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Special Issue

The Region

Federal Reserve Bank of Minneapolis
1995 Annual Report

Formulating a Consistent Approach
to Monetary Policy

Special Issue

The Region

Volume 10 Number 1
March 1996
ISSN 1045-3369

Federal Reserve Bank of Minneapolis
1995 Annual Report

Formulating a Consistent Approach
to Monetary Policy
By Gary H. Stern, President
Federal Reserve Bank of Minneapolis

The views expressed herein are those o f the author
and not necessarily those o f the Federal Reserve System.


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P r e s i d e n t ’s M e s s a g e

Recently, I was prompted to reflect anew about one of the Federal Reserve System’s most
im portant responsibilities — monetary policy — because I am a voting member of the
Federal Open Market Committee (FOMC) again in 1996, and this tends to sharpen one’s
focus on policy.
For the FOMC, the goal of monetary policy is to achieve maximum economic per­
formance over time, and the best way to achieve this goal is to maintain low inflation. There
is little debate about the merits of a low inflation policy; however, as to how and why low
inflation is best for the economy, there is disagreement and misunderstanding. In this essay,
I offer some explanations for the benefits of long-run low inflation, with emphasis on
resource allocation.
While a strong case can be made for a low inflation strategy in the long run, that
strategy is often required to accommodate a belief that monetary policy can, and should, be
used to soften the ups and downs in the short-run cyclical economy. This requirement pre­
sents a challenge in making short-run decisions that address immediate concerns, but that
are also consistent with long-run price stability. For reasons that I explain in this essay, cur­
rently we don’t have an adequate method to ensure that short-run monetary policy deci­
sions are consistent with long-run objectives; clearly, this gap in knowledge demands fur­
ther study.
I would like to thank colleagues from the Minneapolis Fed for their assistance
with this paper: Mel Burstein, Ed Green, Art Rolnick, Warren Weber and, especially, Preston
Finally, although a disclaimer appears elsewhere in this Annual Report, allow me to
emphasize the point: Any views expressed in this essay are my own and are not intended to
speak for the Federal Reserve System.




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In the Federal Reserve, our working objective is to reduce inflation to the point where
it no longer is a factor in economic decision making. As we succeed, resource allocation
moves closer to optimal, with attendant benefits in growth and living standards.



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Federal Reserve Bank of Minneapolis
1995 Annual Report

Formulating a Consistent Approach
to Monetary Policy

Monetary policy is one of the principal responsibilities of the Federal Reserve, and certain­
ly the one which receives the most attention. Simply stated, the goal of monetary policy is
to achieve maximum economic performance over time. There is considerable agreement
that the most significant contribution the Federal Reserve can make to this goal, character­
ized by sustained economic growth and improved living standards, is to achieve and m ain­
tain low inflation. However, the channels through which inflation influences growth are not
clear, nor is it universally accepted that inflation even influences growth.
In addition to long-run emphasis on low inflation, there is a belief that monetary
policy can improve economic performance by decreasing volatility in business activity —
that is, by smoothing the business cycle. However, given the greatly diminished importance
of the monetary aggregates in the policy process, a major challenge currently confronting
the Federal Open Market Committee (FOMC) is to guarantee that short-run decisions
designed to address cyclical concerns are consistent with the long-run low inflation objec­
tive. Formerly, the monetary aggregates helped to assure that monetary policy was
anchored to low inflation and was “time consistent,” but these roles have not as yet been
filled by other variables or changes in procedures. Several proposals address these gaps in
our practices, but our knowledge is insufficient to make a selection. In my view, it is imper­
ative that we address these issues promptly.
As suggested above, the commitment to low inflation is widely shared among the
members of the FOMC. Nevertheless, a host of questions arise associated with the focus on



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low inflation: Will the low inflation environment contribute over time to growth and to
higher standards of living? If so, how? How does low inflation contribute to financial sta­
bility? Can the Federal Reserve achieve and maintain low inflation? What weight, if any,
should be given to cyclical fluctuations in unemployment and economic activity in policy
determination? How should the Federal Reserve implement a low inflation policy?

In f l a t io n a n d G r o w t h
Evidence has accumulated suggesting that economies perform better, in terms of growth,
employment and living standards, in low inflation environments than they do when infla­
tion is persistently high. This evidence is principally a comparison — across countries and
over long periods — of the association between economic performance, measured by, say,
growth of output or growth of productivity, and inflation. The correlations indicate a neg­
ative relation; that is, the higher the inflation, the lower the rate of real growth. This evi­
dence is neatly summarized in several recent academic papers.1
Evidence suggesting that low inflation promotes growth has motivated recent deci­
sions by a number of central banks and governments, most notably New Zealand. Canada,
the United Kingdom and Sweden also have moved in recent years to establish monetary
policy regimes with official low inflation targets. Such actions indicate the preeminence of
this goal and frequently signify increased independence for the central bank in pursuit of
its policies as well. Decisions to adopt a policy objective of low inflation suggest that other
policy-makers are reading the evidence pertaining to inflation and growth as we are.
An issue logical to consider next is: Why is low inflation relatively favorable for
growth? After all, association does not prove causality; the relation between growth and
inflation reported above may simply be fortuitous, or the causality may run the other way.
This is indeed a difficult question, in part because until recently there were not well-artic­
ulated theories to explain the relationship. However, basic economic reasoning suggests that
there are at least two channels through which inflation influences real economic perfor-



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Given the greatly diminished importance of the monetary aggregates in the
policy process, a major challenge currently confronting the Federal Open Market
Committee (FOMC) is to guarantee that short-run decisions designed to address
cyclical concerns are consistent with the long-run low inflation objective.

mance. First, in contrast to high inflation, low inflation leads to improved resource alloca­
tion because price signals are more easily and more accurately interpreted. Second, low
inflation contributes to financial stability.2 Let me explain.

