Mr. Greenspan considers the recent history of the Federal Reserve System's
policy process Remarks by the Chairman of the Board of Governors of the US Federal Reserve
System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic
Policy Research at Stanford University, Stanford, California on 5/9/97.
It is a pleasure to be at this conference marking the fifteenth anniversary of the
Center for Economic Policy Research. The Center, by encouraging academic research into
public policy and bringing that research to the attention of policymakers, is performing a most
valuable role in our society.
I am particularly pleased that Milton Friedman has taken time to join us. His
views have had as much, if not more, impact on the way we think about monetary policy and
many other important economic issues as those of any person in the last half of the twentieth
century.
Federal Reserve policy, over the years, has been subject to criticism, often with
justification, from Professor Friedman and others. It has been argued, for example, that policy
failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary
creation, contributed to the inflationary upsurge. Surely, it was maintained, some monetary
policy rule, however imperfect, would have delivered far superior performance. Even if true in
this case, though, policy rules might not always be preferable.
Policy rules, at least in a general way, presume some understanding of how
economic forces work. Moreover, in effect, they anticipate that key causal connections observed
in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes
that action x will, with a reasonably high probability, be followed over time by event y.
Another premise behind many rule-based policy prescriptions, however, is that
our knowledge of the full workings of the system is quite limited, so that attempts to improve on
the results of policy rules will, on average, only make matters worse. In this view, ad hoc or
discretionary policy can cause uncertainty for private decision makers and be wrong for
extended periods if there is no anchor to bring it back into line. In addition, discretionary policy
is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't
those of elected representatives supersede those of unelected officials?
The monetary policy of the Federal Reserve has involved varying degrees of
rule- and discretionary-based modes of operation over time. Recognizing the potential
drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit
past patterns and regularities to operate in a systematic way. But we have found that very often
historical regularities have been disrupted by unanticipated change, especially in technologies.
The evolving patterns mean that the performance of the economy under any rule, were it to be
rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating
how much we can infer from the past and how relationships might have changed. In an ever
changing world, some element of discretion appears to be an unavoidable aspect of
policymaking.
Such changes mean that we can never construct a completely general model of the
economy, invariant through time, on which to base our policy. Still, sensible policy does
presuppose a conceptual framework, or implicit model, however incompletely specified, of how
the economic system operates. Of necessity, we make judgments based importantly on historical
regularities in behavior inferred from data relationships. These perceived regularities can be
embodied in formal empirical models, often covering only a portion of the economic system.
Generally, the regularities inform our interpretation of "experience" and tell us what to look for
to determine whether history is in the process of repeating itself, and if not, why not. From such
an examination, along with an assessment of past policy actions, we attempt to judge to what
extent our current policies should deviate from our past patterns of behavior.
When this Center was founded 15 years ago, the rules versus discretion debate
focused on the appropriate policy role of the monetary aggregates, and this discussion was
echoed in the Federal Reserve's policy process.
In the late 1970s, the Federal Reserve's actions to deal with developing
inflationary instabilities were shaped in part by the reality portrayed by Milton Friedman's
analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs,
followed on the heels of similar patterns of average money growth. The Federal Reserve, in
response to such evaluations, acted aggressively under newly installed Chairman Paul Volcker.
A considerable tightening of the average stance of policy -- based on intermediate M1 targets
tied to reserve operating objectives -- eventually reversed the surge in inflation.
The last fifteen years have been a period of consolidating the gains of the early
1980s and extending them to their logical end -- the achievement of price stability. We are not
quite there yet, but we trust it is on the horizon.
Although the ultimate goals of policy have remained the same over these past
fifteen years, the techniques used in formulating and implementing policy have changed
considerably as a consequence of vast changes in technology and regulation. Focusing on M1,
and following operating procedures that imparted a considerable degree of automaticity to
short-term interest rate movements, was extraordinarily useful in the early Volcker years. But
after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the
Federal Open Market Committee became too interest-sensitive for that aggregate to be useful in
implementing policy. Because the velocity of such an aggregate varies substantially in response
to small changes in interest rates, target ranges for M1 growth in its judgment no longer were
reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated
movement in spending and hence the quantity of money demanded, a small variation in interest
rates would be sufficient to bring money back to path but not to correct the deviation in
spending.
As a consequence, by late 1982, M1 was de-emphasized and policy decisions per
force became more discretionary. However, in recognition of the longer-run relationship of
prices and M2, especially its stable long-term velocity, this broader aggregate was accorded
more weight, along with a variety of other indicators, in setting our policy stance.
