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REMARKS

from

WESTERN ECONOMIC ASSOCIATION INTERNATIONAL CONFERENCE

June 22, 1993
Lake Tahoe, Nevada

Fred Furlong
Jerry L. Jordan
Frank Morris
Questions & Answers

August 13,1993

Ms. Lisa M . Grobar
Associate Professor
Co-editor, Contemporary Policy Issues
California State University, Long Beach
Department of Economics
1250 Bellflower Boulevard
Long Beach, California 90840-4607
Dear Lisa:
The transcript is enclosed as well as a diskette in W o r d Perfect.
I have edited m y initial remarks and responses to questions. I added a few
clarifying sentences, but it is mostly as given. W e did not try to edit Frank's presentation
or the questioners; it is as our typist heard on the tape.
G o o d luck in preparing an article.
Sincerely,

Jerry L. Jordan
Enclosures
Copy:

Gerry Anderson

THE SEARCH FOR A TARGET FOR MONETARY POLICY

(Fred Furlong)

When we are looking at the session, I thought

that one of the key parts of the title was a target. Certainly, on a
day-to-day basis, when the policymakers are trying to decide what
to do that they have to have some idea of the targets to know what
they want to do with policy. The real question though, is there a
single target that one can agree on that would be consistent to
policymakers and also across time? We had three panelists
originally scheduled for this session, but Steve Axilrod won't be
able to make it. Since Steve's not here, I can tell a story about him
before we go on; at least he can have his presence recognized
that way. Steve and I think it fits in with what we are trying to do in
the session; to say the day-to-day issue is what are you trying to
do with policy and how do I know whether or not policy should be
moved one way or another as a policymaker. But Steve one day, he
is now Vice Chairman of Nikko Securities, but when I knew him he
was with the Federal Reserve as the Director of Monetary Affairs.
One late afternoon he was trying to find someone to run one of the
models, and he came into one of the offices, where a bunch of
officers and among them were Tom Simpson and David Lindsey.
He asked the people in the office if they knew how to run this
model that he needed to get some results and to know what

reserves were going to be the next day. The answer was, "no we
don't know."

Steve said "Well, what do you do then?"

And their

response was, "We think about the big picture." And Steve's
response was "Well, no, no, no, that's my jobl" I think what we are
here today for is to look at the big picture. And to do that we have
two distinguished individuals - a current and a former
representative of the Federal Reserve. Both of these individuals
had to tackle this question of search for the target in practical ways
in terms of deciding on and implementing monetary policy. They
have also had the advantage of looking at this issue as outsiders. I
think that anyone who has been in the Federal Reserve will tell you
that your view of monetary policy changes once you've been part
of the Federal Reserve. But I think the advantage here that both
Jerry and Frank have is the advantage of seeing it from both sides.
First, we will have Jerry go first. Currently, Jerry is President of the
Federal Reserve Bank of Cleveland. Jerry is the insider, turned
outsider, turned insider again. Of course, the insider started out
with the Federal Reserve Bank of St. Louis. He has made a number
of important contributions to monetary policy between St. Louis
and coming back to the Cleveland Fed. He has had some practical
experience, and maybe some less practical experience. The
practical experience is on the commercial bank side (12 years of

3

commercial banking). On the less practical side, is maybe
academia and also government. Jerry will present his remarks. I
would like to hold the responses and questions until the end, after
each of the speakers has presented. I will ask, I will say it now, I
will say it later, just to reinforce it later, that when you do get up to
ask questions, you use the mike - it is being taped. We will have
Jerry go first.
(JERRY JORDAN)

Thank you. It is a pleasure to welcome so

many fellow search party members here. I'm going to throw the
program a little bit of a curve by saying that I'm not sure that the
questions should be "searching for a monetary aggregate" or
monetary target, but it may be really searching for objectives.
Seventeen or eighteen years ago, Karl Brunner, hosted at UCLA a
couple of conferences called "Targets and Indicators for Monetary
Policy." This was when Lee Hoskins and I were young students at
UCLA, trying to learn about all of this monetary kind of thing, and
they brought in all of the eminent people in the profession. These
were some 50 or 60 of the leading names doing research and
writing on the subject of monetary theory and policy, both within
the Federal Reserve and the academic profession. It was a
fascinating couple of days, both times.
What I failed to appreciate at that time, however, was that

4

those conferences were conducted in the context of more than a
decade of under 2% inflation, then inflation had jumped up in 1964
and 1965 into the range of 3 or 4%. It was thought at that time that
the problem was only one of having the appropriate targets and
indicators. That is, the levers, or handles for monetary policy
which would serve as guides to formulation and implementation of
our policy objectives. The mindset of the American people at that
time, I think, was that increases in inflation and interest rates were
temporary, destined to go back down, sometime.
Now, after more than three decades of inflation, the mindset
of the American people is that declines of inflation and interest
rates are temporary. People believe that the permanent condition is
for inflation and interest rates to go back up.
Coming back to the Fed after some 15 or 16 years out of the
System, I initially thought the question was "which M" (monetary
aggregate)? The subject of this session might imply more debate
about M1 versus M2 and the various measures of the monetary
base.

Or, should we add this or that into some measure of

money. In fact, three months before rejoining the Fed I was a
consultant, (as the Board of Governors likes to call it) and I did an
analysis of what was going on with M2 in 1991. Already there was
concern about the extent to which it was or was not giving a

5

reliable indication of the thrust of policy actions.

Now, however,

I've spent 15 months or so not only going to meetings, but worse,
living with the staff that I inherited from Lee Hoskins. The staff
persistently over and over said to me "It's the objective -- stupid -­
not the target, that is the real issue!" And, I kept saying that I
thought the objective was quite clear -

not only to myself, but

also to my colleagues. The staff kept telling me I was naive.
Recently, when discussing with my daughter (who's getting
married, buying a house as an inflation hedge, and getting a fixedrate mortgage) I tried explaining my view. And she said, "Dad you
need a reality check. If you don't think inflation is going up,
you're the only one that doesn't think that.
up."

We all know it's going

So, dealing with daughters is difficult especially when they

start learning economics, as I'm sure Frank will agree.
After sitting with the Committee for 10 FOMC meetings,
watching the deliberations, the interaction between our decisions
and the financial market participants, the people's elected
representatives, and the media, I'm now convinced too, it's the
objective -- not the target -

that is the real issue of monetary

policy.
Some years back, I heard about a thing called "Goodhart's
Law."

I think it was Henry Wallich who first told me about it and

6

wrote about Goodhart's Law. The idea is that once a Central Bank
makes it known that it is using a certain variable as an indicator or
intermediate target because of some past empirical relationship to a
specific objective, that variable ceases to be reliably related to the
objective.
The analogy was something from physics called the
Hiesenberg Principle, which I don't understand very well but it has
something to do with when you focus a high-powered microscope
on an electron, it alters the behavior of the electron. Therefore,
you can never see it behaving as it would behave if it was not being
observed. The analogy to monetary policy is, once the Central
Bank has a target that people know that it is responding to, the
behavior of the people is changed -- traders in the markets, such
as bond markets, equity markets, foreign exchange market - as
well as real people. Then, because they change their behavior in
anticipation of what the Central Bank is going to do based on these
indicators, you don't get the same outcome that you otherwise
would.
So, we went through the silly season in the later 1970s
when the Thursday night money numbers would cause the interest
rate futures markets to do wild gyrations. There was a period
some years back when it was the norm that the merchandise trade

7

was all the markets responded to for awhile. And, unfortunately,
during the last year or two it was nonfarm payroll employment or
the jobless claims numbers. The lack of theory or empirical
evidence relating these variables to ultimate objective seemed to be
irrelevant. What it is now is up for grabs.
I think that Goodhart's Law was valid only if monetary policy
is not anchored by clear, well-understood objectives. Goodhart's
Law will not hold if everyone understands and acts on the belief
that the objective will be achieved. That is because people will not
care what the intermediate targets are.
So, I'm going to assert what I will call the "Hoskins'
Corollary" to Goodhart's Law (after he kept hammering on this
thing for four years while he was in my job). That is, if the
monetary authorities have an objective of a stable purchasing
power of money, which is known and believed -- it is truly
understood by the people, and agreed to by the people -- such
that the actions of households and businesses reflect this
knowledge and belief in the objectives, then it may be that any
target is adequate. It certainly becomes a secondary issue at that
point.
I no longer think that monetary targeting is a sufficient
condition for a satisfactory monetary policy.