Resource Allocation
Relative prices provide a guide in the allocation of resources. For example, a change in rel­
ative prices resulting from a change in demand patterns should shift resources and produc­
tion from the activity whose price has fallen (relatively) to that whose price has risen, while
a general rise in the price level— inflation— should not alter resource allocation in this way.
But in an inflationary environment it may be difficult for individual decision makers to dis­
tinguish between inflation on the one hand and a change in relative prices on the other, and
such confusion is especially likely if high inflation is correlated with variable inflation (infla­
tion rates which fluctuate substantially from period to period), as it appears to be. Thus,
resources may be seriously misallocated during inflationary periods.
In addition, inflation creates a problem in estimating the real interest rate. The real
(that is, inflation-adjusted) interest rate— the relative price of current to future goods — is
not explicitly given as a market price, but rather people deduce it from the nominal (that is,
unadjusted) interest rate by taking inflation into account. When inflation becomes variable,
this task of determining the true relative price becomes more difficult. The resulting misallocation of resources will adversely affect growth and living standards, because resources are
not being put to their best use. Further, if the tax system is not indexed, inflation may
adversely affect incentives to work and to invest. In the extreme, considerable resources may
be devoted to efforts to avoid or to offset the ravages of inflation. And, without widespread
indexation, inflation may well result in capricious transfers of wealth.
All of these effects diminish when inflation is persistently low. Indeed, in the Federal
Reserve, our working objective is to reduce inflation to the point where it no longer is a fac­
tor in economic decision making. As we succeed, resource allocation moves closer to opti­
mal, with attendant benefits in growth and living standards.



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There is widespread agreement that the supply of money is determined by the
central bank in the long run. Thus, with appropriate policy, the Federal Reserve
can achieve and maintain low inflation — it should be expected to do so and
can be held accountable for doing so.

Financial Stability
The second broad reason why low inflation favors growth is that it contributes, in my judg­
ment, to financial stability. A low inflation economy is less likely to engender the sharp
swings in asset prices and in expectations about such prices that have been so devastating
to the financial system from time to time. Consider, for example, the damage wreaked by
inflation on the savings and loan industry and some of its customers 15 or so years ago.
Similarly, the “credit crunch” which inhibited the U.S. economy just a few years ago can be
traced in part to capital pressures at commercial banks stemming from earlier misjudgments about inflation and asset values.
In a fundamental sense, problems associated with misjudgment of asset prices and
their prospects are no different than the confusion about relative and general price changes
described earlier. Investors and creditors misjudge price signals and draw incorrect conclu­
sions, financial resources are then misallocated, and disruptions occur.
Financial stability is vital to a prosperous economy in a number of ways. Implicit in
the preceding discussion, credit decisions, which determine the allocation of financial
resources, are likely to be closer to optimal in a low inflation economy. This follows from
the common sense notion that bankers and their customers will on average do a better job
of assessing business prospects in an atmosphere of relatively stable prices.
Financial stability also enhances an economy’s ability to weather shocks — run-ups
in energy prices, significant technological changes, unforeseen developments in the
economies of major trading partners, and so forth — the bane of policy-makers and fore­
casters alike. Such events will cause dislocations, to be sure, but a financial system which can
absorb them without significant feedback to economic activity helps to limit the extent and
duration of the disruption. In these circumstances, real growth will be affected less than it
would be under conditions in which the financial sector magnifies and spreads the effects
of the shock. Furthermore, it is likely to be easier to identify the effects of shocks and the
proper responses to them in a noninflationary environment.



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P o l ic y a n d I n f l a t io n
To this point, I have suggested that low inflation can make significant contributions to
growth and prosperity through its effects on real resource allocation and on financial sta­
bility. This suggestion is not of much moment, however, if monetary policy cannot achieve,
and maintain, low inflation. On this subject, fortunately, evidence and opinion are largely
of one mind.
One of the few topics about which most macroeconomists agree is that inflation is
first and foremost a monetary phenomenon.3It results from a long-term pattern of money
creation which is excessive relative to the economy’s ability to produce real goods and ser­
vices. Further, there is widespread agreement that the supply of money is determined by the
central bank in the long run. Thus, with appropriate policy, the Federal Reserve can achieve
and maintain low inflation — it should be expected to do so and can be held accountable
for doing so. In a general sense, then, the operational responsibility of the Federal Reserve
is to provide for long-run growth in money consistent with low inflation. And, as I empha­
sized earlier, there should be significant economic benefits to the extent the Federal Reserve
achieves this objective.
Long-run m onetary grow th of 4 percent, fo r example, could be consistent w ith 4 percent grow th
in each and every period, as illustrated by the straight line, C, or 4 percent grow th in the lo n g -ru n
could also be consistent w ith a num ber of different patterns, as illustrated by lines A and B.



