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ISSN 0007-7011 NOVEMBERDECEMBER 1979 Commentary: Monetarism and Practical Policymaking : :i 't' '-:V > S 4 i _____________________________ NOVEMBER/DECEMBER 1979 MONETARISM AND PRACTICAL POLICYMAKING Commentary by Edward G. Boehne i s i CURRENT MONETARY DILEMMAS: HOW EFFECTIVE IS ORTHODOXY IN AN UNORTHODOX WORLD? David P. Eastburn . > I I t<\ t] . . . Traditional monetary policy tools must be used with extra care in an era o f external shocks and high inflation expectations. ON ACTIVE AND PASSIVE MONETARY POLICIES: WHAT HAVE WE LEARNED FROM THE RATIONAL EXPECTATIONS DEBATE? Donald J. Mullineaux Federal Reserve Bank of Philadelphia S£Si.2! 100 North Sixth Street (on Independence Mall) Philadelphia, Pennsylvania 19106 : . . . A fundamentally passive stance in mone tary policy could avoid destabilization while retaining the flexibility to respond to major econom ic disturbances. TABLE OF CONTENTS 1979 ; The BUSINESS REVIEW is published by the Department of Research every other month. It is edited by John J. Mulhern, and artwork is directed by Ronald B. Williams. The REVIEW is available without charge. Please send subscription orders, changes of address, and requests for additional copies to the Department of Public Services at the above ad dress or telephone (215) 574-6115. Editorial com munications should be sent to the Department of Research at the same address, or telephone (215) 574-6426. ■ ~ ■ The Federal Reserve Bank of Philadelphia is part of the Federal Reserve System—a System which includes twelve regional banks located around the nation as well as the Board of Gover nors in Washington. The Federal Reserve System was established by Congress in 1913 primarily to manage the nation’s monetary affairs. Supporting functions include clearing checks, providing coin and currency to the banking system, acting as banker for the Federal government, supervising commercial banks, and enforcing consumer credit protection laws. In keeping with the Federal Reserve Act, the System is an agency of the Congress, independent administratively of the Executive Branch, and insulated from partisan political pressures. The Federal Reserve is self supporting and regularly makes payments to the United States Treasury from its operating sur pluses. H ~ ....... ■ . I Monetarism and Practical Policymaking* by Edward G. Boehne, Senior Vice President Federal Reserve Bank of Philadelphia religiously follow such a simple, neat policy prescription to stabilize the econom y and rid it o f inflation? Paraphrasing H. L. Mencken, it is because for every human problem there is a solution which is simple, neat, and unreal istic. This is not to say that the Fed has not made mistakes; it has. Or, that the Fed knows all that it needs to know about the econom y; it doesn’t. But it is to say that the actual implementation o f monetary policy— whether through the targeting o f the reserve base or the Federal funds rate—is much more imprecise and complicated than many have com e to believe. For one reason, as we have learned partic ularly in recent years, the use o f money is not always that predictable. Velocity can bounce around for meaningful periods o f time for Nearly 75 years ago a professor at Yale University—named Irving Fisher—turned a truism into a policy prescription that Milton Friedman has popularized as “ Monetarism.” The truism is that GNP equals the amount o f money available for spending multiplied by the number o f times m oney is used. If the number o f times money is used (velocity) is predictable, then GNP can be controlled simply by regulating the supply o f money. On this proposition rests the foundation of modern monetarism. W hy then doesn’t the Federal Reserve ‘ Based on a talk given to the Philadelphia Investment Group at the Union League, Philadelphia, Pennsylvania, September 5, 1979. 3 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW to allow for the effects on the rate o f inflation o f such nonmonetary forces as oil-price hikes, bad harvests, Federal deficits, and the like. The more intense these inflationary pressures are, the more difficult becom es the Fed’s job o f restraining monetary growth without excessively adverse effects on jobs, sales, output, and financial markets. Inshort, monetary policy can “lean against the w ind,” as the saying goes, but because we live in a political economy it alone cannot change the direction o f the wind. Implementing an effective anti-inflation policy, therefore, requires initiatives on a wide front. Clearly, fiscal restraint is essen tial along with monetary restraint. But so are policies that stimulate investment, rejuve nate productivity, cut back on regulatory burdens, help brake the wage-price spiral, and foster competition, especially in mar kets where government itself contributes to higher prices. None o f these is a substitute for the essential ingredient o f monetary re straint, but monetary restraint can’t go far enough, long enough to unwind inflation without some help. Hopefully, after more than a decade o f persistent and worsening inflation, the national resolve is firming to the point where it is possible to maintain in place a broad-based policy that will lead in time to price stability. Despite the simplicity, neatness, and at tractiveness o f Irving Fisher’s equation, the implementation o f monetary policy is still an art—not because the Fed wants it to be, but because that is the nature o f the econom y and policymaking environment in which the Fed operates. There are always hard-togauge trade-offs in society between long term and short-term considerations, em ploy ment and inflation, and equity and efficien cy, that have to be made with imperfect knowledge by imperfect people with im perfect results. And there are always those who make the job sound easier than it really is. known and unknown reasons. For example, in 1975, velocity grew at a faster rate than it had in the first year o f any economic recovery since 1950, thus making it more difficult for policymakers to set goals for appropriate monetary growth rates. Or, more recently, with the onset o f telephone and automatic transfer services, m oney market funds, and other new services and innovations, velocity has been much more unpredictable than usual. The econom ic significance o f the com m only measured m oney supply, there fore, has been difficult to interpret. T o have follow ed the aggregates strictly early in the year would have led to unwarranted declines in interest rates. True, many o f these financial innovations are related to Regulation Q and the prohibition against paying interest on demand deposits. But the fact is that market impediments do exist and innovations do occur that affect the velocity o f m oney and distort the meaning o f the m oney supply. The second and more important reason for not adhering to textbook monetarism is that the econom ic and social costs are just too great to be generally acceptable. Economists have charts showing that monetary growth and inflation m ove closely together. That they do this over long periods o f time is undeniable, but the