8

Whether or not it is a

necessary condition is still debatable. I do think that having a clear
objective of monetary policy is necessary. I'm still waiting for
people to persuade me whether it is or is not sufficient.
Milton Friedman had taught us that having and hitting any
monetary growth target was superior to a pure discretionary policy.
I think what was left unsaid about this Friedman dictum was that it
was valid in the absence of policy being anchored by a clear
objective.

I'm not so certain that a policy that is anchored is

flawed, just because implementation involves discretion. All of the
debate about rules vs. discretion that we saw in the profession for a
couple of decades. I think now implies an absence of an
unambiguous long-run objective.
Back in the 1960s - 20 or 30 years ago when all of that lively
debate was going on -- we had the Friedman-Meiselman research
relating money growth to measures of income or output, and the
response by Ando-Modigliani. (Karl Brunner once called that the
battle of the radio stations - AM and FM). Then we had Deprano,
Mayor and Hester and a number of other people involved in the
debate and the economists at the St. Louis Fed, with some
responses by the New York Bank and the Board of Governors'
staff, and other participants.
I now think that whole framework was wrong. That

9

framework related money growth to total spending
-- nominal GDP -- and then we derived from that implications for
the rate of change or prices, and the rate of change of output and
employment, and so on. We sort of decomposed spending into its
output and price components.

I think there was a fundamental

mistake in our research strategy at that time, and all of the rhetoric
of "demand management" was wrong because both the research
strategy and the rhetoric assumes knowledge that we did not
have -- knowledge about the economic structure and factors
aggregate supply of output.
A lot of what we did at St. Louis, including my own writing at
that time, was in the context of demand management. Think about
the message that is implied by that. It says that the role of
monetary policy is to manage demand or spending. That clearly is
wrong.
It left a lot of people with the idea that you could pursue an
activist discretionary monetary policy to hit certain objectives in
terms of output growth, the rate of inflation, employment, levels of
employment, unemployment rate, and so on. And, that monetary
policy was appropriate to pursuing "countercyclical stabilization
policy" to either offset real shock affects, or shocks emanating
from the rest of the government sector -fiscal policy, and so on.

10

And, we hear right up to present time references to the ideas of a
monetary policy being adjusted based on what happens on the
fiscal side.
In one important respect, monetary and fiscal policy actions
should be thought of in concert. That is, that in a fiat money world,
monetary policy is a fiscal instrument -- a way to finance
government. No one can possibly know the effects of proposed
changes in explicit tax rates without knowing what is going to
happen to the purchasing power of money. The Chairman of the
House Ways and Means Committee should be just as interested in
the Central Bank's intentions regarding future inflation as the
Chairmen of the Senate and House Banking Committees.
While I now think that most of the discussion about activist
monetary policies is nonsense, it did derive from the work that I
and others were involved in back in the '60s and '70s.

We should

not have allowed the emphasis of our work at the time to turn out
to sound to people as though monetary targeting was about
creating alternative levers for monetary authorities to push and pull
in order to achieve some sort of unspecified and frequently
changing objectives. People thought that it was substituting
money growth for free reserves, nonborrowed reserves, Fed Funds
or whatever. It was sort of operating on a quantity axis in a

11

V

discretionary way, instead of on a price axis in a discretionary
way.
What we failed to make clear was a crucial underlying
premise of monetarism -- the Hayekian principle that a market
system, based on private property and using prices to allocate
resources, is inherently resilient and naturally gravitates toward
full utilization of its productive resources in absence of various
types of shocks emanating from the government sector. That
means that the true ultimate objectives of monetary policy would be
to achieve the highest sustainable growth over time that is
consistent, not only with the endowment of resources, but also
with the various fiscal policies and regulatory policies of
government, but not trying to compensate or offset the affects of
those policies.
It implies a rejection of all the rhetoric about hawks and
doves. It is just nonsense to talk about some members of the
FOMC being hawkish and others being a dove. Lee Hoskins was
often labeled a hawk, and the rhetoric in the press was that he was
antigrowth because he was antinflation, and that was a conceptual
mistake and one that we need to clarify. It is a false dichotomy;
there is no choice between inflation and growth over time. It also
implies a rejection of all of the jargon of "tightening" and "easing"

12

of monetary policy, but most of all, it implies a rejection of the
Phillips curve -- the notion of some sort of a social/political
tradeoff between the rate of change of prices and the level for the
employment, or unemployment.
The persistence of that idea of a social, political tradeoff is
what's behind the recent Congressional efforts to alter the FOMC,
to take the Presidents of the Reserve Banks off the Committee, or
make them subject to presidential appointment or confirmation by
the Senate. It is a line of argument that says, " because this is a
political decision, it must be made by people that are politically
accountable."

But, I reject the premise, so the conclusion does

not follow. The basic inherent resiliency proposition implies a role
for monetary policy in the economy means that there is no political
influence in the formulation and implementation of monetary
policy.
We have other problems in our language with the
terminology of monetary policy. Lee popularized this idea of "zero
inflation."

Homer Jones at the St. Louis Fed once said, "If people

see something often enough, they come to believe it whether they
understand it or not."

I think that was a part of Lee's operating

strategy. Just keep saying "zero inflation" over and over again
until it became respectable to talk about price stability and zero

13

inflation.
I believe in "stable prices" in a certain manner of speaking,
but I realized that we have problems with our language when I
started meeting people from the former Soviet Republics and
eastern block countries. These are people that have been listening
to the messages from us as their regimes were starting to break up,
and we would tell them two things: "among the various things you
need to do, such as establish property rights and so on, is that you
need to end all forms of price controls. Let prices be free to move,
create flexible prices, and achieve price stability at the same
time!" And, they say, "well wait a minute, which is it you want? Do
you want prices to be stable, or do you want them to be flexible?"
We'd say, "Well, both." And, we have had trouble explaining to
them what price stability means. It doesn't mean constant prices
fixed by government, but rather some other notion. I struggled
with this idea of trying to explain to them what it was that we
wanted to be stable.
I think that we sometimes miscommunicated with our own
people when we talk in these terms. What we really want to be
stable is in the minds of the people - the national standard of value,
or unit of account, or something. So following Brunner and
Meltzer --

or Armen Alchian's piece on "Why Money." -- "Society

14

chooses to use as money, that entity that economizes best on the
use of other real resources in gathering information about relative
prices and conducting transactions." The implication is that money
belongs in the production function because a less than optimally
efficient money means that you are under employing real resources.
Uncertainty about the trend in the price level lowers the production
possibility boundaries. So, given the state of knowledge and
technologies, what we are trying to do is create the condition that
achieves the highest production possibility boundary obtainable
over time, consistent with the other things that the government is
doing, such as reallocation of command over resources. Any
uncertainty about relative prices -- both current output prices and
asset prices, and the present price of future consumption -- moves
us to a lower production possibility boundary. That condition of
achieving the highest production possibility boundary is what we
really mean by price stability.
While fiscal and regulatory policies might be used by
government, for redistribution, I don't think it would be appropriate
for monetary policy to either intend to cause redistribution, or to
have an unintended consequence -

neither interpersonal nor

intertemporal - of redistribution.
None of that should be taken to mean that I don't think that

15

money targeting is not desirable, or that it is not useful. When we
are starting from a position of past inflation -

having conditioned

people to act in the belief -- that the purchasing power of money
will be eroded over time -- then I think it is a question of how do we
proceed to restore credibility in the commitment to what we call
price stability, or sound money.
When Lee took this job in 1987, he started talking in public
about M2 growth.