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The preceding policy “prescription” glosses over at least one difficult issue, namely:
The mandate to avoid excessive long-term money creation permits considerable latitude in
how the stock of money moves in the short term and, therefore, is not necessarily useful for
short-run policy determination. [See graph on page 7.] In the past, monetary aggregates
were used to tie the short run to the long run, but the short-run relation between money
and the economy has seriously deteriorated. Likewise, confidence in the use of monetary
aggregates in practical policy setting has understandably been undermined.4Experience has
convinced me that the aggregates are now of little value in short-term decision making.
This leaves a significant gap in our procedures, especially when we want to calibrate a
response to business cycle developments.

Business Cycle Considerations
Indeed, a critical question is: How can the Federal Reserve achieve low inflation and effec­
tively respond to business cycle excesses in an environment in which the money supply is
not a useful short-term guide to policy? Having previously addressed the money-inflation
issue, I will turn to two other aspects of this question: (1) Can monetary policy influence
real activity in the short run? and (2) If it can, should it?
These questions have long been debated in academia and in the Federal Reserve,
and a consensus has not emerged. My position is that monetary policy has effects on real
economic variables in the short term, but the magnitude of such effects is uncertain and the
timing between policy action and its effects is variable. Thus, our knowledge of the shortrun effects of policy is insufficient to permit us to act aggressively in most circumstances.
This is a fairly conventional position. Certainly the Federal Reserve behaves as if
monetary policy has real effects, and empirical evidence supports the notion.5 But because
of uncertainty about magnitude and lags, policy-makers have to be cautious in their
response to unexpected deviations in economic performance. The fundamental reason is
that there is a real risk of aggravating the situation — that is, our actions could be destabi­
lizing rather than constructive.



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If not carefully implemented and explained, countercyclical policy might create
confusion about the long-run objective of the FOMC, could disrupt private sector
planning and decision making, and could add uncertainty and inflation premiums
to market interest rates.

Some would go further and would maintain that even a cautious response to busi­
ness cycle fluctuations is unwise, given all the reservations expressed over the years about
fine tuning. But in my view it is not too difficult to argue in favor of some response. Given
that monetary policy has real effects, it is only necessary to observe that short-run volatili­
ty inhibits long-run real growth. Put more forcefully, boom-bust cycles damage the econo­
my, and therefore policy should be employed countercyclical^ to moderate, if possible, the
tops of booms and the bottoms of contractions.6
Countercyclical policy to avoid or at least to moderate boom-bust cycles thus seems
defensible but, as already suggested, such a policy should be pursued cautiously. It could be
destabilizing if policy-makers are wrong about the size and timing of the effects of their
actions, and thus it conceivably could inadvertently deepen a recession or stimulate infla­
tion. Moreover, if not carefully implemented and explained, countercyclical policy might
create confusion about the long-run objective of the FOMC, could disrupt private sector
planning and decision making, and could add uncertainty and inflation premiums to m ar­
ket interest rates.

An Anchor for Policy
Money growth ranges provided a framework that reconciled the long-run commitment to
low inflation with short-run reactions to economic developments. To see how, let me
explain the roles the monetary aggregates formerly played in the policy process. The place
to begin is with the quantity theory of money. According to the quantity theory, there is a
relation between the rate of growth of the money supply, growth in real economic activity,
and inflation. The linkage between money and the variables we care about — inflation and
real growth — is provided by the velocity of money. This is precisely where recent difficul­
ties have arisen for, as we have seen recently, money velocity has deviated from previous
experience, and accurate prediction has become increasingly challenging. Over time, this
deterioration in the relation between money growth and nominal business activity has
afflicted virtually all of the conventional measures of money.



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The quantity theory in its crude form would suggest a strict, mechanical pursuit of
a precise target for money-stock growth. Although such a policy regime was approximated
briefly to re-establish monetary policy credibility after the inflationary episode at the end of
the 1970s, monetary aggregates have been used in a looser, more discretionary way in pol­
icy determination since that time. But it seems to me that the deteriorating relation between
money growth and nominal business activity has undermined the advisability of even this
looser policy regime.
To see why, consider how this regime worked. When the monetary aggregates were
useful in policy determination, a rate of growth for an aggregate could be specified consis­
tent with the FOMC’s inflation objective and its understanding of the relations in question.
For example, if the trend rate of growth in real GDP was estimated at 2.5 percent per
annum, money velocity constant, and 3 percent an acceptable inflation outcome for the
period in question, then money should expand at 5.5 percent per year. In practice, the
Committee not only selected a midpoint for money growth — 5.5 percent in this example
— but also established a range around the midpoint, recognizing both that these relations
do not hold precisely on an annual basis and that flexibility to respond to unanticipated
developments is desirable. When conditions turned out as expected, open market opera­
tions were conducted to keep the path of bank reserves or the federal funds rate, depend­
ing upon the short-run operating rule, consistent with desired money growth and,
ultimately, inflation.
In this setup, the range for money supply growth fulfilled several functions. The
midpoint of the range was typically established consistent with the Committee’s inflation
objective. When the aggregates were employed successfully, midpoints were reduced grad­
ually over time, in keeping with the FOMCs desire to bring inflation down. The money
supply was thus the “anchor” of policy — the variable on which the FOMC focused in order
to pursue a low inflation policy.
The upper and lower bounds of the ranges served as the limits within which the
Committee was prepared to see money growth deviate from its midpoint. That is, the



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1996 Federal Open Market Committee Members
Alan Greenspan, Chairman
William J. M cD onough, Vice Chairman
Edward G. Boehne

Robert D. McTeer, Jr.

