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fcccfivw,c AsSh iJ-.hj'1'•/ . THE SEARCH FO R A TARGET FO R MONETARY POLICY i JORDAN: I t 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 th a t I'm not sure th at the question should be searching for a monetary aggregate, or monetary target, but rather, searching for an objective for monetary policy. A l m o s t d e c a d e s ago, K arl B runner hosted at UCLA a couple of conferences called "Targets and Indicators for M onetary Policy.” This was when Lee Hoskins and I were young students at UCLA. They brought in all of the eminent people in the profession, some 50 or 60 of the leading names in monetary theory and policy, both within the Federal Reserve and the academic profession. It was a fascinating couple of days, both times. W hat I failed to appreciate at th at time was th at those conferences were conducted in the context of more than a decade of under 2% inflation, followed by a couple of years (1964 and 1965 ) when inflation jum ped into the range of 3 or 4%. It was thought at that time th at the problem was only one of choosing the appropriate targets and indicators - th at 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 th a t time, I think, was that increases in inflation and interest rates were tem porary, destined to go back down. Now, after more than three decades of inflation, the mindset of the American people is th at declines of inflation and interest rates are temporary. 2 * # People believe th at the permanent condition is for inflation and interest rates i to go back up. Coming back to the Fed after some 15 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 M l versus M2 and the various measures of the monetary base. In fact, three months before rejoining the Fed I did an analysis for the Fed of w hat was going on with M2 in 1991. Already there was concern about the extent to which it was or was not giving a 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 th at I inherited from Lee Hoskins. The staff persistently said to me " It’s the objective, stupid - not the target, that is the real issue!" And, I kept saying th at I thought the objective was quite clear - not only to myself, but also to my colleagues. The staff kept telling me I was naive. But after sitting with the Committee for 10 FOM C meetings, watching the deliberations, the interaction between our decisions and the financial m arket participants, the people's elected representatives, and the media, I ’m now convinced too, it's the objective, not the target, th at is the real issue of m onetary policy. Some years back, I heard about "G oodhart’s Law." I think it was Henry Wallich who first told me about it and wrote about G oodhart's Law. The idea is th at 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, th at variable ceases to be 3 reliably related to the objective. The analogy was something from physics called the Hiesenberg Principle, which states th at 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 m onetary policy is, once the Central Bank has a target which the people know it is responding to, the behavior of the people is changed ~ traders in the m arkets, such as bond markets, equity markets, foreign exchange m arket, as well as real people. Then, because they change their behavior in anticipation of w hat the Central Bank is going to do based on these indicators, you d on't get the same outcome that you otherwise would. So, we went through the silly season in the late 1970s when the Thursday night money numbers would cause the interest rate futures m arkets to do wild gyrations. There was a period some years back when the m onthly merchandise trade balance was all the markets responded to. 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 K irrelevant. I think th at G oodhart's Law is/galitjjonly if monetary policy is not ^ anchored by clear, well-understood objectives. jG oodhartV iaw ^w ill-B ot-hol^-- ^ J^fev ery o n e understands and acts on the belief th at the objective will be achieved^ Thrcf^lm tnfTr people will not care w hat the interm ediate targets are. So, I'm going to assert what I will call the "Hoskins’ Corollary" to 4 ^ ^ ^ G oodhart’s Law (after he kept hammering on this thing for four years while he was in my job). That is, if the m onetary authorities have an objective of a stable purchasing power of money which is known and believed , such th at the actions of households and businesses reflect this knowledge and belief, then it may be th at any target is adequate. It certainly becomes a secondary issue at th at point. I no longer think th at monetary targeting is a sufficient condition for a satisfactory monetary policy. W hether or not it is a necessary condition is still debatable. I do think th at having a clear objective of m onetary policy is necessary. I'm still waiting for people to persuade me w hether it is or is not sufficient. Milton Friedman taught us th at having and hitting any monetary growth target was superior to a pure discretionary policy. I think w hat was left unsaid about this Friedman dictum was th at it was valid in the absence of policy being anchored by a clear objective. I'm not so certain th at a policy th at 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 implied 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 AndoModigliani. Then we had Deprano, M ayor and Hester and a num ber of others including economists at the St. Louis Fed, the New York Fed, and the 5 Board of G overnoriV I now think th at whole framework was wrong. That fram ework related money growth to total spending-- nominal GDP ~ and then we derived from th at implications for the rate of change of prices, and the rate of change of output and employment, and so on. We in rt nf . <7 decomposed spending into its output and price components. I think there was a fundam ental mistake in our research strategy at th at time, and all of the rhetoric of "dem and 