I would see the FOMC (in what they then called,

"Record of Policy Actions"), talking about M2, and I would badger
Lee about M1, or the monetary base, or something else, and the
*

problem about control of M2, let alone what it implied. He would
explain to me that the Board staff had developed a model based on
an idea of opportunity cost of holding M2 balances that allowed
them to jiggle short-term interest rates -- the Fed Funds rate,
relative to something else -

that gave them pretty good predictions

of what M2 growth was going to be over subsequent months and,
what's more , based on longer-term historical correlations -

the so-

called "p-star model" that Alan Greenspan helped give birth to that they had some pretty good idea of the implications. So, the
idea was: use open market operations to influence short-term
interest rates, which influences M2 growth, which achieves
objectives for the price level, or the rate of inflation. The model

16

seemed to work pretty well, roughly from the time Lee got there
until 1989 or 1990.
My dissents last year at 3 of the 7 meetings that I attended in
1992, were conditioned by that experience. The idea was that in
order to achieve credibility in the objective of monetary policy, we
had to hit the targets that we actually announced. And, if we
wanted people to believe in the upper limits of the target range, we
had to hit the lower boundary of the target range. It simply wasn't
credible to me to give ad hoc explanations for being below the
minimum limit, but not doing anything to try to get it back up,
while saying to the people "but don't worry, you can trust the upper
limits, we will act decisively when the time comes."
Some weeks back, I was talking to a member of the Board
staff about what we call the Blue Book -- which is the input to
policy and the tradeoffs of various money growth and interest rates
-- and about the experience of the last couple of years about what
has happened to their opportunity cost model and M2 growth, how
lousy the projections have been, and the velocity of the M2
problem (the linkage between money growth and inflation or
something.)

The Board staffer said, "Well, with no casualty

intended, it worked pretty well before you got here."
To some of the people that try to advise us on policy, it

17

seems to be the case that we don't know how to hit our monetary
growth targets, and we wouldn't know what it meant if we did.
Other than that, we don't have any problems.
It's pretty clear to most people that the linkages are broken.
That the link between open market operations and money growth,
at least in terms of the broader money measures, is not as reliable
as once thought, and also the linkage between some measure of
money and the rate of inflation, or the price level is not working.
Back in 1980, we had some legislation that was in part
intended to enthrone M1. We had had a couple of decades where
the M1 velocity (really the variance around the trend of the M1
velocity) was quite good compared to the other things leading us
to believe that if we conducted monetary policy (open market
operations) in such a way so as to hit an M1 target, we had a pretty
good idea of what was going to happen to a nominal GDP growth,
and that could help us achieve what we wanted. So, the legislation
was to move toward what we called uniform and universal reserve
requirements -- to have reserve requirements only on transactions
liabilities, and have the same reserve ratio on all transactions
liabilities at all institutions, so as balances bounced around from a
credit union, to a savings and loan, to a bank - from a big bank to
a little bank, and so on - we did not release and absorb reserves in

18

an erratic way, causing noise in the multiplier. The legislation was
intended to improve monetary control because we thought all we
needed to do is tighten up on our control of M1 and everything
would be fine. Along about that time, or maybe shortly after --some
people say it was the 1982 Garn/St. Germain legislation -- M1 got
dethroned.

While we were trying to work on improving the

monetary control side, the connection to something we cared
about seemed to go haywire as the velocity of M1 started to
become less predictable.
The Committee then shifted to an emphasis on M2, based
on the historic relation between broad measure of money and the
rate of inflation. But, we had the wrong institutional arrangements
in order to hit a money growth target when we defined it as a broad
measure. That is what gave rise to this opportunity cost model. If
we still believed that we had a reliable linkage between M2 growth
and what we really care about, then the objectives should be to
seek institutional arrangements -- in the form of something like a
change in reserve ratios - to stabilize the multipliers. We could
have one standard reserve ratio, say about 4 or 5%, on all
noncapital liabilities of all depository institutions, and that would
improve the link between open market operations and M2 in order
that M2 growth would then produce results we wanted.

19

But, given the problems of velocity of the last couple of
years, I don't think that anyone has the conviction that we could
enthrone M2 through legislation and regulation, and achieve a
better result.

So, there is no support for that at the moment.

In the past two years, after the Gulf War, there have been
two rival conjectures about monetary policy, and the role that it
played. And they are sort of revealing about how the people that
give us solicited and unsolicited advice view the world. One view
was that the recession was caused by an oil shock and war fears.
According to this view, all you had to do was remove this shock
that was depressing economic activity, and you would naturally get
a rebound. And, for a couple months, in the spring of 1991, it
appeared that was happening. Then the economy simply went flat
for about 4 quarters or so, and it's been kind of bouncing around
on a fairly low growth trend since. That view says that it was a
restrictive monetary policy, summarized by M2 growth, that held
back total spending, causing subpar economic performance.
According to that view, all that is necessary is to get our foot off
the brake, to be more generous in reserve supplying operations,
and allow M2 growth to move up into the middle of its target range,
and the economy will be fine.
A second view, quite a different one, is that various regional

20

and sectoral depressants have been at work over the last couple of
years, and these include such things as cuts in defense spending;
the unwinding of the commercial real estate overhang, and the
redeployment of those resources to something more productive;
the corporate restructuring that's going on -- including all of the
reengineering, or right sizing that partly is technology driven, the
balance sheet restructuring related to the unwinding of leverage
buyout and junk bond phenomenon of the '80s; the overhang of
consumer indebtedness; commercial bank recapitalization; and
the demise of the savings and loan industry. This set of
depressants constitutes what Alan Greenspan calls the "50 mile an
hour headwinds."

According to that view, monetary policy has

been very expansionary, as summarized by either the exceptionally
rapid growth of narrow measures of money (M1 grew 14% in 1992,
the highest rate for a year in the post-war period). Or, the low level
of short-term interest rates, (fed funds being the lowest level in 30
years) and the steepest yield curve in post-war history.

According

to that view, the trick is to back off of the accelerator as these
headwinds dissipate, so that we do not sow the seeds of soaring
inflation.
The first view says it is a question of "easing" monetary
policy. The second view says it is a question of when is the

21

appropriate time to begin to "tighten".

I think that both of those

divergent movements of the money measures can be reconciled in
the environment we have been in. Nevertheless, what gives rise to
my concerns is the lack of understanding on the part of the
American people, and their elective representatives, as to where
we're going.
If households and business do not believe the Central Bank
has both the intent and the ability to achieve and maintain price
stability, they will naturally look for evidence of changes in Central
Bank policies. They will assume that changes in the political party
occupying the White House, or controlling the U. S. Congress, will
affect the objectives and results of monetary policy. They will
assume that success or failure to achieve certain fiscal policies will
have implications for monetary policy. In short, they will base their
own plans and decisions on the assumption that any society that
does not have the political will to constrain the growth of
government spending within the range of tax revenues will
ultimately resort to debt monetization and the consequent
debasement of the currency. That means they do not believe the
stated objectives of the monetary authorities; there is a lack of
credibility in the commitment to price stability. Our challenge is
one of trying to reinstitute a regime in which people once again

22

believe that any increase in inflation and interest rates is temporary;
the longer-term trend is toward price stability.

(Intro for Frank)
Frank was President of the Federal Reserve Bank of Boston
for 20 years, and currently is the Peter Drucker Professor of
Management at Boston College.

I guess now you can tell us

everything that was done right or wrong over the last twenty years.