Jerry L. Jordan

Susan M. Phillips

Edward W. Kelly, Jr.

Gary H. Stern

Lawrence B. Lindsey

Janet L. Yellen

ranges defined acceptable short-run deviations in money growth — perhaps for cyclical
reasons — which nevertheless were viewed as consistent with the Committee’s commit­
ment to low inflation. Because the ranges were relatively narrow, policy remained disci­
plined and, even if in error, was unlikely to be highly destabilizing.7

Consistent Policy Over Time
With the monetary aggregates no longer of significant value in the policy process, we find
ourselves without an effective policy anchor — that is, without a quantitative way of indi­
cating the FOMC’s long-run objective and of guiding open market operations toward that
objective — and without a means to define acceptable countercyclical action, whereby
acceptable I mean an effective response to incipient booms or busts which does not com­
promise our long-run objective. What I am striving for is the concept of policy consisten­
cy over time: a countercyclical response which is consistent with, or can be reconciled with,
the FOMC’s long-run goal and which, furthermore, is seen as consistent by the public. To
be sure, policy has been implemented effectively and largely successfully in recent years, in
my view, without an explicit anchor and a method to assure time consistency. Nevertheless,
the FOMC’s judgment may not always be adequate, and hence it is desirable to find a more



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systematic way to conduct policy so as to achieve and maintain low inflation and to m od­
erate business cycle extremes.8
There are several ways we might go about establishing a framework for a more sys­
tematic policy capable of addressing these two matters. But before describing specific pro­
posals, we need criteria by which to evaluate the options. Based on the preceding discussion
of the roles formerly played by measures of the money supply, im portant criteria are:
(1) Does the proposal contain a clear and appropriate policy anchor which guides
monetary policy to the low inflation objective?
More formally, is there a variable that bears a close and unchanging rela­
tionship with inflation that the FOMC can influence in a predictable way?
(2) Does the proposal have an effective way of delimiting the policy response to
business cycle fluctuations?
Again, more formally, is there a way of putting a range around the anchor
that allows responses to fluctuations, but limits those responses to ensure con­
sistency with the FOMC’s low inflation goal?
Of the three following proposals, none is especially original, and none is entirely
satisfactory. Nevertheless, they are offered to illustrate a range of available approaches and
to stimulate further thought about how we can best establish an anchor for, and assure time
consistency in, monetary policy
One approach to a more systematic framework for policy implementation is to res­
urrect the monetary aggregates, based on the following considerations. We would acknowl­
edge that the aggregates have lost value as short-term guides to policy, but at the same time
we would reaffirm that inflation remains a long-term monetary phenomenon. The respon­
sibility of the central bank, thus, would not change: It is to keep money supply growth with­
in bounds over long periods — say 10 years — so as to keep inflation low.
This proposal effectively satisfies the first criterion specified above. Money growth
would once again become the anchor of policy, with exclusive emphasis on its long-run
performance in view of its shortcomings as a short-term guide. Assuming past relations



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There is only limited agreement at the moment about the systematic conduct of policy,
in view of the diminution of the role of the money supply measures. I have offered several
suggestions to address this issue, including exclusive focus on the long-run growth in
money, on the inflation objective itself and on a real short-term interest rate.



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hold, long-run monetary control should result in long-run inflation control. The evidence
as to which aggregate to select is mixed, but it appears to be a “horse race” between M2 and
the monetary base; either would probably do.
The proposal to concern ourselves only with the long-run performance of a m on­
etary aggregate fares less well against the second criterion of disciplining the response of
monetary policy to changes in business conditions. On one interpretation, in the singleminded pursuit of moderate money growth and low inflation, the proposal would permit
no reaction to significant deviations in business activity from what was anticipated. This is
a potentially costly policy stance if earlier observations about the desirability of containing
instability — that is, smoothing boom-bust cycles — are accurate. But another interpreta­
tion of the proposal suggests that “anything goes.” This is because the proposal simply leaves
open the questions of when or how to respond to unanticipated or undesired developments
in the economy.
A second alternative to enhance systematic policy implementation is to focus
directly on the policy objective, the rate of inflation, and adjust the instrument, say the fed­
eral funds rate, to influence the objective as desired. Intuitively, this approach is appealing,
for it does not involve “extraneous” variables like intermediate policy targets. Presumably,
an empirical model of the economy would be used to solve for the path of the federal funds
rate consistent with the FOMC’s inflation goal, and the Committee would authorize open
market operations to achieve the funds rate path.
Arrayed against the two criteria specified above, the virtues and shortcomings of
this proposal are evident. Since it focuses directly on inflation, it would seem to satisfy the
first criterion of providing an appropriate anchor for policy. One has to be cautious, how­
ever, because our goal is optimal long-run economic performance and, as discussed above,
the evidence suggests that low inflation over the long run is favorable for growth; but I am
aware of no evidence which indicates that inflation control period by period is conducive
to real growth. Indeed, even proposals to maintain constant growth in the money supply
have recognized that there could well be a lot of period-by-period price volatility.