linkage between them is not so direct or painless as simple charts would portray. As the 1974-75 recession demonstrated, tight m oney can reduce inflation, but it reduces jobs, production, incomes, and pro fits far more in the process. The link is not between m oney and inflation, it is between money, prosperity, and then inflation. While as a nation w e are pretty good at sharing our gains, as yet w e haven’t figured out a socially acceptable w ay to share our losses. As a consequence, a policy o f prolonged recession and high unemployment to dampen inflation is not acceptable. Some monetary accom modation, even in a period when financial discipline is underscored, may be necessary 4 FEDERAL RESERVE BANK OF PHILADELPHIA Current Monetary Dilemmas: How Effective Is Orthodoxy in an Unorthodox World? by David P. East burn, President Federal Reserve Bank of Philadelphia* still the old problem o f too much money chasing too few goods. Its solution is still a stiff dose o f good old-fashioned monetary discipline, painful as it maybe. Paul Volcker’s appointment and recent m oves by the Fed toward higher interest rates have been well received by people holding this view because they see these developments as confirming their idea o f what the Fed should do. A second view is that the econom y is becoming increasingly unorthodox and that in this new environment orthodox measures by the Fed are not effective. People who take this line are a much more varied group than those who hold the orthodox view, and their recommendations are much less definitive. As a practitioner o f monetary policy, I am fascinated by two widely divergent kinds o f advice people are now offering the Fed. What I’d like to talk about for a few minutes today reflects an effort to find my way between these views. One view is the orthodox one, held by many very savvy and prestigious people, but particularly by money-center bankers, here and abroad. This is the idea that inflation is •Remarks delivered before the Financial Analysts of Philadelphia at the Racquet Club, Philadelphia, Penn sylvania, September 12, 1979. The views expressed are mine and do not necessarily reflect those o f my col leagues in the Federal Reserve System. 5 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW ernmental efforts on the social front are important to relieve undue and unfair impacts of recession or slow econom ic growth. I happen to have certain ideological reasons for thinking this way, but one can also believe this for purely practical reasons. Monetary discipline simply w on ’t work un less there is awareness of these practical, political, realities. So I’m wary o f advice that the Fed simply turn the screw. Doing so without considering the pertinent circumstances could impose an unwise dose o f monetary discipline. For one reason, the unorthodox people are negative about what the Fed can do rather than positive about what it should do. And for another, different individuals have dif ferent reasons why the Fed can’t be effective. Some o f these reasons are: • • • • • • Inflation is caused by OPEC. Inflation is caused by govern ment deficits. Inflation is caused by labor unions. Higher interest rates no longer bite. Even a recession no longer can solve inflation. The whole idea o f controlling the econom y through the demand side is passe; what is needed is policy to affect the supply side. UNORTHODOXY Among those circumstances are the facts cited by those who take the unorthodox view. The econom y is different than it was, and resorting to monetary orthodoxy in a world o f econom ic unorthodoxy poses very difficult problems for the Fed. The various arguments I have attributed to those who espouse the unorthodox view fall into two categories. The first involves different forces external to monetary policy which the Fed has to decide whether to validate or not. The second involves the impact o f inflationary expectations. Let me take each one in turn. Validation. The most severe shock to the econom y in recent years has com e from OPEC increases in oil prices. Clearly, these increases have raised the overall level of prices as well as the price o f oil. This needn’t necessarily have happened, however. If other prices had gone down enough to offset the increase in oil prices, the OPEC action wouldn’t have been inflationary. The Fed could have helped this com e about by suffi ciently slowing money growth. As you know, we haven’t done that and, in fact, have validated at least part o f the increase in oil prices. The reason, o f course, is that the OPEC shock in itself has tended to depress the econom y, and for the Fed to add to that impact a highly restrictive policy would have had a very depressing effect. We have been in a Catch-22 position. If we had offset all o f the OPEC price effects, we So what does the Fed do? Is orthodoxy still effective? ORTHODOXY M any economists in recent years have been heard to say, “I’m not a monetarist, but . . . .” You can count me as one o f these. I don’t follow the monetarist line to the point of holding to an invariable growth rate o f money regardless o f the effect on interest rates, but I certainly believe that m oney is a basic cause o f the inflation w e now have and that a slower growth rate is essential in getting rid o f inflation. All other efforts to combat inflation will surely fail without monetary discipline. If this puts me in the orthodox camp, I’m happy to be there. But I’m just as convinced that the problem isn’t all as simple as some orthodox viewers might think. W e live in a political econom y. This fact tells me, for one thing, that exer cising monetary discipline unmercifully would provoke a counterproductive reaction which would produce even worse inflation. So I believe the Fed should guard against precipitating a m oney crunch and a serious recession. I also believe that various gov 6 FEDERAL RESERVE BANK OF PHILADELPHIA and wage-push pressures at the same time cloud the picture and sharpen the dilemma which the Fed faces. In hindsight, it is probably true that the Fed has validated too much and not offset enough. Certainly, the rate o f money growth has been higher than we would like it to have been. But responsible policy could not have had monetary policy offset all o f these forces completely. The Fed does have a responsi bility for weighing the risks o f aggravating inflation against the risks o f recession. You may not agree with how it has assessed these risks and acted on them, but it is hard to conclude that some validation o f these ex ternal forces was an unwise thing to do. In the future, whenever the problem arises, each situation will have to be evaluated separately. Overall I would favor some vali dation, although not as much as in the past. Expectations. Many o f those who espouse the unorthodox view claim that monetary policy is ineffective because o f inflationary expectations. The fact o f increasing infla tionary expectations is familiar to all o f us. The magnitude o f the increase comes as a shock. In the 1950s, inflation was expected to be about one-half percent (on average, that is, because in the early 1950s people