(Frank will now speak)
I remember that debate in the 80s was at Berkeley with Jerry
Jordan where we had quite diverse opinions on the whole issue of
monetary targeting, and I now find that there is very little difference
between us. So this session is going to be much less heated than
the one at Berkeley was. I think we have all learned something of
the events of recent years. What I would like to do is to take a look
at the history of monetary policy since the Treasury - Federal
Reserve Accord in 1951, and try to pick out some of the lessons
that I think we should have learned from that 42 year period. I find
it useful to break down this whole period into four periods. Two of
which were successful interest rate targeting periods, one from
1951 through the mid 60's. The second successful interest rate

23

targeting period, is the current period. The one from 1982 up to
date. We also have one period of one policy failure in the 70s using
interest rate targeting, and one brief period of targeting
nonborrowed reserves from 79-82. Now the first period ran from
1951 through the mid 60's. This broadly viewed is one in which
the Federal Reserve conducted an extremely successful monetary
policy. It was in a sense, the high water mark for the U.S.
economy that 61-65 period and perhaps the high water mark for
U.S. monetary policy. And it is ironic that the Chairman during this
period, William McChesney Martin, Jr., who during his regime,
accomplished probably the most successful job of controlling the
monetary aggregates. This man did not believe in targeting the
money supply. Now if you look at that period, compared to others,
the conditions for monetary policy were generally pretty favorable.
We have no supply shocks, such as we had in the 70s. We had one
war, the Korean war, but it was a well financed war, and we did not
get any sustained, fiscal pressure in the financial markets. And we
had in place throughout the period Regulation Q. Now Reg Q had a
great many faults. And nobody was terribly sorry to see it go. But
the fact remains that Regulation Q was a wonderful device for
monetary control because all the Fed had to do to begin tightening
up the economy was to move short term rates a little bit above the

24

ceiling which meant that money would flow out of the banks and
thrifts into the open market instruments and you would have an
immediate impact on all of the parts of the economy that were
sensitive to the position of the banks and the thrifts. And that
meant with very small, relatively small interest rate movements you
could control the economy quite well. Once Regulation Q died,
and we didn't have the kind of credit rationing that it produced, it
took much higher interest movements to have the same effect that
small movements had in earlier years. Now there was no great
theoretical structure guiding monetary policy in those years. There
was a very successful structure which Martin encompassed in two
sayings, one - leaning against the wind. And the other, taking
away the punch bowl when the party was just getting going. Both
of those meant that what we should do is lean against the wind
when every the economy began to grow at a rate that could not be
sustained without generating increasing inflation rates. And
conversely, leaning against the wind in the opposite direction when
the economy moved into the recession. And in fact, this very
simple construction produced as a byproduct very stable rates of
growth in the monetary aggregates. Now when the Accord initially
took affect, the Federal Reserve targeted free reserves. Now there
is no theoretical basis whatsoever, for choosing free reserves as a

25

target for monetary policy. It was done because the Fed at that
time wanted to demonstrate to the market that it would no longer
peg interest rates as it had for the whole period of World War II and
that was the rationale for adopting free reserves. Well, as time went
on and the market began to understand that the Fed was not going
to continue to peg rates, they dropped free reserves and went to
overt interest rate targeting. Now the leaning against the wind
doctrines produced four mild recessions in 19 years if you send it
through 69-70. But all recessions were very mild, the average
unemployment rate was very low and the inflation rate was low. We
have not succeeded since that time in sustaining periods of that
kind of inflation, low inflation rate and low unemployment rate.
Now when we turn to the second period, the period of failure and
interest rate targeting of the 1970s clearly the conditions were much
more difficult than in the 60s and 50s. We had the two oil price
stocks, which were very difficult to contend with. We had
continuing what was at least then thought to be a wise government
deficits although it looks much smaller in these days and of course
we had the demise of Regulation Q. Now the Federal Reserve
moved vigorously in response to the 1973 oil shock and produced
the biggest recession we have seen. The deepest recession since
the I930s. The problem was that the recession while the amplitude

26

was about right the recession was too short and the inflationary
expectations that were generated by the oil shock and the Viet Nam
war build up emerged for the 74-75 recession pretty much in tact. I
think the big problem from the policy maker in the 70s was a
fixation on nominal interest rates. First we had been accustomed to
very small interest rate changes, having big results. When the Q
ceiling was taken off and we needed much larger interest rate
moves to have the same effect, I think policy makers were a little
bound down by the earlier experience and looked upon what they
considered to be very high nominal rates and which of course were
much higher than anybody had seen since going back to the 20s.
But rates then in real terms were negative. There was not any real
focus on real interests either inside the Federal Reserve or in the
bond market. The bond market was taken in by the same fixation in
a nominal interest rates that the Fed was taken in by. In retrospect
it seems almost unbelievable that for 10 consecutive quarters the
real rate on 10 year Treasury's was negative. And I calculate that
using a 3 year average, the average inflation rate of 3 preceding
years. And in fact, if you look at the period 1971-1980 and half of the
quarters during that period the real rate of return on 10 year
Treasury was less than 1%. Now the Fed for this reason did not
move. Did not move to lean against the wind in 75, 76, 77 - the

27

years when big trouble was building up. And when they did begin
to move in 78, 79 driving rates up to as high as 1 l/2% and the
funds rate in Sept. 79 it was too little and too late. The Fed was
behind the curve, the horse was out of the barn, and when we went
into the most dramatic FOMC meeting of probably the life of the
Federal Reserve System. A Saturday meeting in October 79 where
the FOMC by unanimous vote moved not only to move interest rate
up sharply but to change their operating procedure to quit targeting
the federal funds rate and begin to target nonborrowed reserves.
The rationale for this was not that the whole committee had all of a
sudden turned monetarist in their thinking but simply that we all
came to the conclusion about the same time that it was obviously
going to take very high interest rates. Higher than any of us even
conceived of to turn around this powerful tide in inflationary
expectations and that if we were overtly targeting interest rates we
would have great political difficulties accomplishing those very high
interest rates. So it was felt that moving to a program of targeting
nonborrowed reserves would give us a little political shelter in this
difficult time and in fact it worked. The Chairman of the Federal
Reserve appeared before the Congress, the Congress was
concerned about high interest rates and the Chairman would say
well we don't control interest rates anymore, were controlling the

28

rate of growth of bank reserves and the money supply. Now the
Congressman get a lot of letters about interest rates, they get
damned few letters complaining about the rate of growth, the
money supply, or the bank reserves. And it is quite amazing that
the Fed was able to get away with this in this situation. And that is
one reason why in 1982, when we had to abandoned targeting
nonborrowed reserves I think most of the members of the FOMC
were very reluctant to do so because they valued so much the
political sheltering that targeting reserves rather than interest rates
gave to the Fed. But they had no alternative in 82 because while
Bill Poole's doctrine that targeting interest rates can be procyclical
when the economy is stronger or weaker than is expected and we
had plenty of that evidence in the late 60 and 70s the other part of
his doctrine that interest rate targeting is superior when faced with
a increase in liquidity preference. And what we found in 82 was
that all though the economy was contracting ( we had the most
serious recession since the 30s) that all of the monetary
aggregates were growing at very high rates. The impetus for this
increase in liquidity preference this was not related to a strong
economy but quite conversely existed despite a very weak economy
and the Federal Reserve was forced to supply that liquidity or face
a financial crisis of possibly quite fast proportions. And so with

29

this reluctance to leave the political sheltering the nonborrowed
reserve had given them we move back to interest rate targeting in
the summer of 1982. Now when we did sell we did not announce
that we were overtly targeting interest rates again. We picked
another concept that we are now targeting borrowing from the Fed.
This may sound very similar to the decision of the Fed in 1951 to
cover up the fact that there was interest rate targeting by using a
free reserve_________ . And of course, bolster reserves and
borrowing as this targets has the same characteristics as interest
rate targeting because the FOMC manager because if he is
controlling free reserves or if he is controlling borrowings has got
to give to the market whatever nonborrowed reserves they require
or demand. Because to do otherwise would be to increase or
reduce the level of borrowing which he is charged by the FOMC to
keep at a certain level. So we went back to interest rate targeting
with this very fragile coverup with our directors still saying to this
day that we are controlling reserves meaning borrowed reserves.
But I think the Federal Reserve learned a great deal from the
experience of the I970s. I think there is an unspoken doctrine,
maybe spoken now, Jerry, that we're not going to allow short-term
interest rates to stay in negative real levels. If you look back in the
70s the short term rates they were negative in real terms based on