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 influencing the aggregate supply of output. A lot of w hat we did at St. Louis, including my own writing at th at time, was in the context of demand management. Think about the message th at 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 th at you could pursue an activist discretionary monetary policy to hit certain objectives in terms of output growth, the rate of inflation, levels of employment, the unemployment rate, and so on. And, that it was appropriate to use monetary policy to pursue "countercyclical stabilization policy" to either offset real shock affects, or shocks emanating from the rest of the government sector. And, we hear right up to present times references to the idea of a monetary policy being adjusted based on what happens on the fiscal side. In one im portant respect, monetary and fiscal policy actions should be thought of in concert. That is, that in a fiat money world, monetary policy is 6 a fiscal instrum ent —a way to finance government. No one can possibly I know the effects of proposed changes in explicit tax rates w ithout knowing w hat is going to happen to the purchasing power of money. The C hairm an of the House Ways and Means Committee should be ju st as interested in the C entral Bank's intentions regarding future inflation as the Chairm en of the Senate and House Banking Committees. W hile I now think that most of the discussion about activist monetary policies is nonsense, it did derive from the work th at I and others were involved in back in the 1960s and '70s. We should not have allowed the emphasis of our work at the time 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. W hat we failed to make clear was a crucial underlying premise of monetarism — the Hayekian principle th at a m arket 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 the absence of various types of shocks emanating from the government sector. That means th at the4wiPuitimate objective^of m onetary policy would be to achieve the highest sustainable growth over time th at is consistent, not only with the endowment of resources, but also with the ^ | ^C_ various fiscal policies and regulatory policies of g o v ern m en ^ n o t trying^to compensate or offset th e ^ fic t^ o fth o se policies^ Oj a ^ wjflatinffwf all the rhetoric about hawks and doves,/Ifc«=cr*) ^ ' ^ rHjy '- id fir ^ m|Taaon^n^ti"trallO dimii^iiuuaiip.nrln i »nMli^rn[VTP-ln!liuUwwMiCff*>mr ethtrrblH lig'tt d tflt. Lee Hoskins was often labeled a hawk, and the rhetoric in the press was th at he was anti-growth because he was anti-inflation. T hat was a conceptual mistake and one th at we need to clarify. It is a false dichotomy; there is no choice between inflation and growth over time. -atoo-H plics a rejection of.alM | the jargon-of "tightening'*- a n d ^ e a s in g ^ o f M -jmonetarv Dolicv^but-nrovH)f all, it.iin p liira''f eh.QhiiiJuf the Phillips curve / - the notion u f some suit uf siuclal/Mlillial tradeoff between the rate of change of prices and the level of employment, m uiiemployiuculi ■ .— y The persistence of the idea of a social/political tradeoff is what's behind tiifrvgcent Congressional efforts to alter the FOM C, toprtfc the Presidents of the R&«cye Banks off the Committee, jtp'fnake them subject to presidential appointm enfv0t^onfirm ation> y'the Senate. It is a line of argum ent th at says, " because th isjs^ p o litical decision, it must be made by people who are poIiticallv^eCountable." B ut> 4reject the premise, so the conclusion does nj*Hollow. The basic inherent resiliency proposition implies a role forjnt>netary policy in the economy such that there is mKpolitical Iinfluence in the formulation and implementation of monetary W e have other problems in our language with the terminology of m onetary policy. Lee popularized this idea of "zero inflation." Hom er 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 th at was a p art 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 inflation. I believe in "stable prices" in a certain m anner of speaking, but I realized th at we had a problem with our language when I started meeting people from the form er Soviet Republics and Eastern Bloc countries. These are people th at had been listening to the messages from us as their regimes were starting to break up, and we were telling them two things: "am ong the various things you need to do, such as establish property rights and so on, is th at 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 tim e!" And, they'd say, "well wait a minute, which is it you want? Do you w ant prices to be stable, or do you want them to be flexible?" W e'd say, "Well, both." And, we 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 w hat it was th at we wanted to be stable. I think th at we sometimes miscommunicate with our own people when we talk in these terms. W hat we really want to be stable is in the minds of the people - th e national standard of value, or unit of account. So following B runner and Meltzer -- or Armen Alchian's piece on "W hy M oney" -- "Society chooses to use as money, th at 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 th at you are under employing real resources. Uncertainty about the 9 trend in the price level lowers the production possibility boundaries So, ies. given the state of knowledge and technologies, w hat we are trying to do is create the condition th at achieves the highest production possibility boundary obtainable over time, consistent with the other things th at th - government is doing, such as reallocation of command over resources.. Any K / A ^ r« * * e < & /Incertainty about relative prices - both current output prices and asset , y p r ic e s ^ uid-thg n n m itM iw t of future consumntion — moves us to a lower production possibility boundary. That condition of achieving the highest .... production possibility boundary is what we really nrean price stability. ' y & M While fiscal and