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W hat I am striving for is the concept of policy consistency over time: a counter­
cyclical response which is consistent with, or can be reconciled with, the FOM C’s
long-run goal and which, furthermore, is seen as consistent by the public.

Although a multiperiod inflation targeting procedure would seem to ameliorate
this problem, it also has problems. With a short-period horizon, the instability problems
associated with a single-period horizon remain. But with a long-period horizon, there is
basically no policy discipline in the short run.
A third approach to the issue of the systematic implementation of policy is for the
Federal Reserve to focus on a short-term market interest rate. One question is whether the
interest rate should be nominal or real. Based on stability considerations, a real interest rate
seems preferable. The argument that pegging a nominal interest rate can be destabilizing is
now familiar: Normally, high interest rates are associated with restrictive monetary policy,
but if expected inflation rises for some reason and the Federal Reserve pegs the nominal
rate, then policy actually becomes increasingly expansive. A symmetric problem occurs
with nominal rate pegging when inflation expectations diminish or when deflation sets in.
This problem does not apply to a real short-term interest rate, as I argue below.
Another question, then, is how to implement a real interest rate proposal. One way
would be to use an empirical macro model to solve for the real rate, or the path of the real
rate, consistent with the Federal Reserve’s low inflation objective. Given its best estimate, or
best judgment, of inflation expectations, the FOMC would then establish the nominal rate
that produced the desired real rate. Presumably, the more actual and prospective inflation
are above the goal, the higher the nominal rate a given real-rate target would imply. If one
believes that this pattern of nominal rate setting is what the FOMC ought to be doing, then
a virtue of real-rate targeting is that the FOMC would implement it in a stable and self-reg­
ulating way. Adjustment of the real-rate target would be justified when the environment of
the economy changes in some fundamental way, such as an increase in the rate of return to
capital investment. Advocates of a real-rate target believe that it would thus lead the FOMC
to focus its deliberations appropriately on long-term considerations, without sacrificing
responsiveness to short-term disturbances in the economy.
An advantage of this approach is that economic theory suggests that real rather
than nominal interest rates matter for spending decisions, so the Federal Reserve would in


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fact be emphasizing a variable that can be expected to affect economic performance. This
observation implies that this proposal could fare relatively well against the second criterion
of defining the policy response to cyclical disturbances in activity.
Since there could well be a long-run correlation between real rates and inflation,9
the proposal would seem to have the potential to achieve the Federal Reserve’s low inflation
objective. However, the first criterion specified above calls for a clear and appropriate poli­
cy anchor; a real rate maybe appropriate but its clarity is another matter. There is not agree­
ment on measurement of the real rate nor on its controllability.
Indeed, critics of the real rate proposal assert that the Federal Reserve cannot hope
to control a real rate of interest, which they view as ground out by interactions in the real
economy independent of monetary policy. I hold a somewhat different view. In a world
with interest-bearing and noninterest-bearing government fiat debt — bonds and money
— there must be frictions in the marketplace which induce the public to hold them both,
since bonds dominate on a rate of return basis. An implication of this observation is that
monetary policy actions which alter the relative supplies of money and bonds held by the
public affect real interest rates.

C on clusion
The Federal Reserve is committed to achieving and maintaining low inflation. This is an
objective the central bank can legitimately be expected to accomplish and for which it can
be held accountable.
Although important, accountability is not the reason to focus on low inflation,
however. Rather, a sustained environment of low inflation should contribute over time to
economic growth and to improvement of living standards. The way in which low inflation
contributes to these outcomes is not entirely understood, and I have suggested in this essay
that positive effects on real resource allocation and on financial stability are key.
There is only limited agreement at the mom ent about the systematic conduct of
policy, in view of the diminution of the role of the money supply measures. I have offered



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Recent policy successes notwithstanding, establishing a method for the systematic
conduct of policy is worthy of serious consideration and debate going forward.
It is imperative that we identify an anchor for policy and a procedure which assures
time consistency, so that short-term decisions are related appropriately to the
long-term commitment to low inflation.



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several suggestions to address this issue, including exclusive focus on the long-run growth
in money, on the inflation objective itself and on a real short-term interest rate. Each of
these proposals has its flaws, and I do not think that we possess sufficient knowledge at pre­
sent to make a selection with confidence. However, recent policy successes notwithstand­
ing, establishing a method for the systematic conduct of policy is worthy of serious
consideration and debate going forward. It is imperative that we identify an anchor for pol­
icy and a procedure which assures time consistency, so that short-term decisions are relat­
ed appropriately to the long-term commitment to low inflation.