were expecting deflation). In the 1970s, expecta tions have averaged close to six percent and currently are nearing nine percent. This in crease in expectations is perhaps the biggest fact that distinguishes our economy from that in which orthodox policy was presumed to operate. It raises questions, first, about the effec tiveness o f high interest rates. Mortgage lenders, for example, constantly marvel at how young couples can take on mortgage debts at 11 percent plus without seeming to bat an eye. The reason, o f course, is that house prices are increasing at a rate closer to 15 percent; and if home buyers expect the trend to continue, the expected real rate is negative. There is no question that inflationary ex pectations greatly change the w ay people would have aggravated the recession. If we had validated all o f it, we would have aggra vated inflation. As a result w e have follow ed a middle course. The validation problem, however, was with us long before OPEC. It often comes with budget deficits, which many people regard as the most inflationary force o f all. The record o f large deficits is distressingly familiar, but let me mention a new fact that just has com e to my attention: the 1970s promise to be the first decade in our entire econom ic history with not a single year of surplus. N ow , we in the Fed have been known to speak in loud and clear tones about the evils o f budget deficits. The increased spending and borrowing which are involved tend, when the econom y is operating relatively near capacity, to raise prices. But again, this needn’t last if the Fed refuses to validate the higher prices by sufficiently slowing money growth. This hasn’t happened. As in the case o f the OPEC price increases, the Fed has validated part o f the deficits and offset part o f them. Finally, the validation problem is associ ated with the wage-push phenomenon, which many who espouse the unorthodox view think is the main cause o f inflation. When wages rise faster than productivity, they force prices up. If the higher prices are not validated by increases in m oney growth, however, demand will not support them. Producers will lay o ff workers, sales will slow, and the econom y will turn down. In fact, the Fed has validated part o f the price increases caused by the wage push. I want to make two points out o f all this. First, those w ho take the unorthodox view are not correct in asserting that OPEC, budget deficits, and wage pushes make monetary policy impotent. The Fed can offset all these forces by sufficiently slowing money growth. But, second, those w ho espouse the unortho dox view are correct when they say that these external forces greatly complicate the Fed’s decisionmaking. OPEC actions, deficits, 7 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW flationary expectations are rising fast enough, their impact on inflation can overwhelm the effect of a slowing econom y or even a recession. The point of all this is not that expectations make monetary policy ineffective but that they call for a different approach. The simple concept o f monetary policy is that it tightens during boom s and eases in recessions, and the record during the postwar period does show sharp changes in money growth and interest rates over the course o f the cycles. But now, with inflationary expectations so high, this kind o f up-and-down policy can be self-defeating. As the economy slows further in coming months, it will be important for the Fed not to move precipitously to ease. People need to see that the effort to eliminate inflation is proceeding by persistent steps to slow money growth. This persistence prob ably must continue for several years if infla tion expectations are to be reduced. regard high and rising interest rates. Yet, I believe the argument has been overdone. The fact that expected real rates are negative may mean that existing rate levels do not discourage some people from borrowing. But borrowers w ho incur debt at today’s high nominal rates still take on large burdens o f servicing the debt. Unless their incomes and cash flow are rising equally as fast as their debt burdens, they are going to feel the pinch. Many businessmen I talk with indi cate that high nominal interest rates do indeed bite. The most telling argument o f the unortho dox viewers is that even a recession and high unemployment may not make a permanent dent in inflation. Rather than trading more unemployment for less inflation, we may find ourselves with more o f both. Their reason, again, is inflationary expectations. Back in the 1960s, economists seized on the so-called Phillips curve both as an ex planation o f what goes on in the econom y and as a guide to policymakers. The Phillips curve showed that unemployment was low when wages were rising rapidly (during periods o f inflation] and unemployment was high when wages were rising slow ly (during periods o f recession). Accordingly, policy makers who wanted to slow down inflation had to decide how much unemployment they were willing to tolerate. Well, it is now fashionable to say that the Phillips curve is obsolete. Shifts in expecta tions shift the entire curve in ways that are hard to predict. W hy? Because workers are concerned about their real wages and will demand higher wages to make up for higher prices. So we have two results. First, a higher level o f inflation is now associated with any given level o f unemployment. Thus, achieving price stability requires a bigger increase in unemployment in the short run than was the case 20 years ago. Second, rather than ending up with more o f one and less o f the other, w e sometimes end up with more o f both unemployment and inflation, or what has been termed stagflation. If in SUMMING UP So where does all this com e out? By now you can see that the sharp distinction I made at the outset—between those who advocate a more orthodox view o f the econom y and those who say the world has changed so much that traditional monetary policy is ineffective—was overdrawn. There is some, but not complete, truth in both views. Monetary discipline is essential to the elimination o f inflation; the rate o f money growth must be worked down. But the de velopment o f an unorthodox econom y adds new constraints on orthodox monetary rem edies. Undue tightness can produce counterreaction that will only embed inflation more deeply. Undue ease can aggravate inflation ary expectations. T oo much validation can make inflation worse; too little can lead to severe recession. The trade-off between in flation and unemployment is much more uncertain than it used to be. I come out o f this with the conviction that monetary policy is still effective but that it has becom e much more difficult and com pli 8 FEDERAL RESERVE BANK OF PHILADELPHIA cated. At the same time, good monetary policy is even more essential. I agree with those who argue that efforts are needed to strengthen the supply side o f the econom y. Vigorous steps to raise productivity will help to restore the dynamism o f the econom y and help to reduce inflation. But demand man agement is not obsolete; demand and supply management must