regulatory policies might be used by government, for redistribution, ! d on't think it would be appropriate for m onetary policy to either intend to cause redistribution, or to have an unintended consequence - neither interpersonal nor intertemporal -- of redistribution. None of th at should be taken to mean that I think th at money targeting is not desirable, or that it is not useful. W hen we are starting from a position of past inflation, having conditioned people to act in the belief th at 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 w hat we call price stability, or sound money. W hen Lee Hoskins took this job in 1987, he started talking in public about M2 growth. He would explain to me that the Board staff had Vn ^ developed model b ased on ail idea'of opportunity cus^uHiuldiiig M2------- - M — balances th at allowed them to jiggle short-term interest rates, giving them pretty good predictions of what M2 growth was going to be over subsequent 10 I months. Furtherm ore, based on longer-term historical correlations, the so/ called "p -star model," they argued th at they had sjgne pretty good idea of It** the^implications. So, the idea was: use open m arket operations to influence u < short-term interest rates, which influences M2 growth, which achieves objectives for the price level, or the rate of inflation. The model seemed to work pretty well, roughly from the time Lee got there until 1989 or 1990. My dissents-jast year at Suuftttfi^meetings llmli I lilt* illlllll nl I ST Ti \ were ^enditnmed- by th at 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-sim ply-wasn 't cr cdiblc-to-mfr-to gi ve-a o r be mg be|ew-thenntirimttin4tmitr'bttt*ROt>doti>g-airything40‘try>to^etit4>aek^pr while-saying to4he^eppler> 'b~frrdqn> t~worry7you-cairtrusfr'the-uppep»limitsy Some weeks back, I was talking to a member of the Board staff about w hat 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 of their opportunity cost model of M2 growth; how lousy the projections have been, and the velocity of M2 problem . The Board staffer said, "Well, with no causality intended, it worked pretty well before you got here." 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 11 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 p art intended to enthrone M l. W e had had a couple of decades where the M l velocity (really the variance around the trend of the M l velocity) was quite reliable, leading us to believe th at if we conducted monetary policy (open m arket operations) in such a way so as to hit an M l target, we had a pretty good idea of w hat was going to happen to nominal GDP growth. So, the legislation was to move toward w hat 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 an erratic way, causing noise in the multiplier. The legislation was intended to improve monetary control because we thought all we needed to do was tighten up on our control of M l and everything would be fine. Along about th at time, or maybe shortly after — some people say it was the 1982 G arn-St. Germain legislation -- M l got dethroned. While we were trying to w ork on improving the monetary control side, the connection to something we cared about seemed to go haywire as the velocity of M l started to become less predictable. The Committee then shifted to an emphasis on M2, based on the historic relation between the broad measure of money and the rate of 12 * inflation. But, we had the wrong institutional arrangem ents in order to h i t M 2 . _____ I TV*. A u d k j cr*M, / " . Ui mfttwyvFiftwIg33n=gftt whon-wa defined-it-as a brood-mcnstire. That-fo-what « gave rise to this opportunity cost model. If we still believed th a t we had a reliable linkage between M2 growth and w hat we really care about, then-tb*^ i)^jyct^cs-s h ^ dP l^ to seek institutional arrangem ents — in the form of s«^MgBg9BM-a change in reserve ratios ~ to stabilize the^multiplier/^VVe could have one standard reserve ratio, say about 4 or 5% , on all noncapital liabilities of all depository institutions, and th at would improve the link between open m arket operations and M2# in-ordeHhat-MJ-growtb-wou: ) t hen p roduce r esults we-wanted. But, given the problems of velocity of the last couple of years, I don't think that anvong ha« llp - r n n y tr t^ - t^nt 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 W ar, there have been two rival conjectures about monetary policy, and the role th at it played. One view was th at the recession was caused by an oil shock and w ar fears. According to this view, all you had to do was remove this shock th at was depressing economic activity, and you would naturally get a rebound. And, for a couple m onths, 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. "Phat view says th at it $Ifrv* r was a restrictive monetary policy, summarized by. M2 growth, th a t held back total spending, causing subpar economic performance. According to thrft view, all th at is necessary is to get our foot off the brake, to be more 13 U rtL generous in reserve supplying operations, and allow M2 growth to move up into the middle of its target range, a n i the economy will be fine. A second view, quite a different one, is th at various regional 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 th at’s going on — including all of the reengineering, or right sizing th at partly is technology driven, the balance sheet restructuring related to the unwinding o^leverage buyout and ju n k 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 w hat Ala Greenspan calls the "50 mile an hour headwinds." According to th atA view, m onetary policy has been very expansionary, as summarized by either the exceptionally rapid growth of narrow measures of money (M l 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 th at view, the trick is to back off of the accelerator as these headwinds dissipate, so th at 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 appropriate time to begin to "tighten". I