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E n d notes

'I am referring to “The Growth Effects of Monetary Policy,”
by V. V. Chari, Larry E. Jones and Rodolfo E. Manuelli, Quarterly
Review, Federal Reserve Bank of Minneapolis, Fall 1995
(h ttp ://res.m p ls.frb .fe d .u s/re sea rc h /q r/q rl9 /q rl9 -4 -2 .h tm l);
“Private Information, Money, and Growth: Indeterminacy,
Fluctuations and the Mundell-Tobin Effect,” by Costas Azariadis and
Bruce D. Smith, forthcoming in the Journal of Economic Growth,
1996; and “Inflation and Economic Growth,” by Robert J. Barro,
National Bureau of Economic Research, Working Paper 5326,1995.
2 third channel related to distortions stemming from the
interactions between inflation and financial regulations is discussed
in Chari, Jones and Manuelli, 1995.
3 recent study shows a high correlation between the rate of
growth of the money supply and the rate of inflation; this correlation
holds across three definitions of money and in a sampling of 110 coun­
tries. “Some Monetary Facts,” by George T. McCandless Jr. and Warren
E. Weber, Quarterly Review, Federal Reserve Bank of Minneapolis,
Summer 1995 (
4 “The Rise and Fall of Money Growth Targets as Guidelines
for U.S. Monetary Policy,” 1995, Benjamin Friedman writes: “In 1987
the Federal Reserve gave up setting a target for the narrow money
stock but continued to do so for broader measures of money. In 1993
the Federal Reserve publicly acknowledged that it had ‘downgraded’
even its broad money growth targets — a change that most
observers of U.S. monetary policy had already noticed long before.”
When Lawrence J. Christiano investigated the supposed change
in the relationship between money and the economy, he examined two
types of models — the first showed a break in the relationship, and the
second revealed no break. However, in the second model the link
between monetary aggregates and inflation was so weak that it would
be of no practical use for short-term policy-making anyway. “Money
and the U.S. Economy in the 1980s: A Break from the Past?” Quarterly
Review, Federal Reserve Bank of Minneapolis, Summer 1986
John H. Cochrane, in “Identifying the Output Effects of
Monetary Policy,” National Bureau of Economic Research, Working

Paper 5154, 1995, cites a large amount of recent work which con­
cludes that anticipated monetary policy changes can have real effects
on the economy. For example, Cochrane cites David H. Romer and
Christina D. Romer, “What Ends Recessions?” in NBER
Macroeconomics Annual (1994), Cambridge: MIT Press; and
Lawrence J. Christiano et. al., “Liquidity Effects and the Monetary
Transmission Mechanism,” American Economic Review 82, 346-53.
6 recently published study marshals considerable evidence
that economic growth is inversely related to volatility (Garey Ramey
and Valerie A. Ramey, “Cross-Country Evidence on the Link
Between Volatility and Growth,” American Economic Review, 85,
Although the ranges occasionally were violated, the FOMC
had to explain the errors to Congress. The FOMC generally pre­
ferred to abide by the ranges.
8Interestingly enough, in his recent Nobel prize acceptance
speech, Robert E. Lucas Jr. grapples with similar issues. Lucas con­
cludes that, absent a better understanding of monetary non-neutral­
ities, it does not seem possible “to determine whether an optimal
monetary policy should react in some way to the state of the econo­
my or should be fixed on some pre-assigned objective ... In the
meantime, policy must be made, nevertheless, and existing theory,
empirically well-tested, offers much useful guidance.”
T h e legal restrictions theory implies a long-run relationship
connecting monetary policy, real interest rates and inflation (see
Wallace). The broad implications of this theory seem consistent with
observations (see Miller-Todd and Chin-Miller).
Neil Wallace, “A Legal Restrictions Theory of the Demand for
‘Money’ and the Role of Monetary Policy,” The Rational Expectations
Revolution (1994), Cambridge: MIT Press.
Preston J. Miller and Richard M. Todd, “Real Effects of Monetary
Policy in a World Economy,” Journal of Economic Dynamics & Control
19,1995 (
Dan Chin and Preston J. Miller, “Fixed vs. Floating
Exchange Rates: A Dynamic General Equilibrium Analysis,” Staff
Report 194, Federal Reserve Bank of Minneapolis, 1995


The Region

Sta tem en t


C o n d i t i o n (in thousands)
December 31,

Bank Premises and Equipment
Less Depreciation of $40,889 and $39,393
Foreign Currencies
O ther Assets
Interdistrict Settlement Fund



Cash Items in Process of Collection



Gold Certificate Account
Special Drawing Rights
Loans to Depository Institutions
Federal Agency Obligations
U.S. Government Securities

December 31,












Deferred Credit Items
Other Liabilities



Total Liabilities









Total Assets
Federal Reserve Notes
Depository Institutions
Foreign, Official Accounts
Other Deposits
Total Deposits

Capital Accounts
Capital Paid In
Total Capital Accounts
Total Liabilities and Capital Accounts

Notes to Financial Statements

Bank recognized these costs when paid. The cumulative effect of this change
in accounting for compensated absences was recognized by the Bank as a one­
time charge to expense of $2.5 million. Ongoing operating expenses for the
year ended December 31, 1995, were not materially impacted by the change in
accounting for these costs.