30

*

the trailing 12 month inflation rates for 7 years. From the 4th Q
1973 to the 4Q of I980, 7 years of negative real short term rates. I
think if in the 70s, the Fed had been operating with a rule that real
short term rates should not be permitted to fall to negative levels. I
think the recession of 74-75 would have lasted quite a bit longer
and the subsequent of the growth rate of the economy would have
been smaller and inflationary expectations could have been in
pretty good shape between the second oil price shock hit. So if
this one lesson the Fed has already learned, but if you haven't you
might tell them Jerry, that we should not permit negative short
term rates except perhaps under conditions of extreme emergency
conditions that none of us have seen in the past 50 years or so.
Ok - where does that leave us for the future. I've had little contact
with academia lately and I see them targeting things like nominal
GNP or commodity prices or change rates or the yield curve. And
the fact is that none of these can be targeted by the Federal
Reserve in the same sense that we targeted M1. The Fed has only
two instruments at it's disposal. It can control short term interest
rates or it can control the rate of growth of bank reserves. A target
has to be something that is acceptable to fairly precise controls by
one of these two instruments. And it would be certainly wonderful
if we could by setting a certain level of short term rates all be

31

setting a certain rate of growth of bank reserves to attain a fairly
precisely a given nominal GDP. But we have no model that would
permit us to work this magic. So I think that the Fed's policy has
got to be what it was during the Martin years, one of leaning
against the wind. Now a lot of these variables that are suggested
as targets for the Fed will supply information (end of tape - side A)
. . . . policy. It will tell us a lot about, (I keep slipping into the us,
thinking I'm still in the Federal Reserve) it will tell them a lot about
the wind direction velocity and permit them to shape a result
leaning against the wind program. But none of these things can be
targeted in that sense and the only sense that is meaningful for the
word target. What about the monetary aggregates. The things we
can target and I suppose the only one can target now is M1 and M1
unfortunately has become too interestsensitive to be a satisfactory
target for monetary policy. The problem is the pricing of interestbearing M1 accounts which is very sticky. And therefore, because
of this price stickiness in a NOW account you get big swings in the
spread between NOW account interest rates and CD rates. And
when the spread is very wide such as it was back in early 80 when
the spread between the average NOW account rate and the average
six month CD rate was 375 basis points. And at that time of
spread, you are going to get very low rate of growth and interest

32

bearing M1 accounts and very low rate of growth as consequence
in M1 in general. In the past two years, that spread has dropped to
between 65 and 80 basis points. The spread between a 6 month CD
and a NOW account. The evidence suggests that whenever that
spread drops below 1% the opportunity cost of holding interest
bearing M1 accounts becomes so low that you begin to see a very
rapid rate of growth in M1 - and that is what we are getting. For
that reason, the next time we see the Fed push interest rates up
you're going to see a big decline in the rate of growth of M1 as the
opportunity costs of holding M1 interest rate and bearing deposits
when those opportunity costs rise. Now what M2 and M3? I find it
amazing to read works written by such formally sensible people as
Martin Feldstein and Paul McCracken, and I think Jerry and I agree
on this point, arguing the Federal Reserve policies too tight
because M2 is not growing very much. The question is that M2
growth rate a function of monetary policy being too tight and I think
no - the slow rate of growth of M2 and M3 does not reflect monetary
policy these deposits the none M1 deposits in M2 and M3 carry no
Reserve Requirement. They are not constrained by Fed policy in
any way. They are constrained by the capital position of banks. A
lot of the big banks have found themselves in difficulty with respect
to the new capital requirements. They find that one way of

33

1

improving their capital ratio is to reduce the volume of their assets
and the best way to accommodate a reduction in the volume of the
assets is to let their managed liabilities run off. And we've seen
over the past two years almost every time you get the account of
what the wise banks in the country are doing you see a further
decline in the CD position of the banks in the country. The only
way the Fed could make M2 grow faster to any sizeable degree
would be to increase M1 at an even faster rate which would make
no sense at all. Now in time, I suppose you could conjecture that
A) the banks change there way of pricing NOW account interest
rates, which I probably think is not likely, so I don't see a comeback
for M1, but you could see a period some time ahead when M2 and
M3 begin to gain some respectability as targets for monetary policy.
Presumably, at some point, banks are going to feel comfortable
about their capital position and be willing to go into the
marketplace and to increase their managed liabilities again. And in
time, conceivably see M2 and M3 grow at something like their
normal rates in the 60s and 70s. But even if this happens, this is
going to take a long time to establish the fact that we have renewed
stability in the M2, M3 GDP relationship. So until this happens, I
think the Federal Reserve has no choice but to target the Federal
Funds rate. There are no targets in sight that it can sensibly use

34

\

and achieve by varying the rate of growth of nonborrowed reserves.
So if they were making book on the floor below us they make book
on almost everything down there. If they were making book on
what the Federal Reserve would be targeting 5 years from now I
would bet that they would targeting in a discretionary way the
Federal Funds rate. Because I think it would take at least 5 years of
data to generate any confidence in stability of the relationship of
any of the monetary aggregates to the GDP. So I think I will stop at
that point for questions.

Just before we open it up to more general discussion to give
you a chance - 1 think Jerry has some comments then we will take
questions. When you have questions, go up to the mike.
Couple thoughts, and a question. Your noting the role of Reg
Q and interaction with policy Reg Q as a instrument in that period.
Whatever, we thought of them or since, about the efficiencies and
desirability the effectiveness of that, when you put into political
economy or public choice context it did involve identifying victim
sectors as we call them. But those interest sensitive sectors that
took the brunt of monetary policy action. (Mr. Morris - they always
take the brunt of monetary policy actions) Well, but it was very,
very focused when you created disintermediation at that time, in

35

which created a political reaction from the housing and the auto
sectors, and so that I think is the politics of it that killed it as much
as any argument in the profession about desirabilities and
efficiencies and all of that. (I think what killed it was the money
market fund.) That was an innovation that came from that
environment. What is intriguing to me is to think back hindsight, is
in the 70s City Corp., City Bank, wanted to issue a VISA card, I
believed passed in Maryland with a credit balance of which they
were going to pay a positive market rate of interest and the Board
of Governors says if quacks like a deposit, it is a deposit, it's
subject to Reg Q and Reg D, therefore its on economic and Merrill
Lynch says Gee, we can do that. We can have a credit balance on
a brokage account and pay a market rate of interest and the Board
of Governors in effect regulatory prohibition that created a
alternative vehicle transmission mechanism and killed a part of the
banking industry. The other comment that intrigues me is your
emphasis on the role of free reserve as a transmissions vehicle
after the accord to unhook political and market sensitivities to
interest rate targeting until the time was receptive to go back and
then your characterization of the 79, 82 reserve targeting is again,
political shelter and nonhooky(sp). Can you think about what you
might do in this environment if were in a highly politicized focus on

36

short term interest rates. We've had 5 years of cuts in the Funds
rate and the very first time after, is it 4 years or 5 years?, anyway,
after 4 or 5 years of cutting the funds rate 23 times or whatever its
been by 7 percentage points, the first increase is headline news.
So, in order to again whether your bet about 5 years from now
targeting the funds rate - I'm not going to bet against that for sure,
but that doesn't mean that between now and 5 years from now
during that whole period we would also target. Can you imagine
using some other instrument as a transition devise to unhook the
markets and the political sensitivities from this preoccupation with
the funds rate until sort of a time we could go back to it, and if so
what would it be?