think that both of those divergent movements of the money measures can be reconcile ----- " Nevertheless, w hat gives rise to my concerns is the lack of understanding on the p a rt of the American people, and their elective representatives, as to where w e're going. If households and business do not believe the Central B ank 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 th a t changes in the political party occupying the W hite House, or controlling the U. S. Congress, will affect the objectives and results of m onetary 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 th at 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. T hat means they do not believe the stated objectives of the monetary authorities; there is a lack of credibility in the commitment to price stability. O ur challenge is one of trying to reinstitute a regime in which people once again believe that any increase in inflation and interest rates is tem porary; the longer-term trend is toward price stability. M ORRIS: I remember th at debate in the 80s was at Berkeley with Jerry Jo rd an where we had quite diverse opinions on the whole issue of monetary targeting, and I now find th at there is very little difference between us. So this session is going to be much less heated than the one at Berkeley was. 15 We have all learned much from the events of recent years. W hat I propose j to do is to take a look at the history of monetary policy since the Treasury Federal Reserve Accord in 1951, and try to identify some of the lessons we should have learned from that 42 year experience. I find it useful to break down the 1951-1993 experience into four periods. Two of the periods were successful interest rate targeting periods: one from 1951 through the mid-' 60s, the second from 1982 through 1993. W e had one period of one policy failure in the '70s using interest rate targeting, and one brief period of targeting non-borrowed reserves from *79 to ’82. The first period , from 1951 through the mid -'60s, is widely viewed as one in which the Federal Reserve conducted an extremely successful m onetary policy. These years were the high w ater m ark for the U.S. economy and, perhaps the high water m ark for U.S. monetary policy. It is ironic th at the Chairm an during this period, William McChesney M artin, Jr., who during his regime had the greatest success in controlling the monetary aggregates, was a man who did not believe in targeting the money supply. The conditions for monetary policy were generally pretty favorable during those years. We had no supply shocks such as we had in the '70s. We had a war, the Korean war, but it was a well financed war. There was no sustained fiscal policy pressure on financial markets. Furtherm ore, we had Regulation Q in place throughout the period. Regulation 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 16 for monetary co n tro l. All the Fed had to do to begin restraining the economy was to move short term rates a little bit above the ceiling rate, money would flow out of the banks and thrifts into the open m arket instrum ents and there would be an immediate impact on all of the parts of the economy th at were dependent on financing by the banks and the thrifts. T hat meant th at with relatively small interest rate movements the economy could be controlled quite well. Once Regulation Q died, there was no longer the kind of credit rationing th at it produced. It took much larger interest movements to have the same effect that small movements had in earlier years. There was no grand theoretical structure guiding m onetary policy in those years. There was a very simple structure which M artin encompassed in two sayings: one was "leaning against the w ind” and the other was "to take away the punch bowl when the party was ju st getting going". They m eant th at the Fed should "lean against the wind " whenever the economy began to grow at a rate th at could not be sustained w ithout an acceleration in the inflation rate. Conversely, policy should lean in the other direction whenever the economy weakened. This very simple policy guideline produced, as a by-product, modest and relatively stable rates of growth in the monetary aggregates. W hen the Accord initially took affect, the Fed decided to target free reserves. There was no theoretical basis, whatsoever, for choosing free reserves as a target for monetary policy. It was chosen because the Fed at th a t time wanted to demonstrate to the market that it was no longer pegging 17 interest r a te s . As tim e passed and the m arket understood th at the Fed would move interest rates to achieve its objectives, the Fed dropped free reserves and moved to a policy of overtly targeting interest rates. The leaning against the wind doctrine of the M artin years produced four recessions in nineteen y e a rs, for which the Fed was much criticized by the academic community. But all recessions were very mild, both the inflation rate and the unemployment rate averaged out at very low levels and the rate of productivity growth was at a historic high. We have not succeeded since th at time in sustaining inflation rates and unemployment rates as low as they were during that period. W hen we turn to the second period, the period of failure with interest rate targeting in the 1970s, we find that conditions were much more difficult than in the 50s and 60s. We had the two oil price stocks, which were very difficult to contend with. We had continued large budget deficits associated with the Vietnam W ar, and we had the demise of Regulation Q. The Federal Reserve moved vigorously in response to the 1973 oil shock and produced the biggest recession we had seen since the 1930s. But while the am plitude of the recession was about r i g h t , the recession was too short. As a consequence, the inflationary expectations that were generated by the Viet Nam w ar build- up and the 1973 oil shock emerged from the recession of 1974-75 pretty