As an indicator, M2 served us well for a number of years. But by the early 1990s,
its usefulness was undercut by the increased attractiveness and availability of alternative outlets
for saving, such as bond and stock mutual funds, and by mounting financial difficulties for
depositories and depositors that led to a restructuring of business and household balance sheets.
The apparent result was a significant rise in the velocity of M2, which was especially unusual
given continuing declines in short-term market interest rates. By 1993, this extraordinary
velocity behavior had become so pronounced that the Federal Reserve was forced to begin
disregarding the signals M2 was sending, at least for the time being.
Data since mid-1994 do seem to show the re-emergence of a relationship of M2
with nominal income and short-term interest rates similar to that experienced during the three
decades of the 1960s through the 1980s. As I indicated to the Congress recently, however, the
period of predictable velocity is too brief to justify restoring M2 to its role of earlier years,
though clearly persistent outsized changes would get our attention.
Increasingly since 1982 we have been setting the funds rate directly in response to
a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose
much of the information on the balance of money supply and demand that changing market rates
afford, but for the moment we see no alternative. In the current state of our knowledge, money
demand has become too difficult to predict.
Although our operating target is a nominal short-term rate, we view its linkages to
spending and prices as indirect and complex. For one, arguably, it is real, not nominal, rates that
are more relevant to spending. For another, spending, prices and other economic variables
respond to a whole host of financial variables. Hence, in judging the stance of policy we
routinely look at the financial impulses coming from foreign exchange, bond, and equity
markets, along with supply conditions in credit markets generally, including at financial
intermediaries.
Nonetheless, we recognize that inflation is fundamentally a monetary
phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or
real interest rates. In current circumstances, however, determining which financial data should
be aggregated to provide an appropriate empirical proxy for the money stock that tracks income
and spending represents a severe challenge for monetary analysts.
The absence of a monetary aggregate anchor, however, has not left policy
completely adrift. From a longer-term perspective we have been guided by a firm commitment
to contain any forces that would undermine economic expansion and efficiency by raising
inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability.
Within that framework we have attempted not only to lean against the potential for an
overheating economy, but also to cushion shortfalls in economic growth. And, recognizing the
lags in the effects of policy, we have tried to move in anticipation of such disequilibria
developing.
But this is a very general framework and does not present clear guidance for
day-to-day policy decisions. Thus, as the historic relationship between measured money supply
and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and
discretionary.
Nonetheless, we try to develop as best we can a stable conceptual framework, so
policy actions are as regular and predictable as possible -- that is, governed by systematic
behavior but open to evidence of structural macroeconomic changes that require policy to adapt.
The application of such an approach is illustrated by a number of disparate events
we have confronted since 1982 that were in some important respects outside our previous
experience. In the early and mid-1980s, the FOMC faced most notably the sharp swings in fiscal
policy, the unprecedented rise and fall of the dollar, and the associated shifts in international
trade and capital flows. But I will concentrate on several events of the last decade where I
personally participated in forming the judgments used in policy implementation.
One such event was the stock market crash of October 1987 shortly after I
arrived. Unlike many uncertain situations that have confronted monetary policy, there was little
question that the appropriate central bank action was to ease policy significantly. We knew we
would soon have to sop up the excess liquidity that we added to the system, but the timing and, I
believe, the magnitude of our actions were among our easier decisions. Our concerns at that time
reflected questions about how the financial markets and the economy would respond to the
shock of a decline of more than one-fifth in stock prices in one day, and whether monetary
policy alone could stabilize the system. By the early spring of 1988 it was evident that the
economy had stabilized and we needed to begin reversing the easy stance of policy.
Another development that confronted policy was the commercial property price
bust of the late 1980s and early 1990s. Since a large volume of bank and thrift loans was tied to
the real estate market and backed by real estate collateral, the fall in property prices impaired the
capital of a large number of depositories. These institutions reacted by curtailing new lending
-the unprecedented "credit crunch" of 1990 and 1991.
Not unexpectedly, our policy response was to move toward significant ease. Our
primary concern was the state of the credit markets and the economy, but we could also see that
these broader issues were linked inextricably to the state of depository institutions' balance
sheets and profitability. A satisfactory recovery from the recession of that period, in our
judgment, required the active participation of a viable banking system. The extraordinary
circumstances dictated a highly unusual path for monetary policy. The stance of policy eased
substantially even after the economy began to recover from the 1990-91 recession, and a
stimulative policy was deliberately maintained well into the early expansion period.