I would like to respond to two things. One with respect to
Reg Q. When Fidelity Fund first decided to permit customers of
this money market fund to withdraw their funds by use of a check, I
called up Ned Fitzgerald and I told him you're destroying the
concept of the money supply in the United States. You've got
checkable money market funds. And he said, "We didn't have
anything like that in mind. What we found out was that the
cheapest way for us to handle withdrawals was to give them a bank
account and let them write checks out. It was purely a dollars and

37

sense administrative thing. With respect to the second thing is
something the FOMC has got to be thinking about now. How to
reduce the political flack when you have to start pushing interest
rates up. I wish I could have had a concept that I could give to you
to meet this. I don't think you go up before the banking committees
and make credible a response that we are not controlling interest
rates, we're controlling borrowings from the Fed. I just wonder how
long that would fly. I think the FOMC is simply got to do what was
done during the Martin regime. Of doing what they thought was
right and standing up to Congress. Why can't the committee get
like this when it gets you away from that kind of pressure. Ok,
thank you. Let's open it up to some questions. First question,
please identify yourself and then go to your comment.
My name is David Fand, and I'm with the Center for Study of
Public Choice. I would like to ask Jerry Jordan a few questions.
First of all, I think the juxtaposition of M2 vs. zero inflation is
incorrect. In other words, one is saying I want to end up in
Jerusalem and the other is saying I'm going to fly or should I go by
ship. You're talking about different animals there. Let's take the
zero inflation first. I'm as anxious for zero inflation as Lee Hoskins.
But the real question is how soon do you want to get there? Do
you want to get there in six months, or eight months, or three

38

years, or four years? If we want to get to zero inflation in six
months, we may produce 30% unemployment. I think even Lee
Hoskins would question if that is wise. So to talk about zero
inflation, you're just talking about where you want to end up.
You're not telling me how to get there. That's where M2 comes in.
M2 is the target that the Federal Reserve can achieve. Now, you
mentioned that some staffer said something to the effect, "we don't
know how to get to the M2 target, and we wouldn't know what it
meant if we got there. Now let me be precise. When he implied he
couldn't get an M2 target, did he mean he couldn't get M2 or as
Frank Morris put it he couldn't get an M2 target without most of the
increase being M1. I would say, so what? Who has told you, or on
what basis do you know, that the composition of M2 between M1
and nonM1 is the critical factor. Second, with respect to saying he
wouldn't know what it meant if he got there is it or is it not a fact
that most of the regressions will show that the M2 target gives you
a much better indication of GDP than any other M. Next, you
mentioned that there were regional and sectional depressants.
True. But were these depressants helped by the FOMC consistently
missing targets which already incorporated an attempt to reduce
inflation. Next, you mentioned that many think the Fed was very
easy because short-term rates were low. Is it or is it not a fact, that

39

short- term rates, all rates, were very low during the Great
Depression after several years of very low growth of money. In
fact, a 35% reduction. The question I ask, is it or is it not a fact that
it is true, in general, that most of the time when interest rates are
falling they are the result of monetary easing. But is it also not true
that interest rates could be falling and very low as a result of 3, or
4, or 5 years of tight money? Is it or is it not a fact, that since '87,
'88 you've taken M2 from 9, to 4, to 3, to 2, to 1 point days. So,
these low interest rates could have been the result of a very
restrictive policy and not in the elements of easing. Let me just
sum it all up. The summation really is this: we all want zero
inflation, believe me, I'm just as much for it as Lee Hoskins. You
may not believe me, but believe me I am. But, the real problem is if
you continue with a tight policy, and you produce a week economy
as we've had the last three years, the real question is '90, '91 and
'92 what the Fed has done, and why it consistently fails to hit the
midpoint of their own targets. Now, you're going to get a weak
economy. You've got an army of engineers from Yale Law School
ready to do all kinds of things, which incidently they would have
done already, were it not for Ross Perot, we're just lucky Ross
Perot has thrown a monkey wrench in. They've got all the programs
ready, all the initiatives. Is there not a danger that by continuing

40

with a tight money policy, in a weak economy, you're going to give
the Robert Reichs of the world the material they need for their new
program.
(Jerry Jordan) Thank you, David. We just published an
article in one of our publications in our Bank saying that all
evidence still supports that M2 is in fact the best measure. The
authors of that publication think that the article is wrong.

who do not work for our Bank -- now
We got it out just in time. You've

used the reference to "tight" money a couple of times. But, that of
course, implies that you know which indicator relates to something
down the road. You also made reference to "low real interest rates"
in the Depression. I would say that is wrong. You had deflation in
the '30s and the low level of nominal interest rates was misleading
people to think that policy was expansionary when in fact it was
contractionary. This is back to Frank's point - nominal interest
rates are not real interest rates. How do you know what real
interest rates were. It depends on the expected rate of inflation.
With the asset prices and other prices dropping absolutely in the
1930s it was an illusion that there were low real rates. You had low
nominal interest rates. It's an ex ante, not an expost, concept.
Our problem today, is in part knowing what is in the minds of
households and businesses in America as they make their plans

41

and take actions that influence the future. What we see is we've
had a record corporate calendar of debt issue -- a lot of it at fixed
rates at what they perceive as being fairly low. It may be low
compared to the past, but the important thing is whether or not it
is low compared to what it's going to be in the future. We have
households refinancing mortgages in the belief that 7 or 7 1/2% on
intermediate and longer-term mortgages is going to, in the future,
turn out to be low. But, if we're successful in moving toward
stable money, then that is going to turn out to be a high expost real
rate. The Committee does discuss real rates. There are some
differences as to how to measure real rates -

over how many

months of the rate of change of which index, and with and without
this or that component in the various inflation measures. Some put
it in a Wicksellian concept of a natural rate. They are trying to
interpret whether a 3% fed funds rate is high or low. You obviously
think it's high.
You're also saying "tight money" because of slow growth of
GDP.

We don't want to gauge what we're doing in monetary policy

over some perception about statistical indicators of economic
activity. Milton Friedman's '67 Presidential Address told us we
didn't know enough then to do that and I don't believe we know
enough now to gauge monetary policy actions by what happens to

42

nonfarm payroll employment, or real output growth, or all of these
other measures. You cannot control a real variable with a nominal
instrument.
Monetary analysis comes down to excess supply and excess
demand, and you have to have independence between the demand
function and the supply function. Part of Frank's analysis was that
when you move into these periods where you do not have
independence between the demand for a certain measure of money
and the supply of it -- whether it's M1, M2 or some aggregation -­
then you're not going to have effective monetary policy. When I
think that we are faced with those situations, I fall back to the
monetary base where clearly we have independence between
supply and demand. The current construction of M2 is not the
same as what was in the Friedman-Schwartz studies. It is a
different aggregate and if you go back and look at an M2 today that
consists of the same component parts as the Friedman- Schwartz
studies, you get different results than what is implied by the
published M2.
I dissented three times out of my first 7 FOMC meetings on
the grounds that it's our target, we announced it, we communicate
this way, and we should hit it because it is our target. But, not out
of any conviction that empirical results are going to tell us we are

43

going to get a certain outcome in terms of short-term output or
employment growth.
(Fred Furlong) We've heard from Lee indirectly throughout
this session. Right now I think we will hear from him directly.
(Lee Hoskins)

I'm just going to ask a question or two, and

make an observation. One observation - as many people in this
room have established, a very large body of information, research
about instruments and targets and it has always surprised me the
paucity of research about the value of price stability relative to that.
So, I agree with Jerry.

I think we focused on the wrong thing

through most of our academic efforts in terms of looking at these
interest rates or money growth. There are two large central banks
and large economies that have a better record than the U.S. Central
Bank in terms of inflation in the last 25 years; one is Germany, the
other is Japan. One uses monetary targets, and the other uses
interest rates as targets. I think all we are talking about is a very
built-in inflation around the mean in terms of choosing which target.
In terms of zero inflation, and the question I want to pose, and may
be a little directed to David, is I think really if the Central Bank truly
wants to get zero inflation, it can do it with either set of targets.
That is interest rate or money growth. The point is we don't have a
clear cut objective about what we want to do as a Central Bank.

