/or inflation
increases relative to the Fed's objective, the resulting higher nominal income growth, relative to the
constant rate of money growth, would result in an increase in interest rates. The second property of a
money supply target is that it builds stability into the economy by insuring pro-cyclical movements in the
interest rate in response to demand shocks. Another way of saying this is that it insures that monetary
policy automatically leans against the cyclical winds to stabilize the economy.
The Taylor Rule as a Strategy for an Interest Rate Operating Procedure
Despite the desirable properties of a constant money growth rule, in principle, most
central banks implement policy by setting short-term interest rates in practice. This choice reflects at least
two considerations. First, instability in money demand reduces the usefulness of money supply targets.
Second, interest rate targets allow the central bank to smooth out the effects of transitory shocks to
financial markets.
But how should the Fed vary its interest rate "instrument" to achieve its ultimate
objectives? The simplest answer is that interest rates should vary to imitate qualitatively the way they
would behave if the Fed were implementing a money supply target. In other words, interest rates need to
be varied systematically to effectively impose a nominal anchor and to insure that policy leans against the
cyclical winds. Setting monetary policy in this manner via an interest rate target, in principle, allows the
Fed to achieve the best of both worlds. It can impose the same nominal anchor and short-run stabilization
properties as would be the case with a money growth rule, but, at the same time, smooth out shorter-run
volatility in interest rates. In addition, by careful choice of the degree of response of interest rates to
changing economic conditions, the rule can, in principle, improve upon the stabilization properties of a
money supply rule.
A simple specification of a strategy for varying the federal funds rate in response to
changing economic conditions is provided by the Taylor Rule, a rule developed by John Taylor, a
professor at Stanford University.
The appeal of the Taylor Rule is that it is simple and specifies how the federal funds rate
(effectively the Fed's instrument) should be varied directly in response to inflation and to deviations of
output and inflation from the Fed's ultimate targets of full employment and price stability. My point here
is not to extol the virtues of the precise specification in the Taylor Rule, but to use it to highlight some of
the central principles that should guide decisions about the setting of the funds rate.
It is useful to appreciate how Taylor derived his rule and how he views its role in
monetary policy. The rule emerged from Taylor's analysis of simulations of a variety of rules in a variety
of models. He concluded that the simple form embodied in the Taylor Rule had, based on this work,
excellent stabilizing properties. The rule was therefore initially developed as a normative guide, meaning
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a set of principles to guide policy that, if followed, would result in relatively good economic
performance, at least compared to other rules and perhaps relative to historic US economic performance.
Subsequently, Taylor found the rule described reasonably well the way policy was indeed carried out
over the last decade. That is, the rule was also descriptive of recent policymaking.
The Taylor Rule begins by assuming that there is some level of real federal funds rate
consistent with full employment and stable inflation. The real interest rate is the nominal interest rate less
some measure of inflation expectations (measured by Taylor as actual inflation over the last year) -- a
measure of the increase in purchasing power (rather than in dollars) associated with holding an asset.
Taylor calls this the equilibrium real interest rate and assumed it was 2%. Let's assume that the economy
is initially at full employment and price stability. Then the level of real and nominal interest rates would
be set at 2%. I am not going to quibble with this choice, because I am focusing on general principles
rather than precise details.
The economy is, of course, not always at full employment and price stability and the
purpose of the Taylor Rule is to specify how the federal funds rate should respond to shocks that push the
economy away from price stability and/or full employment. Because both objectives are explicitly
incorporated into the rule, it provides a disciplined approach to juggling the dual mandate for monetary
policy.
The real equilibrium interest rate is viewed as consistent with full employment and any
stable rate of inflation. So the first implication of this rule is that, in order to be consistent with full
employment, nominal interest rates should be adjusted in response to inflation to maintain the
equilibrium real interest rate.
The next message of the rule concerns how the real federal funds rate should be adjusted
in response to deviations of output and inflation from full employment and price stability. According to
the rule, when output rises relative to potential output, real interest rates should rise. When inflation rises
relative to the inflation target, real interest rates should also rise. These movements of real interest rates
in response to departures of inflation and output from their target levels can be shown to stabilize output
and inflation relative to their targets.
The Dangers of an Interest Rate Strategy
There are natural dangers inherent in interest rate targeting, at least in the absence of a
rule that guides its adjustment to changing economic conditions. If cyclical movements in output are
dominated by demand shocks, the failure to move interest rates aggressively enough in response to the
shocks can result in monetary policy destabilizing rather than stabilizing the economy. For example, if
there is a demand shock resulting in higher income and/or prices, the demand for money will increase,
putting upward pressure on interest rates. If the Fed maintains an unchanged nominal interest rate target,
it will have to add reserves to support a higher money supply at the initial interest rate. This means that,
under a constant interest rate target, a demand shock would lead to perverse monetary policy, specifically
to stimulative open market operations, reinforcing rather than damping the demand shock.
The inherent danger in interest rate targeting is reinforced by the preference for central
bankers for smoothing interest rates. This preference takes two forms. First, there is a preference for
implementing a rise in rates in a series of small changes in the same direction. Second, there is a
reluctance to change the direction of policy, without particularly strong rationale. Nevertheless, interest
rate targets can, in principle, be implemented in a way that avoids this pitfall, and one of the values of
rules is to remind policymakers of the importance of adjusting interest rates in response to changing
economic conditions, thereby preventing policy from becoming destabilizing.
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Principles to Guide the Setting of Interest Rates
We are now ready to identify a set of principles to guide decisions about the setting of
the federal funds rate at FOMC meetings. Underlying these principles are the lessons gleaned from both
the constant money growth rule and from the Taylor Rule. Both rules highlight the importance of
imposing a nominal anchor to pin down the long-run inflation rate and of varying real interest rates
pro-cyclically to lean against the cyclical winds. The Taylor Rule also highlights the critical importance
of real interest rates in the conduct of monetary policy.