By mid-1993, however, property prices stabilized and the credit crunch gradually
began to dissipate. It was clear as the year moved toward a close that monetary policy,
characterized by a real federal funds rate of virtually zero, was now far too easy in light of the
strengthening economy on the horizon. Financial and economic conditions were returning to
more traditional relationships, and policy had to shift from a situation-specific formulation to
one based more closely on previous historical patterns. Although it was difficult at that time to
discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated
pre-emptive action.
The 1994 to 1995 period was most instructive. It appears we were successful in
moving pre-emptively to throttle down an impending unstable boom, which almost surely would
have resulted in the current expansion coming to an earlier halt. Because this was the first
change in the stance of policy after a prolonged period of unusual ease, we took special care to
spell out our analysis and expectations for policy in an unusually explicit way to inform the
markets well before we began to tighten. In addition, we began for the first time to issue
explanatory statements as changes in the stance of policy were implemented. Even so, the idea
of tightening to head off inflation before it was visible in the data was not universally applauded
or perhaps understood.
Financial markets reacted unusually strongly to our 1994 policy actions, often
ratcheting up their expectations for further rate increases when we actually tightened, resulting
in very large increases in longer-term interest rates. At the time, these reactions seemed to reflect
the extent to which investment strategies had been counting on a persistence of low interest
rates. This was a classic case in which we had to be careful not to allow market expectations of
Federal Reserve actions to be major elements of policy determination. We are always concerned
about assuming that short-term movements in market prices are reflections of changes in
underlying supply and demand conditions when we may be observing nothing more than
fluctuating expectations about our own policy actions.
Most recently, the economy has demonstrated a remarkable confluence of robust
growth, high resource utilization, and damped inflation. Once again we have been faced with
analyzing and reacting to a situation in which incoming data have not readily conformed to
historical experience.
Specifically, the persistence of rising profit margins in the face of stable or falling
inflation raises the question of what is happening to productivity. If data on profits and prices are
even approximately accurate, total consolidated corporate unit costs have, of necessity, been
materially contained. With labor costs constituting three-fourths of costs, unless growth in
compensation per hour is falling, which seems most unlikely from other information, it is
difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in
excess of the officially published annual growth rate of nonfarm productivity of one percent
over recent quarters. The degree to which these data may be understated is underlined by
backing out from the total what appears to be a reasonably accurate, or at least consistent,
measure of productivity of corporate businesses. The level of nonfarm noncorporate productivity
implied by this exercise has been falling continuously since 1973 despite reasonable earnings
margins for proprietorships and partnerships. Presumably this reflects the significant upward
bias in our measurement of service prices, which dominate our noncorporate sector.
Nonetheless, the still open question is whether productivity growth is in the
process of picking up. For it is the answer to this question that is material to the current debate
between those who argue that the economy is entering a "new era" of greatly enhanced
sustainable growth and unusually high levels of resource utilization, and those who do not.
A central bank, while needing to be open to evidence of structural economic
change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to
have been ephemeral would undermine the very good economic performance we have enjoyed.
We raised the federal funds rate in March to help protect against this latter possibility, and with
labor resources currently stretched tight, we need to remain on alert.
Whatever its successes, the current monetary policy regime is far from ideal. Each
episode has had to be treated as unique or nearly so. It may have been the best we could do at the
moment. But we continuously examine alternatives that might better anchor policy, so that it
becomes less subject to the abilities of the Federal Open Market Committee to analyze
developments and make predictions.
Gold was such an anchor or rule, prior to World War I, but it was first
compromised and eventually abandoned because it restrained the type of discretionary monetary
and fiscal policies that modern democracies appear to value.
A fixed, or even adaptive, rule on the expansion of the monetary base would
anchor the system, but it is hard to envision acceptance for that approach because it also limits
economic policy discretion. Moreover, flows of U.S. currency abroad, which are variable and
difficult to estimate, and bank reserves avoidance are subverting any relationship that might
have existed between growth in the monetary base and U.S. economic performance.
Another type of rule using readings on output and prices to help guide monetary
policy, such as John Taylor's, has attracted widening interest in recent years in the financial
markets, the academic community, and at central banks.
Taylor-type rules or reaction functions have a number of attractive features. They
assume that central banks can appropriately pay attention simultaneously to developments in
both output and inflation, provided their reactions occur in the context of a longer-run goal of
price stability and that they recognize that activity is limited by the economy's sustainable
potential.