A. Accounting Changes
Effective January 1, 1995, the Bank began using the accrual method of
accounting to recognize the obligation to provide benefits to former or inac­
tive employees consistent with the requirements of Statement of Financial
Accounting Standards (SFAS) No. 112, “Employers’ Accounting for Post­
employment Benefits.” Prior to 1995, the Bank recognized costs for postem­
ployment benefits when paid. The cumulative effect of this change in
accounting for benefits was recognized by the Bank as a one-time deduction
from income of $2.8 million. Additionally, the Bank recognized an increase in
1995 operating expenses of approximately $.4 million as a result of the
change in accounting for these costs.
Effective January 1, 1995, the Bank also began accruing a liability for
employees’ rights to receive compensation for future absences consistent with
SFAS No. 43, “Accounting for Compensated Absences.” Prior to 1995, the

B. Bank Premises and Commitments
Based on current facility impairments of the Federal Reserve Bank premises
located at 250 Marquette Avenue, a write-down within Net Deductions was
taken in the amount of $14.5 million. When the building is vacated in mid1997, the residual book value of $1.0 million will have been totally depreciat­
ed. In addition, contracts and related expenditures totaling approximately
$138 million have been committed, or are expected, through 1997 for land,
construction, relocation and other costs related to the new head office build­
ing at 90 Hennepin Avenue. As of December 31,1995, $43.1 million of the
$138 million was recognized.


The Region

I n c o m e a n d E x p e n s e s (in thousands)























For the Year Ended December 31,
Current Income
Interest on U.S. Government Securities and
Federal Agency Obligations
Interest on Foreign Currency Investments
Interest on Loans to Depository Institutions
Revenue from Priced Services
All Other Income
Total Current Income
Current Expenses
Salaries and Other Personnel Expenses
Retirement and Other Benefits
Postage and Shipping
Materials and Supplies
Building Expenses:
Real Estate Taxes
Depreciation— Bank Premises
Rent and Other Building Expenses
Furniture and Operating Equipment:
Depreciation and Miscellaneous Purchases
Repairs and Maintenance
Cost of Earnings Credits
Net Costs Distributed/Received from Other FR Banks
Other Operating Expenses
Total Current Expenses
Reimbursed Expenses
Net Expenses
Current Net Income
Net (Deductions) or Additions
Assessment by Board of Governors:
Board Expenditures
Federal Reserve Currency Costs
Dividends Paid
Payments to U.S. Treasury


$ 7,418

Surplus Account
Surplus, January 1
Transferred to Surplus— as above

$ 98,262

$ 90,844

Surplus, December 31

$ 98,953

$ 98,262

Transferred to Surplus


The Region


F e d e r a l R e se rv e B a n k o f M in n e a p o lis

H e le n a B r a n c h

Gerald A. Rauenhorst
Chairman and Federal Reserve Agent

Matthew J. Quinn

Jean D. Kinsey
Deputy Chair

December 31,1995

Lane W. Basso
Vice Chair

C lass A E l e c t e d


M em b e r B an k s

A p p o in t e d

by t h e

B oard


Susanne V. Boxer
MFC First National Bank
Houghton, Michigan

Lane W. Basso
Deaconess Research Institute
Billings, Montana

Jerry B. Melby
First National Bank
Bowbells, North Dakota

G o v ern o rs

Matthew J. Quinn
Carroll College
Helena, M ontana

William S. Pickerign
The Northwestern Bank
Chippewa Falls, Wisconsin
C lass B E le c t e d


A p p o in t e d

M e m b e r B anks


D irec to r s

M in n ea po lis

Sandra M. Stash
M ontana Facilities Manager
Anaconda, M ontana

Kathryn L. Ogren
Bitterroot Motors Inc.
Missoula, M ontana
B oard


Ronald D. Scott
President and Chief Executive Officer
First State Bank
Malta, M ontana

Clarence D. Mortenson
M/C Professional Associates Inc.
Pierre, South Dakota

by the

B oard

Donald E. Olsson, Jr.
Ronan State Bank
Ronan, M ontana

Dennis W. Johnson
TMI Systems Design Corp.
Dickinson, N orth Dakota

C lass C A p p o in t e d

by th e

F ed er a l R eser v e B a n k


G o v ern o r s

Jean D. Kinsey
Professor of Consumption and Consumer Economics
University of Minnesota
St. Paul, Minnesota
David A. Koch
Chairman and Chief Executive Officer
Graco Inc.
Golden Valley, M innesota

F e d er a l A d v iso r y C o u n c il M e m b e r

Gerald A. Rauenhorst
Chairman and Chief Executive Officer
Opus Corporation
Minneapolis, Minnesota

Richard M. Kovacevich
President and Chief Executive Officer
Norwest Corporation
Minneapolis, Minnesota

The Region

M in n e a po lis B o ard


D irectors

Seated (from left): William S. Pickerign, Gerald A. Rauenhorst,
David A. Koch, Jean D. Kinsey; standing (from left): Clarence D. Mortenson,
Susanne V. Boxer, Kathryn L. Ogren, Dennis W. Johnson, Jerry B. Melby

F ederal A dvisory C o u n c il M em ber

Richard M. Kovacevich

H elena B r a n c h D irectors

Seated (from left): Lane W. Basso,
Ronald D. Scott; standing (from left):
Matthew J. Quinn, Sandra M. Stash,
Donald E. Olsson, Jr.