much intact. Probably the biggest problem for the policy maker in the 1970s was the fixation on nominal interest rates. Remember th at the policy m aker had been conditioned during the Regulation Q era to see very small interest rate 18 changes having big results. In the '70s, much larger interest rate increases were needed to have the same results. ^Policy makers were impressed by the fact th a t interest rates were extremely high by historical standards. But those high rates were, in real terms, negative. There was not much emphasis on real rates either in the Fed or in the bond m arket. The bond m arket was taken in by the same fixation on nominal rates. In retro sp ect, it seems almost unbelievable that for ten consecutive quarters the real rate on ten year Treasury notes was negative (based on the average inflation rate of the preceding three years). During the entire period 1971-1980 the real rate of return on ten year Treasuries was less than 1% in more than half of the quarters. The Fed failed to lean against the wind adequately during the years 1975- 77, when big trouble was building up. When they did begin to move in 1978- 79, driving the Federal funds rate up to 11.5% in S eptem ber, 1979, it was too little and too late. W ith the second oil price shock, the horse was out of the barn. The turning point was the famous Saturday meeting of the FOM C in October, 1979 when the Committee, by unanimous vote, decided not only to move interest rate up sharply but to change the operating procedure -- to quit targeting the Federal Funds rate and begin to target non-borrowed reserves. The rationale was not that the whole Committee had suddenly turned monetarist in their thinking, but that everyone had come to the conclusion th at it was going to take extremely high interest rates to deal w ith the powerful tide of inflationary expectations, and that, if the 19 Committee were overtly targeting interest rates, there would be political I difficulties in accomplishing those very high interest rates. It was felt th at moving to the targeting of non-borrowed reserves would give the Fed a little political shelter in this difficult time and, in fact, it worked. When the Fed Chairm an met with the Congress and heard their concerns about high interest rates, he could honestly say th at the Fed was not controlling interest rates any more. They were controlled by the market; the Fed was controlling the money supply. Congressman get a lot of letters about interest rates, but they get few about the money supply. W hen the Fed had to abandon targeting non-borrowed reserves in 1982, most Committee members were reluctant to do so because they valued so much the political sheltering th at targeting reserves rather than interest rates had given to the Fed. B ut there was no choice. The Fed faced an exceptionally strong demand for money, despite a very weak economy, and they had to meet that demand or produce a financial crisis of vast proportions. For obvious reasons, the FOM C did not want to announce that it was again targeting interest rates, so the decision was made to target borrowings. This was very similar to the decision after the Accord in 1951 to target free reserves. As targets, both free reserves and borrowings have the same characteristics as interest rate targeting. The manager, to hit these targets, m ust give the m arket whatever non-borrowed reserves it demands. To do otherwise would be to increase or reduce the level of borrowings from the desired level. The Federal Reserve learned a great deal from the experience of the 20 '70s. There is, I believe, widespread agreement th at the Fed should not allow real short-term interest rates to fall to negative levels, except, perhaps, under extremely depressed conditions. In the 1970s real short term rates were negative for seven years (based on the trailing 12-month inflation rate). If in the 1970s the Fed had been operating with a rule th at real short term rates should not be negative, the recession of 1974-75 would have lasted longer, the subsequent of the growth rate of the economy would have been more subdued, and inflationary expectations would have been greatly diminished by the time the second oil price shock arrived in 1979. W here does th at leave us for the future? I've read papers recently proposing th at the Fed target such variables as nominal GDP or commodity prices or exchange rates or the yield curve. The fact is th at we cannot target any of these in the same sense that we tried to target M l in 1979-82. The Fed has only two instrum ents at its 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 th at is susceptible to reasonably precise control by one of these two instrum ents. M onetary policy-making would be simple, indeed, if by setting a certain level of short- term interest rates or a certain rate of growth of bank reserves , the Fed could determine with some precision the level of nominal GDP. Unfortunately, there is no model which would perm it the Fed to w ork such magic. I think the Fed's policy has got to be w hat it was during the M artin years —one of "leaning against the w ind". The variables proposed as targets for the Fed will provide useful information about the 21 w ind's direction and velocity. . i - W hat about the monetary aggregates? The aggregate against which reserves m ust now be held is M l. U nfortunately, M l has become too interest -sensitive to be a satisfactory target for monetary policy. The problem lies in the pricing of interest- bearing M l accounts ,which has been very sticky. As a consequence of this failure to adjust the rates paid on NOW accounts to changing m arket conditions, there are wide swings in the spread between NOW account interest rates and rates on CDs. W hen it becomes very wide, such as it was back in early 1980 when the spread against the 6 month CD rate was 375 basis points, the growth in NOW accounts slows sharply and dampens the growth of M l. In the