reinforce each other. Finally, in this environment the Fed has a special responsibility to lend an element of consistency to public policy. Fine tuning is now discredited (although I suspect that if the econom y ever com es closer to what we once thought o f as normal, it may come again into vogue). Our problems in these days o f double-digit inflation are more gross. They require a firmer hand and a longer view. Whether the American people will sit still for a gradualist solution to inflation remains to be seen. Whether the Fed will be able to exercise the persistence and constancy which a gradualist solution requires remains to be tested. Certainly, if any institution can perform this role, the Fed, with its indepen dence from short-run political influences, is in a position to do it. 9 From the Philadelphia Fed . . . This new booklet contains summaries o f four panel discussions o f Philadelphia’s econom ic future held at the Federal Re serve Bank in 1978 and 1979. Copies are available without charge from the De partment o f Public Services, Federal Reserve Bank o f Philadelphia, 100 North Sixth Street, Philadelphia, Pennsylvania 19106. 10 FEDERAL RESERVE BANK OF PHILADELPHIA On Active and Passive Monetary Policies: What Have We Learned from the Rational Expectations Debate? By Donald J. Mullineaux* When you are confronted by any complex social system, be it an urban center or a hamster, with things about it that you’re dissatisfied with and anxious to fix, you cannot just step in and set about fixing with much hope o f helping . . . . You cannot meddle with one part o f a complex system from the outside without the almost certain risk o f setting off disastrous events that you hadn’t counted on in other, remote parts. . . . Intervening is a way o f causing trouble. Lewis Thomas, “On M eddling,” in The Medusa and the Snail (New York: Viking Press, 1979). Dr. Thomas is a biologist and we can forgive him if he is more concerned about meddling with hamsters than with other social systems o f at least equal importance, such as the national econom y. His funda mental point, that trying to improve matters often ends up making things worse, has long been a point o f debate, however, among those who have studied government policies aimed at stabilizing the economy. Economists who side against meddling with the economy have typically done so for precisely the same reason that Dr. Thomas counsels hands-off policies—that we are just too ignorant of how systems like hamsters and economies work to be able to accomplish any good. This view holds out the promise, o f course, that one day we may be smart enough to conduct econom ic policy without “ causing trouble.” Those who come down for meddling con tend that our econom ic knowledge, though quite imperfect, is sufficient to allow the ‘ Donald J. Mullineaux, Vice President and Associate Director of Research at the Philadelphia Fed, joined the staff upon receiving his Ph.D. from Boston College in 1971. He writes on financial institutions and markets as well as on monetary theory and policy. 11 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW and firms would respond by laying o ff work ers and lowering production. Rising un employment and declining levels o f income would mean that households also would trim their spending, perhaps triggering an eco nomic recession. Such a scenario provides a cardinal oppor tunity in the eyes of policy activists. By accelerating growth in the money supply, the Fed can boost overall demand for goods and services. This happens because as more money is injected into the econom y than people originally intended to hold, they will attempt to reduce their money holdings by purchasing more goods or financial assets. Purchasing more goods adds directly to demand, while buying more financial assets indirectly boosts demand by lowering interest rates in financial markets. With a sufficient dose of stimulus, policy activists contend, the Fed can offset the reduction in demand— and any other predictable disturbance—so that production and unemployment remain stable. The rational expectations theorists are skeptical of this argument, h ow ever.1 They do not deny that the increases (declines) in money growth will boost (reduce) total de mand. But they question whether these policyinduced shifts in demand will have any influence on the behavior o f suppliers of goods and services. If the production deci sions o f businesses are not som ehow linked to policy changes, then output and unem ployment will not be responsive to changes in m oney growth. Adherents o f the rational expectations view claim that the existence of such a link requires that any shift in money growth be unanticipated by the public at large. But, they continue, because people form their expectations rationally, it is im good effects to outweigh the bad. A new and controversial school o f thought about how the econom y operates recently has shifted the focus o f this long-running debate. This approach, known as the ra tional expectations theory, suggests that it may well be impossible to design policies to stabilize things like unemployment or pro duction o f goods and services, regardless of how much we know about how the economy works. As the label suggests, this new idea centers on the way people form expectations of econom ic events and argues that forecasts of, say, inflation will take account o f all the factors that actually determine h ow fast prices rise. The strong conclusions con cerning stabilization policies have led this view ’s adherents to argue that the Federal Reserve should abandon active efforts to influence the econom y and adopt a passive stance o f setting a constant growth path for the money supply and never deviating from it. Given the importance o f the issues, this rational expectations theory has been much scrutinized o f late. A number o f issues have been raised by critics in attempts to reestab lish an activist role for monetary policy. These efforts focus on several different as pects o f the new theory. While the debate is far from settled, enough may now be known to draw some tentativeconclusions about the desirability o f activist efforts to influence the national econom y. RATIONAL EXPECTATIONS: A CHALLENGE TO MONETARY ACTIVISM Monetary policy activists contend that by appropriately adjusting the, growth o f the money supply, the Federal Reserve can offset disturbances to the econom y and thereby reduce fluctuations in output and unemploy ment. As an example, suppose that business men becom e extremely pessimistic about the profit outlook and cut back on spending for new plant and equipment. The fa ll-off in business spending would be accompanied by an unplanned accumulation o f inventories, ^For a more complete discussion o f the logic of rational expectations theory, see Donald J. Mullineaux, “Money Growth, Jobs, and Expectations: Does a Little Learning Ruin Everything?” Business Review, Federal Reserve Bank of Philadelphia, November/December 1976, pp. 3-10. 