There is one very important difference between the constant money growth and Taylor
rules that deserves comment. While a constant rate of money growth will not always be optimal, if
money demand is sufficiently stable, and not particularly interest sensitive, it will pin down inflation in
the long run and help smooth the business cycle in the short run. That is, under a money growth target,
doing nothing (that is, maintaining an unchanged rate of money growth) may not always be the best
choice, but, for the most part, it won't get you into serious trouble and will in fact do some considerable
good, although it would likely involve a considerable variation in interest rates on a day-to-day basis.
Under an interest rate targeting regime, on the other hand, doing nothing can potentially get you into
great difficulty -- sometimes quite quickly. In this case, policy must constantly be prepared to adjust to
changing economic conditions, to avoid the potential for becoming a destabilizing influence on the
economy.
Rule No. 1: Vary real interest rates in response to departures of inflation from its target.
For example, if inflation increases, relative to its target, the real interest rate should be increased. This is
perhaps the single most important discipline for monetary policy under an interest rate regime. When
inflation increases, nominal interest rates must first be increased just to avoid a decline in the real rate.
But to counter the rise in inflation relative to its target, the real interest rate has to rise. That means that
nominal rates have to rise by more than the increase in inflation. In the Taylor Rule, for example, the
nominal federal funds rate rises by 1.5 percentage points for every one percentage-point increase in
inflation.
Rule No. 2: Vary (nominal and real) interest rates in response to changes in resource
utilization rates. Under a money supply growth rule, interest rates rise whenever growth in real GDP
exceeds the trend GDP growth assumption embedded in the money growth target. Whenever growth is
above trend, the unemployment rate falls and the capacity utilization rate rises. By adjusting real interest
rates in response to such changes in utilization rates, for a given inflation rate, an interest rate regime
insures the same qualitative stabilization property that a constant money growth rule automatically
yields.
In implementing this principle, real interest rates would rise gradually but systematically
during expansions, fall when growth slows to below trend, and decline sharply when the actual level of
output declines, at least for those cyclical episodes where supply shocks (see below) are not very
important. Just following this simple principle will help stabilize output relative to full employment and
inflation relative to the inflation target. It is a reminder that there ought to be nothing startling or
dramatic in FOMC decisions to adjust the federal funds rate. Indeed, the question that might be asked
when nominal rates are constant for long periods is how does the FOMC justify such stability in the face
of changing economic conditions!
You might, therefore, ask whether or not the near constancy of the nominal funds rate
over the most recent episode has been appropriate. I believe monetary policy has, in fact, been excellent
over this period. But this has been a very unusual period with remarkable crosscurrents that balanced out
to allow such stable short-term rates. It should not lull us into believing that stable interest rates and good
monetary policy naturally go together.
Rule No. 3: In setting rates, be forward looking. I noted earlier that, because of lags,
monetary policy has to be forward looking. There are, however, different degrees of forward lookingness
that we could incorporate into policymaking. For example, because higher utilization rates today raise the
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risk of higher inflation in the future, raising interest rates today in response to observed increases in
utilization rates is a forward-looking policy relative to simply responding to current inflation.
Forward-looking policy is sometimes said to be pre-emptive. A movement in interest
rates in response to rising utilization rates would be said to be a pre-emptive move against inflation. The
Taylor Rule thus allows for a combination of pre-emptive policy, changes in interest rates in response to
changes in utilization rates, and reactive policy, changes in interest rates in response to movements in
inflation itself. So good policy can be both pre-emptive and reactive.
A still more forward-looking approach would be for policymakers to respond not to
actual inflation and utilization rates, as in the Taylor Rule, but to forecasts of projected inflation and
utilization rates, assuming an unchanged nominal federal funds rate. A good reason for responding to
forecasts of inflation is that the effects of monetary policy on the economy mostly occur about a year
from now. There is a considerable amount of work under way to assess the usefulness of using forecasts
as opposed to past information on unemployment and inflation in the specification of interest rate rules.
There are clear historical examples when a forward-looking policy would be an
improvement. These episodes illustrate that simple rules are only guides and that good policy sometimes
means following the rule and sometimes means using judgment to improve upon the rule. Judgement is
especially called for in situations where special events point to future changes in output and inflation that
would ordinarily be viewed as unlikely. The current episode provides a good example of such a situation
in which there is much to be gained from forward-looking policy. The economy entered 1998 with
considerable forward momentum, already operating at very high utilization rates. This momentum
reflected persistent strength in domestic demand, particularly consumer spending and business fixed
investment. However, the financial and currency crises in Asia are projected to result in a sharper decline
in net exports than would otherwise have occurred and this promises to slow the expansion in the absence
of any policy action, perhaps substituting for monetary tightening that otherwise might have been
justified. In this environment, a backward-looking policy that ignored the potential drag on future
demand from Asia could risk magnifying the effect of the shift in aggregate demand.
Rule No. 4: The appropriate policy response may depend on the source and persistence of
the shock. Let me distinguish two types of shocks to the economy. The first is a persistent demand
shock -- for example, an increase in aggregate demand that results in a persistent departure from trend
growth and persistent changes in utilization rates. This will have symmetric effects, raising both output
and inflation, and presents a relatively straightforward monetary policy problem that is well handled by
the first set of rules.
A second source of shock is a supply shock, an example of which would be a one-time,
permanent increase in oil prices. We have had several examples of very sharp increases in oil prices,
especially in the 1970s, and, more recently, oil