past two years the spread has dropped to between 65 and 80 basis points, the opportunity cost of holding assets in NOW accounts has declined and we have seen very large growth rates in M l. W hat about M2 and M3? I find it surprising to read works written by such normally sensible people as M artin Feldstein and Paul M cCracken, arguing th at Federal Reserve policies are too tight because M2 is growing so slowly. The slow rate of growth of M2 and M3 does not reflect monetary policy. The non- M l deposits of M2 and M3 carry no reserve requirements. They are not constrained by Fed policy; they are only constrained by the capital position of the banks. W ith the erosion of much bank capital due to losses in real estate, many banks have had difficulty meeting the new capital requirements. They And th at one way to improve their capital ratio is to reduce the volume of 22 their assets, and the best way to accommodate a decline in assets is to allow their managed liabilities run off. The slow growth rates for M2 and M3 reflect those decisions. To get M2 to grow more rapidly in this context would require an even faster rate of growth in M l than the historically high rate we currently have. Perhaps at some time in the future, when the banks become comfortable about their capital positions, a stable relationship of M2 and M3 to the nominal GDP may again emerge. Until such time, the Federal Reserve will have no option but to target the Federal Funds rate. QUESTIONS AND ANSWERS: JORDAN: I have a couple of thoughts, and a question. Y ou're noting the role of Reg Q as an instrum ent of policy in that period. W hatever we thought about the efficiencies and the effectiveness of Reg Q, when you put it into political economy or public choice context, it did involve identifying "victim sectors" th at took the brunt of monetary policy actions. M ORRIS: They always take the brunt of monetary policy actions. JORDAN: But it was very, very focused when you created disintermediation, which created a political reaction from the housing and the auto sectors. I think^was the politics of it that killed it as much as any argum ent in the profession about its desirabilities and efficiencies. M ORRIS: I think w hat killed it was the money m arket fund. — JORDAN: That was an innovation th pt efln»csfr<mi«thnt environment. W hat -fk tL 23 is intriguing to me is to think that back in the 1970s, C itibank wanted to issue a VISA card with a credit balance on which they were going to pay a 'Jr positive m arket rate of interest. The Board of Governors said , "If^quacks like a deposit, it is a deposit, it's subject to Reg Q and Reg D, " therefore it's uneconomic. Then M errill Lynch realized , "Gee, we can do that. We can have a credit balance on a brokage account and pay a m arket rate of interest." So it was the Board of Governors' regulatory prohibition th at led to the creation of an alternative vehicle and killed a p art of the banking industry. The other comment th at intrigues me is your emphasis on the role of free reserves as a transition mechanism after the Accord to unhook political and m arket sensitivities to interest rate targeting until the time was receptive to go back, and then your characterization of the 1979-82 reserve targeting as again, political shelter. Can you think about w hat you would do in the current environment, with its highly politicized focus on short term interest rates? After 5 years of cuts in the Funds rate, the first increase will be headline news. Can you imagine using some other instrum ent as a transition devise to unhook the markets and the political sensitivities from this preoccupation with the funds rate, and if so what would it be? FRANK M ORRIS: I would like to respond to two things. First, with respect to Regulation Q. When Fidelity first decided to perm it customers of their money m arket fund to withdraw their funds by means of a check, I called up Ned Johnson and told him th at he was destroying the concept of 24 the money supply in the United States. He said th at he d id n 't have anything like th a t in mind. They simply found ^that the cheapest way to handle withdrawals was to give customers a special bank account and perm it them to w rite checks on their balances. It was purely a dollars and cents adm inistrative proposition. The second issue is something the FOM C has got to be thinking about now — how to handle the political flack when they have to start pushing interest rates up. I don't think they can go before banking committees and have as a credible response th at they are not controlling interest rates, th at they're ju st controlling borrowings from the Fed. I don't think th a t will fly. They’ll have to do what was done in the M artin years; do w hat is right and stand up to the Congress. HOSKINS: I am Lee Hoskins of the Huntington National Bank, Columbus, Ohio. I'm ju st going to ask a question or two, and make an observation. One observation - as many people in this room have established, is th at there is a very large body of information and research about instrum ents 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 interest rate or money growth targets. There are two central banks in large economies th at have a better record than the US in terms of inflation in the last 25 years; one is Germ any, the other is Japan. One country uses monetary targets, and the other uses interest rates targets. I think all we are talking about is a very 25 built-in inflation around the mean in terms of choosing which target. In terms of zero inflation, the question I w ant to pose is I think if the Central B ank truly wants to get zero inflation, it can do it with either set of targets. That is, interest rate or money growth targets. The point is, we don’t have a clear cut objective about w hat we want to do as a Central Bank. Talking about nominal GDP targeting seems to miss the point. The Fed does not control nominal GDP. The Fed controls one thing