12 FEDERAL RESERVE BANK OF PHILADELPHIA crease production. The sole result, then, of an anticipated increase in money growth is a higher inflation rate, or so the rational ex pectations school contends. If only shifts in unexpected money growth have effects on output and unemployment, why not have the Fed engineer whatever amount is necessary to achieve an unem ployment rate target? The rational expecta tions answer: it can’t be done. If people recognize that the Fed increases money growth every time unemployment rises, they will use this information in making forecasts. Thus the Fed’s response will come in the form o f higher anticipated money growth, which brings only higher inflation. Any systematic policy response by the Fed will eventually be learned by the public and built into its forecast. Unless the Fed has better information than the public, there is no way the central bank systematically can surprise people so as to achieve a lower unemploy ment rate. Once the Fed has reduced money growth to levels consistent with a low rate of inflation, the best monetary policy is one that sets a constant growth target for money and sticks to it, regardless o f the state of the econom y. This passive stance would prevent monetary policy from being a source of instability, or so rational expectations ad herents claim. Though a number o f economists seem sympathetic to the rational expectations view, others have raised questions about the logic of the argument. In each case, the points made, if valid, are sufficient to restore at least the feasibility o f activist monetary policies aimed at influencing unemployment and output. possible for the Fed continuously to engineer shifts in money growth that are unanticipated. Their conclusion: there can be no systematic link between Fed policy actions and firms’ decisions about how much to produce. W hy do the rational expectations theorists claim that m oney growth shifts must be unexpected if they are to be related to output and unemployment? The answer is a little com plex. Econom ic logic tells us that firms will produce more output when they sense higher demand for their goods only if they’re convinced that there has been a relative demand shift—an increase in demand for their product relative to demand for all goods and services.2* But higher money growth doesn’t produce a relative demand shift; rather, it increases the demand for all goods and services— aggregate demand. Therefore, firms will produce more output on the heels of higher m oney growth only if they fail to recognize that aggregate demand is higher and mistakenly conclude that there has been an increase in the relative demand for their goods. Rational expectations theorists claim that business will suffer this kind o f misjudgment precisely when an increase in money growth comes unexpectedly. Having no in formation on the source o f the increased demand, firms treat it as a relative shift. W hen a shift in money growth is antici pated, however, then firms are aware that demand for their product is up simply because aggregate demand is higher. Recognizing that the cost o f labor and raw materials will be rising at roughly the same pace as their output price, they make no attempt to in 2It is only when firms sense a relative increase in demand that stepping up production schedules will increase profits. If firms know that demand for their product is up by, say, 10 percent simply because demand for all goods has increased that much, then it won’t pay to produce more output. The reason is that a 10-percent rise in aggregate demand will mean that prices for labor and raw materials will be rising at roughly this pace. When costs are rising at the same rate as output prices, profits won’t rise as firms produce more output. ACTIVISM REHABILITATED? Attempts to restore the credibility o f activ ist policies have focused on several steps of the rational expectations logic. One line of thought argues that it simply is not correct to claim that changes in anticipated money growth don’t affect variables such as unem ployment. But the same logic that underlies 13 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW output will be unaffected. In econom ists’ jargon, money is neutral with respect to production over the long run. These older analyses failed to draw any explicit distinc tion between expected and unexpected money growth, but what lies behind this work is the notion that in the long run all changes in money growth will be anticipated ones. The novel aspect of the rational ex pectations theory is the statement that, even in the short run, monetary growth changes that are anticipated will be neutral. But is this a valid claim? Some economists think not. They argue that even increases in expected money growth are likely to raise the rate of production by causing people to readjust their asset holdings. In particular, as expected inflation rises on the heels of higher anticipated m oney growth, people will decide to hold less o f their wealth in the form o f money (which bears no interest) and more in the form o f financial and real assets. (Real assets are those which provide their owners with physical service flow s, such as stereos, refrigerators, computers, factories, and so on.) W hy would people undertake such a shift? Because as they com e to foresee higher and higher prices down the road, they recognize that their current holdings o f money not only yield no interest but also represent command over a smaller and smaller future volume o f goods and services. This means that money is providing less service to its holders in terms o f its ability to buy things, so people decide to hold less o f their wealth as money and more in the form o f other assets. But as more new factories and ma chines are purchased, production quite naturally rises since factories and machines are used to produce output.4* this view also tells us that any relation between expected m oney growth and unem ployment (or output) is likely to be quite limited in scope. A second challenge argues that expectations are not fully rational, over short periods o f time at least. M any econ o mists are troubled by this argument, since it suggests that people ignore or misuse in formation when making forecasts. Still an other view is that even though people fore cast rationally, the Fed can bring about unexpected m oney growth, provided the time horizon o f money-growth anticipations is sufficiently long relative to the period over which policy is initiated. If the moneygrowth forecast that matters to the deter mination o f output covers, say, a two-year period, then once expectations are formed, the Fed should have ample time to respond to new information and generate an unex pected shift in m oney grow th.3 None o f these arguments implies that the central bank should adopt activist policies by trying to offset disturbances to the econ omy. Rather, they suggest that, contrary to the rational expectations argument, activist policies are at least potentially useful—they could work. There may be other consider ations that argue against activist policies, however. Is Expected Money Growth Neutral? A venerable proposition in monetary eco nomics states that, in the long run, an increase (decrease) in the money-growth rate will produce a proportionate increase (decrease) in the inflation rate and that the level o f 3Some have criticized the rational expectations view on the grounds that it assumes perfectly flexible prices. But because o f information costs or noncompetitive behavior by some firms, prices in reality are likely to be sticky—to adjust only slowly to changes in demand or supply. It has been demonstrated, however, that sticky prices can be compatible with the rational expectations logic. See Bennett T. McCallum, “Price Level Adjust ments and the Rational-Expectations Approach to Macroeconomic Stabilization Policy,” Journal of Money, Credit, and Banking 10 (November 1978), pp. 418-436. 