edward m gramlich : conducting monetary policy remarks by mr edward m gramlich, member of the board of governors of the us federal reserve system, at a joint meeting of the north american economic and finance association and the allied social science association, washington, dc, 4 january 2003. * * * members of the federal open market committee have many opportunities to discuss the economy. the financial press is full of reports on talks by member x reporting that growth is a bit strong ( weak ), the economy is working its way over a hill ( through a valley ), inflation ( deflation ) is a clear ( remote ) threat. there seems to be an agreed code for translating these statements into the likelihood that member x will vote to raise ( lower ) interest rates at the next meeting, and the federal funds futures market responds accordingly. today i do not want to take part in that exercise. i will have nothing to say about the current status of the economy or my likely vote at the next meeting. rather, i'd like to step back and ask what, in the end, is the federal reserve trying to do? what is its long - term strategy? of course, in doing that, i am giving my own personal view of this strategy, not speaking for others on the committee. as many as eighteen other versions of this talk could be given, and some might show important disagreements. i start my discussion of monetary strategy by alluding to fiscal policy. most economists feel that fiscal policy should be anchored in the long run by the need to preserve overall national saving rates and prevent explosive growth in government debt. over this long term, it is desirable to have budgets roughly in balance ; or, to say it another way, the long - term budget constraint of the government should be satisfied without requiring unacceptable increases in future tax rates or cuts in future spending. this long - term anchoring permits short - term flexibility in the budget, allowing it to respond to more immediate cyclical developments through some combination of automatic fiscal stabilizers and appropriately timed discretionary policy interventions. in my view, monetary policy should be similarly structured. the long - run anchor is clearly price stability. following milton friedman, inflation in the long run is a monetary phenomenon, as is deflation. hence, the long - term goal of the fed is to keep prices stable by some definition, avoiding either inflation or deflation. but the federal reserve has a dual mandate - - to achieve not only price stability but also the maximum sustainable rate

inflation has averaged 1. 7 percent per year, not much above what many consider to be an inevitable quality - change bias in the index, implying a true inflation rate of close to zero. the standard deviation is only 0. 12 percent per year. pretty stable prices, and a pretty reasonable indication of an inflation target for a central bank that has never announced one. a second possible distinction between fit and the taylor rule involves the treatment of lags. as is well known, monetary policy works with long lags : a policy change influences aggregate demand in a distributed lag pattern beginning soon after the change and extending as long as eighteen months or two years. this lag pattern places a premium on monetary policy being ahead of the curve, in current jargon. fit is clearly written so as to be ahead of the curve. taken literally, a simple taylor rule, with the central bank responding to current values of inflation and unemployment rates, is not. it could, however, be modified to respond to forward - looking information and thus moved in the direction of fit. most members of the federal open market committee consider the task of staying ahead of the curve to be among their most challenging job requirements. economic data series are released every day, and the usual pattern is that some indicators point upward and some point downward, many have seasonal adjustment problems, and many are significantly revised in subsequent months and years. to ascertain true economic signals from this welter of data is quite challenging. but the lags in policy are there, and we must make the effort. hence, although a strategy for policy response may be articulated in different ways, the differences may not be so large in actual practice. however the policy strategy is articulated, anchoring it on some concept of long - term price stability is important, as is permitting short - term flexibility to deal with shocks ; essentially the same goals most economists have in mind for fiscal policy. it is also important to stay ahead of the curve. with that as a preamble, i now turn to several arguments about this monetary strategy. money versus interest rates for most of the post - world war ii period, monetary economists have vigorously debated whether the fed should target money or interest rates in setting policy. in the academic literature, the issue depends on the nature of the shocks. as william poole has shown, if spending shocks predominate, it makes sense to target money, or monetary quantities ; if money demand shocks predominate, it makes sense to target