44

Talking about nominal GDP targeting seems to hit or miss the point.
Fed does not control nominal GDP. Fed controls one thing over
time and that's the price level. Period. That's what it controls. So
why not target the price level, and how would you go about doing
it? That's my question. I guess to David Fand's point, yea, I mean
I never wanted to get to zero inflation tomorrow because credibility
is an important thing but I don't think credibility has to come from
an M2 target or an interest rate target. Credibility can come from a
clear statement of objectives, that is, we want price stability in a
timeframe in which to achieve it. I picked five years because
contracts have a chance to adjust to it within that timeframe. So
the question is, why not target the price level?
(Morris) Well, I think the reason the Fed cannot be that
focused on the price level is that very often we're the only tool of
economic control in Washington. It would be nice if the Fed could
say we're going to focus on inflation, and we're going to let the real
economy be determined if need be if something has to be done to
spool or restrain. The real economy is up to fiscal policy to take
care of that. Unfortunately, we don't live in that kind of a world.
I've never stated a zero interest rate target, not that I'm opposed to
it. But I think in terms on realism, if we could get back to the kind
of inflation rates we had during the Kennedy years of 1, 1 1/2%

45

where most of that inflation very well reflect failure of poverty
adjustments, where you had an inflation low enough so that it
wasn't going to distort investment decisions. It seems to me that
would be a perfectly reasonable objective, and I think if we could in
the next five years get the inflation rate down to 1 1/2 to 2% I would
consider that a considerable triumph for the Federal Reserve.
(Jerry Jordan)

Now you know the difference between Frank

and me. Frank wants to get back to the 1 to 1/2% inflation of the
Kennedy years. I want to get back to the 1 to 1 1/2% inflation of the
Eisenhower years.
I would adopt a multiyear objective for the price level. This
multiyear path would be a long-term objective, not an operating
target. To make the price objective explicit and measurable, I
recommend that the FOMC choose a time-path for the intended
inflation rate that leads gradually to a horizontal trend in the level of
prices. For example, today I would choose a path that achieves
price stability in 1998. It would imply 2.5 percent inflation in 1993, 2
percent in 1994, 1.5 percent in 1995 and so on until the intended
inflation rate is zero in 1998.
In the short-run, between meetings and within a year, the
FOMC would continue to use its best judgement in achieving this
objective, based on monetary growth targets, its best models and a

46

wide variety of other indicators. But these judgements would be
exercised within the context of the multiyear objective that, in
effect, would provide the benchmark for setting annual monetary
targets. This is particularly important when velocity is
misbehaving. I would tie our announcements as to what we are
doing to the Humphrey-Hawkins requirements on the budget and try
and put some teeth in it. First, that the administration, the Office of
Management and Budget, and the Congressional Budget Office,
should agree with the Fed on 5 year out - 1 would call them price
levels with a variance at that unexpected level and tie together what
the monetary authorities are aiming for down the road long-term strategic planning in the corporate world -

sort of like

and work

backwords from that to intermediate annual price levels (or rates of
inflation -- year-to-year changes that will produce that price level).
It is important that the public has in their mind that five years or
seven years down the road, plus or minus two or three percentage
points -- here's what a dollar will buy.
Think about 4% inflation, which a lot of people have in their
minds as low or moderate. Yesterday, John Taylor said that he
thinks that the Fed - his empirical results implied, he says -- that
the Fed has shifted up from 2% inflation measured by some index
to a 4% rate of inflation.

A 4% inflation to the parents of a baby

47

born this year means that when their kid is ready to be a college
freshman, the purchasing power of the dollar will be cut in half or the cost of going to college, other things the same, will double.
That has to go into their planning. To me, that is unacceptable.
What we ought to do is try and say to them, and effectively
communicate it through our actions (and this does involve reserve
or money targeting), that the purchasing power of money is going
to be thus and so some years down the road and you can count on

(Morris)

I think the problem here, Jerry, as you well know, is

that it is very difficult to get the Administration and the Congress to
think in any long-term context. I remember one time back when
Jerry was on the Counsel of Economic Advisors and the rosy
scenario came out. Rosy scenario showed 4% real growth rate
forever accompanied by a declining interest rate. I said, Jerry, how
did you come up with this rosy scenario and Jerry said it was
simple. He said that the supply side did the real economy and the
monetarists did the inflation rate.
(Mr. Jordan) It was worse then that because the eclectic did
nominal GDP and it turns out Y didn't equal X plus P.
(Fred Furlong) One thing in this discussion seems to be that
we are talking about interest rate targeting in some sense and why

48

can't we target the price level. Others have come up and suggested
more nominal GDPs and obviously some people disagree with that.
But the fundamental question is the FOMC agrees and no one
knows exactly what the right level of interest rate is in some sense.
You have to have something you are reacting to. The FOMC
deciding, "well do we not change the Fed Funds rate or do we
change the Fed Funds rate." We are reacting to something. I
guess Jerry's suggestion that maybe the price level but I guess the
question for Frank is well if it's not the price level what's your
alternative. What is it that you are basing your decisions on in
terms of how you move that interest rate around.
(Morris) Well, I think that any FOMC meeting it seems to me
that most of the members have a concept of what the optimal
realistic expectation for nominal GNP ought to be over the next
period. That may not be zero inflation 4% real growth rate, it may
be a higher inflation rate that you like to get over long-term and a
lower rate of growth then you would like to have long term. But
you have to have some concept of what the best mix you can
reasonably get in the next four quarters. That's what I always had
in my mind when I approach the monetary policy decisions and
sometimes I made them right and sometimes I was wrong.
(Jerry Jordan)

That response surprises me a little bit

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because in your initial remarks you focused on the level of real
interest rates. The lesson of the 70s was the problems of having
persistent negative real interest rates, and you said we would not
make that mistake again. I thought you would say that in today's
environment with inflation measured over some period, we do have
a negative short- term real interest rate. You would use as your
target, raising the nominal rate to a level so that it was nonnegative.
The problem with responding to nominal GDP, or worse, real
output, is that any pickup in nominal GDP growth in the current
context, given lags and all of that, is almost certainly going to be
the result of faster real output and employment growth. So, if we
use nominal GDP as the trigger to raise the funds rate it will cast
the Fed as being antigrowth. That gives us a real political problem.
The reason I was disturbed by last year's action to cut the funds
rate on the day of, or the day after, release of the nonfarm payroll
employment, was that it conditioned the market to believe that all
we cared about was employment. They concluded that with the
first sign of strength in employment we were going to raise the
funds rate. That casts the Fed as a scrooge, because we would be
viewed as anti-employment and anti-growth.
(different speaker) This is really following up on discussion
with Jerry Jordan. We've got the objective and in your

50

discussion/presentation, Jerry, you very clearly set out that in
order to obtain that objective you need credibility and you need a
nominal anchor. Now, I don't agree with Lee Hoskins here that you
get c re d ib ility by announcing something. In fact, I think you lose
credibility because we've announced so many things in the past
that we haven't done, that another announcement won't do it. It's
got to be actions over sustained period of time, and that links
whether the actions are going to be successful, it seems to me that
you're right that we need the nominal anchor. Do you have a
suggestion for nominal anchor that will work in this environment?
(Jerry Jordan) Not one that I can sell. In order to reconcile
the problem of interpretation of current M1 and various
combinations of things to produce a broader measure of M2, I use
the monetary base - adjusted for increases in foreign holdings of
U.S. currency. However, we do not have timely information. It does
involve doing something that I am not at all comfortable with as
saying, "Well, if you take this measure and either add to it
something or other, or subtract from it something or other this is
what you get." And there is no way to sell that to the Committee,
let alone to try to communicate it to a larger audience through the
media or political people.
So, I think that the focus has to be on longer-term objectives