4While firms might readjust their asset holdings by building new factories and buying new equipment, households of course will purchase either consumer durables or financial assets. Nevertheless, the behavior of households still affects the stock of plant and equipment since the funds they place in the credit markets or the stock market will facilitate the acquisition of new equipment by firms. 14 FEDERAL RESERVE BANK OF PHILADELPHIA were said to be rational if, on average, they were formed with full knowledge of the process that actually determined the inflation rate.6 For example, suppose that in every month the inflation rate is equal to the prior month’s money-growth rate. Then a rational expectation of next month’s inflation is this month’s money-growth rate. Using any other forecasting scheme would yield an irrational expectation. In a sense, this ex ample loads the dice in favor o f rational expectations because it suggests that the actual inflation rate is determined in very simplistic fashion. Thus it w ould be easy to detect such a relationship and use it in forecasting. In truth, the actual inflation process is (1) apparently quite com plex and (2) only known approxim ately.7 One way to find out whether expectations are rational in this rather strong sense w ould be to conduct a test. But a direct test requires that we have a good measure o f inflation expectations and that w e know the process that actually deter mines the inflation rate. While there are some measures o f inflation expectations, they have a number o f shortcomings.8 And a quick perusal o f two or three econom ic journals will convince any reader that there is no generally accepted notion of how infla tion gets determined. Lacking a suitable test to decide the issue, some claim that com m on sense tells us that expectations can’t be rational. After all, H ow large is this effect o f anticipated money growth on output? An exact answer is No one knows; but there seems to be good reason to think the overall effect is probably small. First o f all, there is a potential offset to any positive impact o f increases in antici pated m oney growth on output. If people are holding less m oney, it becom es more costly to buy things—more time and energy are used up running to the bank or the automaticteller machine. But if more effort is used up transacting, less time is available for pro ducing goods and services, which offsets some o f the output gain from having more factories and machines. Second, people already are holding a fairly small percentage o f their total wealth in non-interest-bearing money. In the first quarter o f 1979, for example, people and firms held about $359 billion o f currency and demand deposits.5 This represents only about five percent o f total estimated consumer wealth o f some $6.8 trillion. There just isn’t much room for a very big effect on the stock o f machines and factories stemming from shifts out o f noninterest-bearing money. Unless some evi dence is turned up showing that this logic is badly o ff base, the anticipated money-output link appears to be a weak reed on which to build a case for an activist monetary policy. Are Expectations Rational? The assump tion that people form expectations rationally is a key building block in the case against activist policies. But what makes a forecast rational? Unfortunately, the term ‘rational’ has been used in a number o f different senses. Originally, expectations o f inflation 6The qualifier ‘on average’ means that in any particu lar instance expectations can differ from what full knowledge o f the inflation process would imply. When we average over all predictions, however, these dif ferences should tend to cancel each other, so that there is no systematic difference between subjective inflation expectations and the values implied by full knowledge of the actual inflation process. 5The stock o f non-interest-bearing money is actually smaller than this figure. The reason is that although commercial banks cannot make explicit interest pay ments on demand deposits, they often pay interest indirectly by providing checking-account services at a price below their cost of production (no-charge checking, etc.). It appears likely that explicit interest on demand deposits will soon become legal, so that currency will be the only non-interest-bearing component of money. The outstanding stock of currency presently is a little over $100 billion. rj This represents a problem for the rational expecta tions theory only to the extent that there are systematic gaps in our knowledge of the inflation process—that something very fundamental to determining the in flation rate has gone unnoticed. 6Some examples: nonrepresentative samples, lack of quantitative data, brief historical sample periods. 15 NOVEMBER/DECEMBER 1979 BUSINESS REVIEW making rational predictions requires that people possess mountains o f information about the things that matter for determining inflation and that they also know h ow it all fits together. Being a less than humble lot, these economists note that since they aren’t all that sure o f the whys and wherefores o f inflation, surely the man-in-the-street can’t be. The somewhat disarming response by ra tional expectations adherents to this argu ment is to agree with it for the most part but then to claim that, in making key decisions about what to buy and sell, people act as if they knew the true inflation process. This shifts the burden o f testing away from the question o f how people form expectations— a process that is very difficult to observe and measure—and toward the issue o f how people behave in various markets. A definitive test here requires that observed outcomes o f mar ket processes—quantities bought and sold and prices—be sufficiently different when people have rational expectations from the outcomes that result when they don’t. In financial mar kets, the existing evidence appears quite fa vorable to the rational expectations view, but in markets for goods and services and in the labor market the evidence is much less clear cut. (See the article by Poole in Suggested Readings.) Thus we must conclude that we don’t yet know enough to decide the question of whether expectations are rational in this strong sense o f the term. There is a weaker version o f rationality, however, that requires only that people fully exploit relevant information, economically speaking, when making predictions.9 If peo ple