over time and that's the price level. Period. T hat's w hat it controls. So why not target the price level, and how would you go about doing it? That's my question. I never wanted to get to zero inflation tomorrow because credibility is an im portant thing, but I d o n 't think credibility has to come from an M2 target or an interest rate target. Credibility can come from a clear statement of objectives, th at is, we want price stability and a timeframe in which to achieve it. I picked five years because contracts have a chance to adjust to it within th at timeframe. So the question is, why not target the price level? M ORRIS: The reason the Fed cannot be focused solely on the price level is th at monetary policy is often the only flexible tool of economic policy in W ashington. It would be nice if the Fed could take the position th at it was going to focus on inflation and leave it to fiscal policy to take care of the real economy. Unfortunately, we don’t live in th at kind of world. I have never proposed a zero interest rate target. Realistically, if we could get back to the kind of inflation rates we had during the Kennedy years --1 to 1.5% -- where most of that inflation reflected the failure to adjust for 26 quality changes and where inflation was low enough th at it was not going to distort investment decisions, I would consider th at a trium ph for the Federal Reserve. JORDAN: Now you know the difference between F rank and me. F rank w ants to get back to the 1 to 1/2% inflation of the Kennedy years. 1 w ant to get back to the 1 to 11/2% inflation of the Eisenhower years. I think we can, and should, target the price level. To achieve this, I would adopt a multi-year objective for the price level. This multi-year path would be a long term objective, not an operating target. To make the price level objective explicit and measurable, I recommend th at the FOM C choose a tim e-path for the intended inflation rate that leads gradually to a horizontal trend in the level of prices. For example, today 1 would choose a p ath th a t 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 FOM C would continue to use its best judgem ent in achieving this objective, based on m onetary growth targets, its best models and a wide variety of other indicators. But these judgements would be exercised within the context of the m ulti-year objective that, in effect, would provide the benchm ark for setting annual monetary targets. This is particularly im portant when velocity is misbehaving. I would tie our announcements as to what we are doing to the Hum phrey-Haw kins requirements on the budget and try and put some teeth 27 in it. First, th at the adm inistration, the Office of M anagem ent and Budget, and the Congressional Budget Office, sliould agree with the Fed on 5-yearout price levels* with a variance at an expected level, and tie together w hat the monetary authorities are aiming for down the road -- sort of like long term strategic planning in the corporate world. W ork backwards from th at to interm ediate annual price levels (or rates of inflation — year-to-year changes th at will produce th at price level). It is im portant th at the public has in their mind th at five years or seven years down the road, plus or minus two o r 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 th at he thinks th at the Fed (his empirical results imply), has shifted up from 2% inflation to a 4% rate of inflation. A 4% inflation to the parents of a baby born this year means th a t 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, th at is unacceptable. W hat 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), th at the purchasing power of money is going to be thus and so some years down the road and you can count on it. M ORRIS: I think the problem is that it is very difficult for the Adm inistration and the Congress to think in a long-term context. I rem em ber when Jerry was on the Council of Economic Advisors and the "rosy scenario" came out. The "rosy scenario" showed a 4% real growth 28 rate into the distant future accompanied by a steadily declining interest rate. I asked Jerry how they came up with /his forecast. Jerry said it was simple: the supply-siders did the real economy and the monetarists did the inflation rate. , -r~ )h . I '‘ JORDAN: It was worst- Ihoififlpiil because the eclectics did nominal GDP and it turns out ¥-di4nlt-equaf-)C plus P. / T FURLONG: I am Fred Furlong from the Federal Reserve B ank of San Francisco. The fundamental problem is th at no one knows exactly w hat the right level of interest rates is in some sense. Yet, you have to have something th a t you are reacting to. When the FOMC is deciding, "Well, do we change the Fed Funds rate or not?" they are reacting to something. I guess Jerry ’s suggestion is th at the Fed should react to the price level. The question for F ran k is, if it's not the price level, what's your alternative? W hat is it that you are basing your decisions on in terms of how you move th at interest rate around? M ORRIS: At any FOMC meeting most members have a concept of what the optimal realistic target for nominal GDP ought to be over the next period. T hat is not likely to be zero inflation and a 4% real growth rate. It will often be a higher inflation rate than one would like to see over the long term and a lower rate of growth than one would like to have over the long term . The issue is the optimum mix that can be reasonably atttained over the next four quarters. That's what I always had in mind when approaching a m onetary policy decision. JORDAN: That response surprises me a little bit because in your initial 29 ^ rem arks 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 th at mistake again. I thought you would say th at 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 iP the nominal rate to a level so th at it was non-negative. 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, 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 antigrow th. 