51

in terms of the price level. We should change our rhetoric and our
focus. Instead of describing our actions as "tightening" and
"easing" --

all of those words that are used about our actions

implying stimulus or restraint -- we should instead, just talk in
terms of achieving sound money. Plain and simple, nothing else.
That's all we are trying to do is stop the debasement of the national
currency.
(Walker Todd from the Fed of Cleveland with a question for
Frank Morris) on interest rate targeting performance in the 1950s
and 1960s. Even if you think it did work fairly well domestically,
isn't it true that from '57 to onward or there abouts that the dollar
was in deep trouble abroad either in terms of gold or foreign
exchange and a whole host of jerry-rigged solutions kept being
patched together over the next decade down to what I view as the
most dramatic FOMC meeting of that whole era just reading the old
minutes, August 1971. That was a jim-dandy meeting right after
Camp David. But isn't it true that the interest rate targeting
exercise, while nice domestically, led to ultimately disaster on the
foreign exchange side?
(Morris) Well, I think that if you look back at that period in
the '60s, we were running a trade surplus and we were running
current account surplus. We were running a deficit in capital

52

account that reflected the very large investments being made
abroad by American corporations. The dollars going abroad for
that purpose on which we are now getting very big returns were
flowing into Central Bank hands and the Central Banks around the
world were becoming more and more restless about holding that
many dollars. Now I think the problem was here you had a domestic
economy that was running very nicely with a low inflation rate - if
we had a high inflation rate during the '60s that generated this
problem and we had a big budget deficit and so on - 1 mean trade
deficit, I think it would be a very different matter. But if you have
trade surpluses and you have low inflation rate, low unemployment
rate in the country, you've got a very satisfactory situation to alter/
tighten policy solely to make dollars a little more scarce it was not
a politically acceptable or even perhaps an economically acceptable
proposition. I think the big problem we had at that time was the
fact the Brettan Woods system did not permit the U.S. dollar to go
down in response to these major capital outflows. We were having
these capital outflows which, in the long run, were very beneficial to
the world economy and to ourselves which would have put
downward pressure on the dollar if it hadn't been for the fact under
Brettan Woods the dollar could not be devalued. And in fact, up
until 1969, the dollar was being revalued upward due to the

53

devaluation of a great many other countries. So I think it was a
structurally unstable situation we had there. And I'm not sure that
it would have made sense for us to try to push interest rates up to
the point where we had enough capital inflow to finance our foreign
investments, because the impact of domestic economy would have
been extremely negative.
(different speaker) That policy though, might have forced a
choice politically in Washington, not at the Fed but among
administration, Congress, and others, it would have forced a
choice over whether in the long run it was better to devote capital
resources to domestic investment vs. playing a leadership role in
the world assuming the matter Great Britain had before World War II
being the financier of the world and things of that sort. That issue
was never really debated explicitly, it was just assumed that we
were going to be the new Britain and we went abroad. But the
point was, that had you made that opposite policy choice in the
'60s, at least you might have had an open debate on the issue and
other things that people would view as a disaster, like the Viet Nam
War, might have been avoided.
We have time for one more question. (Philip Quayle, Ball
State University). The Fed's primarily a political institution, creature
of Congress, that the reason why we can't agree upon targets is

54

that there is no agreement among the general populous. If the Fed
follows a target that is not consistent with what we the public want,
the Fed is not going to last. Evolutionary mechanisms assure that
the Fed's not going to do anything extraordinarily painful, at least,
perceived to be painful. If they attempt to do that, it's going to be
changed. So in essence, the shifting targets you get explicable by
the basis of there's no consensus among American public on zero
price inflation or anything else that monetary policy should do.
(different speaker) I think the only saving grace is that the
Federal Reserve is given, in fact, a lot of leeway in terms of time
because of the slowness of the legislative process. You talk about
the legislature reacting negatively if we pursue, over the prolonged
period, policies that are unpopular. I grant you that the Fed cannot
follow forever policies which are not acceptable by the public. This
does not mean that for a considerable period, the Fed can as it had
followed policies that were unpopular. I think an awful lot of people
that would have voted against the kind of policies we undertook in
'80 - '82, I'm not sure we could have gotten the majority vote among
the public for following policies that were that tough. But we had
enough lead time from the System to permit us to do it before and
to show some benefits before the rebellion got too hot and heavy,
(different speaker) I agree with the thrust of your comment

55

and '92, to make it very simple. The question I'm asking you - If the
Fed had hit the midpoint of their own target, those three years,
would we have been better off, would we have had more income,
more employment and more jobs than we have now. And would it
have been desirable.
(different speaker) You talk about a midpoint for M2?
(different speaker) Just those three years? I don't want to
make it complicated.

Would we have more income, more

employment, more jobs, would we have been better off if they had
hit just the midpoint of their own targets?
(different speaker) My answer is no. I think the only way we
could have done that would be to increase that more than enough
to make up for the drop in the CDs. We're talking here - not small
money. We're talking at least 30 billion dollars. Now, if you're
saying would it have been good for the country to supply enough
additional reserves. Remember, in the two years '91, '92 bank
reserves in those two years went up by 30% and you're telling me
that is not enough. That we should have increased them by
another 30 billion to support, to get up to M2 objectives. I'm saying
the whole concept of M2 as a target for monetary policy is simply
completely outdated by the real facts of the situation. I don't think
there is anything the Fed can do to produce the kind of number that

57

you want which makes any sense at all. The whole idea in my mind
of increasing reserves by more than 30% in two years, I find mindboggling to think that that could produce anything much more
satisfactory for the economy. Remember, we have got a bond
market very different to 1970 and I think we are lucky that we have.
We have a very nervous bond market that has to be persuaded
every day that the Fed is concerned about inflation. I think the kind
of program you've been advocating here, would have had a
negative effect on the bond market.
(Jerry Jordan) I would like to add to that because it is this
lack of credible commitment to where we're going to come out at
the end of the day. That's our problem. Remember 1990.

The CPI

shot up to over 6% in the midst of what was being touted as the
third oil shock and people remember what happened during the
1973-1974 and 1979-1980 oil shocks. Even aside from the shock
you were still averaging between 4 and 5% inflation. The Michigan
survey and everything else you looked at showed an expectation of
a persistent inflation. You had the badgering by the Brady Treasury
and others in the Bush administration about policy being "too tight"
and needing to "ease up". That had the effect that more aggressive
reserve supplying operations in an effort to get up into the midpoint
of the M2 target range would have resulted in simply an "Ah-Ha"

58

experience on the part of the American public; namely that the Fed
had thrown in the towel and is sacrificing its objectives for political
expediency. The dollar would have plunged and bond yields would
have risen. If that had happened, then the economy wouldn't be
better off today. Your question was, would the economy be better
off? And I'm saying, given the lack of a credible commitment to
price stability I don't know if we would have been better off or not.
I wish I did.
(Fred Furlong)

I just want to thank our panelists and given

them a hand. (Applause) Lunch is in about 10 minutes or so, but I
think we have another minute.

Maybe you could ask a question.

(Warren Coates, International Monetary Fund) There is very
interesting literature over the last 15 years or so that Leland Yeager
and Greenfelt summarized and extended and I've done the same
and some others, which takes very much to heart the point every
one seems to agree with here that price stability should be the
ultimate objective of monetary policy and it says if that's so then
why don't we just fix a system around that directly. It's really a
gold standard mechanism with some new modern twists that takes
the whole CPI or a very broad basket of commodities. It intrigues
me that this quite different approach, but very direct approach, to
what everyone agrees to hasn't been touched on as this - you did -

59

I'm sorry - OK - Is this receiving serious consideration at all by the
(Jerry Jordan)

By the Board? I have no idea. I don't

understand it. So until I understand it I can't seriously consider it.
I'll read yours.

Thank you.

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