can’t improve on their forecasts by better utilizing the information at hand, then the rational expectations result that an activist policy can’t influence things like unemploy ment and output continues to hold. Whether or not this crucial condition holds in reality depends on how people go about learning the actual process of inflation. (See the Friedman article in Suggested Readings.) Unfortunately, we know very little to date about how this learning takes place. There is evidence, how ever, that information on past inflation and past money growth is efficiently exploited in some inflation forecasts, which would imply that the condition for the rational expectations theory to hold is satisfied. (See the Mullineaux article in Suggested Readings). But the expec tations analyzed were those of a group of economists rather than those o f the public at large, and there may be differences in fore casting ability between the two groups. Once again, we must conclude that the evidence is not convincing enough one way or the other to confirm or deny the view that expectations are rational. No matter how the term is defined, we don’t yet know enough about how people form expectations to decide the case for or against an activist policy on these grounds. Can the Fed Systematically Engineer an Unexpected Change in Money Growth? Par ticipants on both sides of the debate on activist monetary policy seem agreed that there is a causal connection between, say, unemploy ment and unexpected money growth. The question then becomes: can the Fed produce an unanticipated shift in money growth? The rational expectations logic says No. If the Fed systematically shifts its money-growth targets over time in response to the ups and downs of everyday economic activity, people will notice this and build the information into their ex pectations about money growth. One response to this argument might be that the Fed could engineer an unexpected shift in money growth by follow ing delib erately deceptive policies—that is, by an nouncing its intentions to follow one policy but pursuing another. Ethical issues aside, it seems hard to argue that the Fed could fool the public systematically about its policies, 9The qualifier ‘economically’ recognizes the fact that forecasting is costly. Forecasting requires time-con suming activities such as information gathering, com putation, and reflection. It will be economically rational to consider more information only when the benefits exceed the costs. The benefits of more information come in the form of a better (more accurate) forecast. 16 FEDERAL RESERVE BANK OF PHILADELPHIA result, they cannot adjust their wages until a new contract is negotiated.10 As actual in flation increases, the wage rate adjusted for inflation (the real wage) falls, and firms will hire more workers. Unemployment declines and production rises, temporarily at least. The same result occurs if firms set prices on their products one or more time periods prior to the period over which they will apply (as cat alogue stores must do). These arguments essentially claim that if wages and prices are sticky (because of con tracts or any other reason), then there may be a sufficiently long horizon o f expectations to allow the Fed to produce a systematic devia tion o f actual m oney growth from what was expected. Such a policy does not involve deception in the sense discussed above. Peo ple recognize the shift in Fed policy, but because it is based on information that be com es available only after the contract is in force, they cannot immediately react to it. Thus the Fed can at least temporarily engi neer money growth that is unanticipated. Is there evidence to support this stickyprice unexpected-money linkage? One study has attempted to determine the length of the horizon over which anticipations o f money growth are relevant to production. The evi dence was not sufficiently clear cut to identify a two-year horizon as more or less consistent with reality than a one-year horizon. One might argue, however, that either period is sufficiently long to permit the Fed to coun teract an observed disturbance. This means that the Fed is at least in principle capable of reducing period-to-period fluctuationsin the unemployment rate. But it could not affect provided Fed actions possess some rhyme or reason. Suppose policy shifts are keyed o ff changes in the unemployment rate. People will com e to recognize this and base their policy anticipations not on what the Fed announces but on what they’ve learned about how the Fed actually behaves. For many reasons, then, deliberate deception should be ruled out as a means o f engineer ing unexpected m oney growth. But perhaps there is another route to follow . A recent argument suggests, for example, that if the time horizon over which people form expectations about money growth is sufficiently long, then the Fed probably can bring about an unanticipated policy shift. (See the 1977 article by Fischer in Suggested Readings.) Suppose that the expectations that are relevant to current decisions by businessmen about h ow much to produce were made, say, two weeks ago. Then there is very little time for the Fed to observe an increase in unemployment and respond to it by resetting its targets for money growth. But what if the relevant anticipation about money growth was formed, say, two or three years ago? Then there seems to be ample time for the Fed to recognize a disturbance to the econom y and shift its policy stance to counteract it. H ow long is the time horizon o f the money-growth forecast that is actually relevant to decision makers? Since we know that people fre quently make long-term contractsto buy and sell certain goods and services (labor, for example), at least some behavior appears related to expectations that span a fairly long horizon. Workers frequently contract to supply labor services for a two-year or threeyear period at negotiated terms. Suppose that those terms are predicated on workers’ ex pectations that prices will rise five percent a year and involve an annual wage increase o f seven percent. If, one year into the contract period, the Fed observes some recessionary disturbance, it could announce and pursue higher money-growth targets. While workers might revise their inflation expectations as a 10Some labor contracts are indexed to the rate of inflation; that is, wages are adjusted automatically according to a prearranged schedule to reflect changes in the average price level. Indexed contracts will force monetary policy to lose its effectiveness only if the wage is indexed in a way which duplicates the effects of one-period contracts. While the majority of labor con tracts are not indexed at all, those which are do not typically work like a series o f single-period contracts. 17 BUSINESS REVIEW NOVEMBER/DECEMBER 1979 the average unemployment rate over longer periods—that is, maintain a rate permanent ly lower than that consistent with balanced conditions in the labor market. While more empirical work is sorely needed, this “sticky price in relation to the expectations horizon” argument appears at this time the most fruitful ground on which to base a case for the feasibility o f activist monetary policy.11 play a useful role in reducing fluctuations in output and employment, the appropriate stance for the Fed is to follow a passive policy (set a constant growth-rate target for money and stick with it). Having studied the histor ical policy record, they contend that the knowledge about the econom y required to carry out a successful activist policy is simply not yet available to policymakers. They also suggest that adopting an activist policy opens the Fed to political pressures that may result in actions that are actually destabilizing in a longer run setting. The argument against a passive policy is that the Fed would be immobilized during periods when it could take actions that would yield obvious benefits—in the face of some very large recessionary shock to the econom y, for example. But perhaps there is a middle ground between highly activist and passive policies. Given doubts that very activist policies will produce more good than ill, perhaps the best monetary strategy for the Fed is to adopt a fundamentally passive stance (pursue fixed growth-rate targets), except in the face of major disturbances to economic activity. Presumably the constant growth rate for money that the Fed would pursue would be one consistent with a low level o f inflation over the long run, or perhaps—as some have argued is desirable—a small rate o f deflation (falling prices on average). A prompt move to such a level o f m oney growth would be undesirable, however, since it would no doubt induce a sizable recession. Hence the implementation o f the modified constantgrowth strategy would have to be delayed until the Fed had achieved a gradual reduction in money growth to levels consistent with society’s long-run inflation goals. This modified constant growth-rate policy combines the major advantages o f a passive policy stance—avoidance o f ill-timed, de stabilizing policy actions—with those of an activist mode—flexibility to respond to major disturbances. Policy might still be destabi lizing on occasion, however, since there may DOES ‘SHOULD’ FOLLOW FROM ‘COULD’?: A CASE FOR A MODIFIED PASSIVE POLICY The rational expectations case against an activist monetary policy is founded on three premisses, each a matter o f considerable controversy: (1] people form expectations rationally; (2) expected changes in money growth do not affect output or employment decisions; and (3) while unexpected changes in money growth do influence output and employment, the Fed cannot systematically bring about unanticipated shifts in money growth. Unfortunately, the evidence brought to bear to date has not been suffi ciently strong to settle any o f these con tending issues, so that the question Is an activist monetary policy feasible? has no clear-cut yes or no answer. Suppose, however, that one judges that theory and evidence have uncovered enough chinks in the rational expectations armor to justify a stabilization role for monetary policy. Does it follow that the Fed should undertake activist policies? Not at all. Some economists have long argued that, although activist monetary policies can potentially 11It should come as no surprise that this argument has its critics among those in the rational expectations camp. They argue that the type of contract studied is inferior, in terms of the welfare of both workers and firms, to a different kind o f contract that would consider empJoymentdetermination as well as wage issues. With this better type of contract, the rational expectations result holds. (See the Barro article in Suggested Read ings.) The response to this argument is that though these latter contracts seem better in theory, they are not the kind that we presently find in labor markets. 18 FEDERAL RESERVE BANK OF PHILADELPHIA strate either that there is no scope for any activist policy or that there is considerable justification for frequent stabilization moves by the Fed. Until one or the other of these extreme views is vindicated, however, keep ing “hands o ff” most of the time should “cause less trouble” but perhaps buy us a little good when times are quite bad. be problems in recognizing a major shock. But average policy performance should be improved. When the lack of strong justifica tion for activist policies is combined with the historically observed failure of fine tuning, prudent judgment argues strongly for the modified passive policy. Future research may overturn this conclusion and demon SUGGESTED READINGS Robert J. Barro, “Long-Term Contracting, Sticky Prices, and Monetary Policy,” Journal of Monetary Economics 3 (1977), pp. 305-316. Stanley Fischer, “Long-Term Contracts, Rational Expectations and the Optimal Money Supply Rule,” Journal o f Political Economy 85 (1977), pp. 191-205. ------------, “Anticipations and the Non-Neutrality o f M oney,” Journal of Political Economy 87 (1979), pp. 225-252. Benjamin M. Friedman, “Optimal Expectations and the Extreme Information Assumptions of Rational Expectations M odels,” Journal o f Monetary Econom ics 5 (1979), pp. 23-41. Bennett T. McCallum, “The Current State of the Policy Ineffectiveness Debate,” American Economic Review 69 (1979), pp. 240-245. Franco Modigliani, “The Monetarist Controversy or, Should We Forsake Stabilization Policies?” American Economic Review 67 (1977), pp. 1-19. Donald J. Mullineaux, “Inflation Expectations and M oney Growth in the United States,” American Economic Review (forthcoming, 1980). William Poole, “Rational Expectations in the Macro Model,” Brookings Papers on Economic Activity ( 1976), pp. 463-514. 19 FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW CONTENTS 1979 JANUARY/FEBRUARY David P. Eastburn (Commentary), “Voluntary In flation Restraint and Corporate Social Responsi bility” Janice M. Westerfield, “International Banking in Philadelphia” John Gruenstein, “A New Job Map for the Phila delphia Region” JULY/AUGUST Edward G. Boehne (Commentary), “The McFadden Act: Is Change in the Making?” John Gruenstein, “Mass Transit Subsidies: Are There Better Options?” Robert J. Rossana, “Unemployment Insurance Pro grams: A New Look for the Eighties?” • SEPTEMBER/OCTOBER MARCH/APRIL Edward G. Boehne (Commentary), “Can Phila delphia Expect a Livelier Economy?” Anita A. Summers, “Proposition 13 and Its Aftermath” Anthony M. Rufolo, “An Index of Leading Indica tors for the Philadelphia Region” MAY/JUNE David P. Eastburn (Commentary), “Preserving Dis cretion in Economic Policy” Timothy Hannan, “Lack of Competition: Where It’s Found and How Much It Costs” Nariman Behravesh and John J. Mulhern, “Econ ometric Forecasting: Should You Buy It?” 100 North Sixth Street Philadelphia, PA 19106 John Bell, “A Softer Landing for Housing This Time Around?” Howard Keen, Jr., “Thrifts Compete with Banks: Getting a Clearer View of a Changing Picture” NOVEMBER/DECEMBER Edward G. Boehne (Commentary), “Monetarism and Practical Policymaking” David P. Eastburn, “Current Monetary Dilemmas: ffective Is Orthodoxy in an Unorthodox , “On Active and Passive lat Have We Learned from ions Debate?”
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