As Taylor himself has pointed out, these types of formulations are at best
"guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is
that their formulation depends on the values of certain key variables -- most crucially the
equilibrium real federal funds rate and the production potential of the economy. In practice these
have been obtained by observation of past macroeconomic behavior -- either through informal
inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I
noted earlier, they embody a forecast that the future will be like the past. Unfortunately,
however, history is not an infallible guide to the future, and the levels of these two variables are
currently under active debate.
The mechanics of monetary policy that I have been addressing are merely means
to an end. What are we endeavoring to achieve, and why? The goal of macroeconomic policy
should be maximum sustainable growth over the long term, and evidence has continued to
accumulate around the world that price stability is a necessary condition for the achievement of
that goal.
Beyond this very general statement, however, lie difficult issues of concept and
measurement for policymakers and academicians to keep us occupied for the next fifteen years
and more.
Inflation impairs economic efficiency in part because people have difficulty
separating movements in relative prices from movements in the general price level. But what
prices matter? Certainly prices of goods and services now being produced -- our basic measure
of inflation -- matter. But what about prices of claims on future goods and services, like equities,
real estate or other earning assets? Is stability in the average level of these prices essential to the
stability of the economy? Recent Japanese economic history only underlines the difficulty and
importance of this question. The prices of final goods and services were stable in Japan in the
mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately
undermined the performance of the macroeconomy.
In the United States, evaluating the effects on the economy of shifts in balance
sheets and variations in asset prices has been an integral part of the development of monetary
policy. In recent years, for example, we have expended considerable effort to understand the
implications of changes in household balance sheets in the form of high and rising consumer
debt burdens and increases in market wealth from the run-up in the stock market. And the equity
market itself has been the subject of analysis as we attempt to assess the implications for
financial and economic stability of the extraordinary rise in equity prices -- a rise based
apparently on continuing upward revisions in estimates of our corporations' already robust
long-term earning prospects. But, unless they are moving together, prices of assets and of goods
and services cannot both be an objective of a particular monetary policy, which, after all, has
one effective instrument -- the short-term interest rate. We have chosen product prices as our
primary focus on the grounds that stability in the average level of these prices is likely to be
consistent with financial stability as well as maximum sustainable growth. History, however, is
somewhat ambiguous on the issue of whether central banks can safely ignore asset markets,
except as they affect product prices.
Over the coming decades, moreover, what constitutes product price and, hence,
price stability will itself become harder to measure.
When industrial product was the centerpiece of the economy during the first
two-thirds of this century, our overall price indexes served us well. Pricing a pound of
electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel
sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a
period of years.
I have already noted the problems in defining price and output and, hence, in
measuring productivity over the past twenty years. The simple notion of price has turned
decidedly complex. What is the price of a unit of software or of a medical procedure? How does
one evaluate the price change of a cataract operation over a ten-year period when the nature of
the procedure and its impact on the patient has been altered so radically? The pace of change and
the shifting to harder-to-measure types of output are more likely to quicken than to slow down.
Indeed, how will we measure inflation in the future when our data -- using current techniques
-could become increasingly less adequate to trace price trends over time?
However, so long as individuals make contractual arrangements for future
payments valued in dollars and other currencies, there must be a presumption on the part of
those involved in the transaction about the future purchasing power of money. No matter how
complex individual products become, there will always be some general sense of the purchasing
power of money both across time and across goods and services. Hence, we must assume that
embodied in all products is some unit of output, and hence of price, that is recognizable to
producers and consumers and upon which they will base their decisions.
The emergence of inflation-indexed bonds does not solve the problem of pinning
down an economically meaningful measure of the general price level. While there is, of course,
an inflation expectation premium embodied in all nominal interest rates, it is fundamentally
unobservable. Returns on indexed bonds are tied to forecasts of specific published price indexes,
which may or may not reflect the market's judgment of the future purchasing power of money.
To the extent they do not, of course, the implicit real interest rate is biased in the opposite
direction.
Doubtless, we will develop new techniques of measurement to unearth those true
prices as the years go on. It is crucial that we do, for inflation can destabilize an economy even if
faulty price indexes fail to reveal it.
It should be evident from my remarks that ample challenges will continue to face monetary
policy. I have concentrated on how we have tried to identify and analyze new developments, and
endeavored to use that analysis to fashion and balance policy responses. I have also tried to
highlight the questions about how to specify and measure the ultimate goals of policy.
Nonetheless, all of us could easily add to the list. In dealing with these issues, policy can only
benefit from focused and relevant academic research. I look forward to learning about and
utilizing the contributions made under the sponsorship of the Center for Economic Policy
Research over the years to come.