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 th at it conditioned the m arket to believe th at all we cared about was employment. They concluded th at with the first sign of strength in employment we were going to raise the funds rate. T hat casts the Fed as a scrooge, because we would be viewed as anti-employment and anti-growth. ODRISCOLL: ' I am Jerry O'Driscoll from the Federal Reserve B ank of Dallas. W e've got the objective, and in your presentation, Jerry, you very clearly set out th at in order to attain th at objective you need credibility and you need a nominal anchor. Now, I don't agree with Lee Hoskins here that you get credibility 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, th at another announcement w on't do it. It's got to be actions over sustained 30 period of time. If the actions are going to be successful it seems to me that, you're right, we need the nominal anchor. Do you have a suggestion for a * cM isurrO C^c^ j& i . nominal anchor th at will work in this environment? ___ / ^ n ~ ____ n C L a sJ tH JORDAN: Not o»c=4bAtJ=e»n-s«lK/I n o rd erto reconcile the problem of - r interpretation of current M l and various combinations of things to produce a broader measure p^M 2,1 use the monetary base —adjusted for increases in foreign holdings of U.S. currency. However, we do not have timely inform ation. 'd I think th at the focus has to be on longer-term objectives in terms fefty 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 th a t are used about our actions implying stimulus or restraint —we should instead, ju st talk in terms of achieving sound money. Plain and simple, nothing else. T hat's all we are trying to do is stop the debasement of the national currency. QUAYLE: I am Phillip Quayle from Ball State University. The Fed's prim arily a political institution, a creature of Congress. The reason why we can 't agree upon targets is that there is no agreement among the general populous. If the Fed follows a target that is not consistent with w hat we, the public, w ant, the Fed is not going to last. Evolutionary mechanisms assure th a t the Fed's not going to do anything extraordinarily painful, at least, perceived to be painful. If they attem pt to do that, it's going to be changed. So in essence, the shifting targets you get are explained by the fact that there's no consensus among the American public on zero price inflation or anything else th at monetary policy should do. M ORRIS: The saving grace is that the Federal Reserve is given a lot of leeway, in terms of time, because of the slowness of the legislative process. It is tru e th at the Federal Reserve cannot follow indefinitely policies which are not acceptable to the public. However, for a considerable period of time the Fed can, and has, pursued policies th at were unpopular. I am not sure th at the policies followed in 1979-82 would have been supported by a majority 1 ; ' vote of the public. Fortunately, the system gave the Fed the leeway to follow those policies and to show some results before the rebellion got too hot and heavy. JORDAN: I agree with the thrust of your comment and it was the same th at Lee made earlier about, in effect, m arketing the idea of price stability. In a sense, the R&D has already been done as to the benefits of achieving stable money, but we have not engaged in the successful marketing effort to ptnsiie the American public or their elected representatives as to why th at's the case. Nor have we invested enough in the techniques of implementation of monetary policy to be persuasive th at we can, in fact, achieve it. And so, as a research strategy I would shift resources toward how to achieve price stability and persuade people that it is desirable to do so. FAND: I am David Fand of the Center for the Study of Public Choice, George Mason University. I have one question for Frank M orris. Let's look at ju st 1990, '91 and '92, to make it very simple. If the Fed had hit the m idpoint 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 32 Jh we have now? And would it have been desirable? M O RRIS: M y answer is no. I think tile only way the Fed could have hit the m id-point for M2 would have been to increase M l enought to offset the ru n off o f CDs. Remember th at in the two years 1991 and 1992, b ank reserves rose by 30% , an extremely rapid growth rate by historical standards. To have increased reserves much, much more in order to meet an M2 target by increasing M l does not seem to me to make sense. The whole concept of an M2 target for monetary policy is completely outdated by the real facts of the situation. Remember, also, that we have a bond m arket th at is very different th an in the early 1970s, and I think th at we are very lucky th at it is different. W e have a bond market that has to be persuaded every day that the Fed is sufficiently concerned about inflation. The kind of policy you’re advocating here would have a very adverse impact on the bond m arket. JORDAN: I would like to add th at it is this lack of credible commitment to w here w e're going to come out at the end of the day, th at is our problem. Rem em ber 1990. The CPI shot up to over 6% in the midst of w hat was being touted as the third oil shock, and people remembered w hat 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 M ichigan 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 adm inistration about Fed policy being "too tight" and needing to "ease u p". Because of this, more aggressive reserve supplying operations in an 33 effort to get up into the midpoint of the M2 target range would have resulted in simply an "A h-H a" experience on tlie part of the American public; namely th at the Fed had thrown in the towel and was sacrificing its objectives for political expediency. The dollar would have plunged and bond yields would have risen. If th at 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. 34