The Region

A d v i s o r y C o u n c i l o n S m a l l B u s in e s s , A g r i c u l t u r e a n d L a b o r

Gary L. Brown
Best Western Town ’N Country Inn
Rapid City, South Dakota

Howard Hedstrom
Hedstrom Lumber Co.
Grand Marais, Minnesota

Jeanne Davison
Butterfield Farms
Hokah, Minnesota

Ronald Isaacson
Mid-Wisconsin Bank
Medford, Wisconsin

Clarence R. Fisher
Chairman and President
Upper Peninsula Energy Corp.
Upper Peninsula Power Co.
Houghton, Michigan

Dennis W. Johnson, Chairman
TMI Systems Design Corp.
Dickinson, North Dakota

Thomas Gates
President and Chief Executive Officer
Hilex Corp.
Eagan, Minnesota
William N. Goldaris
Vice President
Globe Inc.
Minneapolis, Minnesota

A d visory C o u n c il


Dominik Luond
Country Pride Meats
Ipswich, South Dakota
Sandra Peterson
Minnesota Federation of Teachers
St. Paul, Minnesota

Sm all B u sin ess , A g r ic u ltu r e


L a bo r

Seated (from left): Thomas Gates, Virginia Tranel, Ronald Isaacson,
Clarence R. Fisher, William N. Goldaris; standing (from left): Gary L. Brown,
Dennis W. Johnson, Jeanne Davison


December 31,1995

Virginia Tranel
Billings, M ontana
Harry Wood
H.A. & J.L. Wood Inc.
Pembina, North Dakota

The Region

O f f ic e r s

F e d e r a l R e se rv e B a n k o f M in n e a p o lis

December 31,1995

Gary H. Stern
Colleen K. Strand

First Vice President

Melvin L. Burstein
Sheldon L. Azine
James M. Lyon
Arthur J. Rolnick
Theodore E. Umhoefer, Jr.

Executive Vice President, Senior Advisor, General Counsel andE.E.O. Officer
Senior Vice President
Senior Vice President
Senior Vice President and Director o f Research
Senior Vice President

S. Rao Aiyagari
John H. Boyd
Scott H. Dake
Kathleen J. Erickson
Creighton R. Fricek
Karen L. Grandstrand
Edward J. Green
Caryl W. Hayward
William B. Holm
Ronald 0 . Hostad
Bruce H. Johnson
Thomas E. Kleinschmit
Richard L. Kuxhausen
David Levy
Susan J. Manchester
Preston J. Miller
Susan K. Rossbach
Charles L. Shromoff
Thomas M. Supel
Warren E. Weber

Senior Research Officer
Senior Research Officer
Vice President
Vice President
Vice President and Corporate Secretary
Vice President
Senior Research Officer
Vice President
Vice President
Vice President
Vice President
Vice President
Vice President
Vice President and Director o f Public Affairs
Vice President
Vice President and Monetary Advisor
Vice President and Deputy General Counsel
General Auditor
Vice President
Senior Research Officer

Robert C. Brandt
Jacquelyn K. Brunmeier
James T. Deusterhoff
Debra A. Ganske
Michael Garrett
Jean C. Garrick
Peter J. Gavin
Linda M. Gilligan
JoAnne F. Lewellen
Kinney G. Misterek
H. Fay Peters
Richard W. Puttin
Paul D. Rimmereid
David E. Runkle
James A. Schmitz
Claudia S. Swendseid
Kenneth C. Theisen
Richard M. Todd
Thomas H. Turner
Niel D. Willardson
Marvin L. Knoff
Robert E. Teetshorn

Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant General Auditor
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant General Counsel
Assistant Vice President
Assistant Vice President
Research Officer
Research Officer
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant Vice President
Assistant Vice President
Supervision Officer
Supervision Officer

H elena B r a n c h
lohn D. lohnson
Samuel H. Gane

Vice President and Branch Manager
Assistant Vice President and Assistant Branch Manager


T h e R e gio n

Public Affairs
Federal Reserve Bank of Minneapolis
P.O. Box 291
Minneapolis, Minnesota 55480-0291

Coming in the next issue of

The Region

The Economic W ar Among the States:

A special issue devoted to a national multimedia
symposium on questions related to states’ use of
incentives to attract business.
The symposium includes several forums:
■ A May conference in Washington, D.C., with
national experts in business, labor, government
and academia
■ On-line discussions with national experts through
live chat rooms and bulletin boards; also, an on-line
case study for public participation from Harvard
University’s Kennedy School of Government
■ A series of reports, including a live call-in program,
from public radio stations; also, major keynote
speeches from the conference on many public
radio stations
The Regions report on the symposium will include
conference proceedings, papers, and information
from the on-line discussions.
The symposium is produced by Minnesota Public Radio,
with a grant from the Ford Foundation.
Further information is available on the Internet at: