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Remarks by Governor Laurence H. Meyer
Before the Department of Finance Lecture Series, University of Missouri, Columbia,
October 12, 1999

New Challenges for Monetary Policy: The View from Jackson Hole
Each year in late August, for the last 23 years, the Federal Reserve Bank of Kansas City has
hosted a conference where central bankers from around the world tackle issues relevant to
the setting and implementation of monetary policy. They are joined by academics, former
Federal Reserve governors, and private-sector economists. A core group returns every year
and contributes a particularly strong sense of camaraderie.
The lure of the conference is the extraordinary combination of an excellent choice of topics,
a high level of formal presentations and discussions, the opportunity to engage in a series of
more informal conversations over coffee, at meals, and on hikes, and to do all this in the
shadow of the Tetons. I told Tom Hoenig, the president of the Kansas City Fed, that when I
was considering whether or not to accept the nomination to join the Board of Governors, the
deciding factor was the prospect that, by doing so, I would receive a lifetime perk of an
invitation to the Jackson Hole Conference.
The themes are always interesting, but I found this year's conference particularly
stimulating--so much so that I decided to use the presentations and discussions at Jackson
Hole as the organizing framework for today's lecture.
The title of this year's conference was "New Challenges for Monetary Policy." The papers
described both the emerging consensus about the objectives and strategies underlying the
conduct of monetary policy and highlighted a number of new challenges.
In the first section of today's lecture I will outline the framework and identify the objectives
of monetary policy, describe the operational procedures used to conduct monetary policy,
and discuss the strategy for carrying out monetary policy to achieve those objectives. A
number of participates at the conference suggested that there was an emerging consensus
about the appropriate strategy--specifically, flexible inflation targeting.
Then I will turn to the new challenges for monetary policy identified at the conference. Each
is illustrated by current or recent experience around the world. First, does a low-inflation
environment--and specifically the possibility that nominal interest rates might decline to
zero in such an environment--constrain the effectiveness of monetary policy, and if so, how
can monetary policy adjust to maintain its effectiveness? Second, how should monetary
policy respond to movements in asset prices in general and, specifically, to the possibility of
asset-market bubbles? Third, what is the best option for exchange rate and monetary policy
regimes for small open emerging market countries, in light of increased globalization and

especially larger and more volatile international capital flows?
The basic theme of the conference was that flexible inflation targeting provides a
constructive response to each of these challenges. Careful design and implementation of the
framework, including the choice of an inflation target, would, for example, reduce the
prospect that monetary policy might lose its ability to stimulate the economy further because
nominal short-term interest rates had fallen to zero. Similarly, following such a disciplined
monetary policy would mitigate, though not entirely eliminate, the effect of asset bubbles.
Finally, countries that move to a flexible exchange rate regime--as many have done
recently--need to put in place a disciplined monetary framework such as is offered by this
I. The Monetary Policy Framework
Let me start this discussion by identifying what the objectives of monetary policy are, and
should be, and then discuss what strategies are useful in achieving the objectives.
A. Objectives of Monetary Policy
One of the themes of the conference was that there is an emerging consensus about the
objectives of monetary policy, one that has been reflected in the conduct of monetary policy
in many countries for some time and now is finding its way into the rhetoric of
I would describe the consensus as an acceptance of a dual mandate for monetary policy.
Monetary policy seeks first to achieve and maintain price stability over the longer run and,
second, to retain the flexibility to damp cyclical fluctuations in the economy around full
employment. That is, I suspect, a sharper statement than many (and indeed most) central
banks today feel comfortable with. At the conference, the consensus was described as
"flexible inflation targeting."
Most central banks want to emphasize, with good reason, their price stability objective. This
reflects a couple of strongly held views. First, monetary policy, in the long run, principally
affects nominal variables such as nominal income, the price level, and the rate of inflation,
but has lesser effects on real variables--such as the level of employment or the level or
growth rate of output. I expect all central bankers would agree that an environment of price
stability offers the best contribution that monetary policy can make to the level and growth
of output because it eliminates distortions to resource allocation and disincentives to saving
and investment associated with high and variable inflation rates. It follows that a more
accommodative monetary policy cannot foster a higher average rate of real growth. The
second strongly held view is that because monetary policy is the principal determinant of the
inflation rate in the long run, central banks have a responsibility to set an appropriate target
for long-run inflation and achieve it. And that target should be price stability or, at the least,
a low rate of inflation.
While monetary policy cannot raise the level or rate of growth of output over the long run
through any means other than maintaining price stability, it is widely, though not
universally, accepted that monetary policy can affect the level and growth rate of output in
the short run and, perhaps, therefore contribute to smoothing out fluctuations in the
economy around full employment. This is sometimes referred to as the short-run
stabilization objective for monetary policy. A central issue for monetary policy is how to
balance the dual objectives of price stability and output stabilization and how explicit to be

about the commitment to these dual objectives.
Both theoretical and, especially, empirical macroeconomics have established the existence
of an inescapable trade-off affecting the conduct of monetary policy. The trade-off is
between the variability of inflation around its target (zero or some low rate) and the
variability of output around its target (the full-employment level of output or potential
Autonomous increases or decreases in aggregate spending push output and inflation in the
same direction relative to their targets and, therefore, do not bring this trade-off into play.
But supply shocks--such as increases or decreases in oil or food prices--drive output and
inflation in opposite directions relative to their respective targets. The more quickly
monetary policy reacts to restore inflation to its target following a supply shock, the greater
will be the variability in output relative to its target.
The reason for this trade-off is that monetary policy affects inflation primarily through its
initial effect on the amount of slack in the economy. Tightening monetary policy slows
spending growth, opens up some slack temporarily in labor and product markets, and allows
the slack to reduce inflation. Once inflation has returned to its target, policy can guide the
economy back to full employment. It probably takes a certain amount of slack over time to
reduce inflation by a given amount, but reducing inflation rapidly means opening up an
especially large output gap for a short period--hence the trade-off between inflation and
output stability.
Several countries have moved to inflation-targeting regimes over the last decade or so,
setting a numerical target for inflation. This was generally part of a process of shifting
responsibility for monetary policy from finance ministries to independent central banks and
often followed a period of poor macroeconomic performance, especially high and variable
inflation. The newly independent central banks often identified inflation as the singular
objective of monetary policy to gain credibility and facilitate the transition to price stability.
In addition, the government wanted to ensure accountability of the central bank and hence
often opted for a narrow and explicit objective. With price stability now largely
accomplished, some of these central banks are becoming more flexible in their approaches
to monetary policy by recognizing a role for short-run stabilization.
B. How Explicit Should the Objectives Be?
In the United States, Congress has set the objectives for monetary policy in the Federal
Reserve Act, as amended in 1977. The objectives are maximum employment and stable
prices, which are mutually consistent and achievable if maximum employment is interpreted
as the maximum employment sustainable without rising or falling inflation. This is an
explicit expression of a dual mandate.
Inflation-targeting countries typically have goals of about 2 percent to 2 ½ percent for
inflation and sometimes establish a range for inflation, for example, 1 percent to 3 percent.
New Zealand, Canada, Australia, and the United Kingdom are examples of countries with
explicit numerical targets, and there are many others. It was widely agreed at Jackson Hole
that the United States has, without an explicit target, achieved the same success in reducing
inflation as countries with explicit numerical targets. I will not be considering the pros and
cons of an explicit numerical target for inflation today, although I recognize this is an
important question and one that warrants further discussion.

C. How Should Policy Be Conducted To Achieve the Objectives?
Once the objectives of policy are set, a central bank must choose an operating regime and
then develop a strategy for using its instruments to achieve the objectives.
Virtually all central banks carry out monetary policy operations by influencing--in effect
setting--some short-term nominal interest rate, typically the rate on overnight inter-bank
loans. The FOMC at each meeting sets a target for the federal funds rate and instructs the
Manager of the Open Market Desk to achieve that target over the intermeeting period by
buying or selling securities. By adjusting this single rate, the Federal Reserve affects the
broader array of interest rates and asset prices in the economy and, in turn, affects aggregate
demand, the level of real economic activity, and inflation.
There are two ways of describing the strategy for monetary policy. One focuses on
"instrument rules," which describe how the policy instrument--in this case a short-term
interest rate--should be moved in response to economic developments. Such a rule was
designed by Professor John Taylor of Stanford University. The Taylor Rule describes how
the federal funds rate should be adjusted in response to movements in output relative to its
long-run sustainable level and to movements in inflation relative to its target. The Taylor
Rule thus explicitly embodies the dual objectives of monetary policy and is a form of
flexible inflation targeting.
In practice, no one expects monetary policy to be conducted according to a rigid rule. Such
rules can, however, be useful in informing policy decisions and helping policymakers
calibrate their responses to changes in utilization and inflation rates. Moreover, research on
how such rules affect the quality of macroeconomic performance can aid policymakers in
arriving at their decisions.
A second strategy is to move the instrument in response to the inflation forecast. In this
approach, the policymakers start with a forecast of inflation over some interval, typically
about two years. Policy is then set over this interval to achieve the price stability target by
the end of the period. The interval chosen to reach the inflation target takes into account the
fact that the more rapid the return to the target, the greater the variability in output relative
to its target. The time interval is thus a vehicle for allowing policymakers to damp
movements in output around full employment and at the same time ensure that the inflation
objective is eventually achieved.
Inflation forecast targeting has the advantage of being explicitly forward-looking. The
Taylor Rule, in contrast, appears to be backward-looking, though the contrast is not as clear
in practice as it might appear. Forecasts are exercises in processing information about
current and past developments to yield anticipated future outcomes. The Taylor Rule takes
explicit account of only very recent observations on inflation and output, but these are, to be
sure, important determinants of future inflation. An inflation forecast approach allows
policymakers to consider a wider range of current and past information in projecting future
D. Setting the Inflation Target
Setting the inflation target to be consistent with price stability sounds straightforward, but an
important theme at this summer's conference was the variety of options and implications of
this choice. The obvious choice would be a target of zero for inflation, taking into account
biases in published price measures. But an intriguing alternative is to set a target for the

price level. If a disturbance results in a period of inflation, under a zero inflation target, the
objective is to return to a zero inflation rate. When inflation has been returned to zero,
however, the price level will be higher than it was before the disturbance. Under a constant
price level target, the aim is to return to the initial price level, requiring a period of deflation
to offset the effect of the period of higher inflation. This can produce a more predictable
price level in the long run, but many analysts are concerned about how the economy would
respond to a period of deflation.
Yet another alternative is to target a low positive inflation rate--specifically an inflation rate
somewhat above a level that reflected estimates of the bias in published measures. One of the
issues I will discuss shortly is whether targeting a low, positive rate of "true" inflation (what
I call price stability plus cushion) might result in better cyclical performance of the economy
than a zero inflation target.
Still another choice is an average inflation target. If the target was 2 percent and inflation
temporarily moved to 3 percent, an average inflation target policy would encourage a decline
in the inflation rate to below 2 percent for a while, moving the average back to 2 percent.
This allows for a predictable (albeit rising) long-run price level, while avoiding the
deflationary episodes that would occasionally be called for under a constant price level
II. Monetary Policy in a Low-Inflation Environment
I turn now to the challenges associated with the conduct of monetary policy in a lowinflation environment. The issue here is whether, at very low inflation rates, the cyclical
performance of the economy would deteriorate. If this were the case, the objectives or
strategy of monetary policy would need to be adjusted. Among the possible responses is
adjusting the definition of the inflation target, so I will be building on the preceding
A. Keynes' Liquidity Trap and the Zero Nominal Bound Problem
John Maynard Keynes, in his classic work, The General Theory of Employment, Interest and
Money, warned that monetary policy might become ineffective once interest rates fell to
some low level at which wealth owners might become indifferent as to whether they held
money or bonds. In the language of economists, money and bonds might become perfect
substitutes. In this case, it would be impossible for monetary policy to affect interest rates by
affecting the composition of portfolios, specifically the amount of money held relative to
bonds. Keynes called this situation a "liquidity trap." Since the end of the Great Depression,
many have interpreted Keynes' liquidity trap to be a theoretical curiosity rather than a
practical problem likely to confront policymakers. But with short-term rates now at zero in
Japan and low inflation almost everywhere in the industrialized world, the problem is taken
more seriously by central banks--to the point that it was one of the topics at Jackson Hole.
Keynes' views on the liquidity trap have, in my view, often been misunderstood. Keynes
understood that central banks could push rates on short-term government debt to zero. The
liquidity trap, as Keynes used the term, is better thought of as a term-structure trap or, more
generally, a limit on how low long-term and private interest rates can go once the interest
rate on short-term government debt is pushed to zero. When short-term government rates
reached zero, Keynes believed that there would still be positive interest rates on both longerterm government securities and private debt and that monetary policy then would be unable
to push those rates any lower.

The conventional view is that the level of long-term rates is determined by current and
expected short-term rates. Given that market participants are unlikely to expect that zero
short-term rates will be sustained for 20 or 30 years, the maturity of long-term bonds, rates
on long-term securities will remain positive when short-term rates reach zero. Stated
somewhat differently, shocks that would otherwise lower short-term rates cannot do so at
the zero bound, while shocks that would raise short-term rates still will do so. In addition,
private rates differ from government rates by an amount that reflects the risk of default on
private debt, assuming that government debt is viewed as being default free. Even if the rate
on government debt reaches zero, therefore, private debt will still carry positive rates.
The liquidity trap is sometimes referred to as the problem of the zero bound on nominal
interest rates. Nominal interest rates cannot be negative, because, in this case, every one
would want to hold cash. Consequently, an environment of very low inflation would
constrain how low monetary policy could push real interest rates in response to a recession
and, therefore, be associated with less-favorable cyclical performance of the economy. If
inflation were 2 percent, for example, monetary policy, by driving the nominal interest rate
to zero, could push real interest rates to minus 2 percent. If prices were stable, on the other
hand, the limit on the real interest rate would be zero, and this limit might constrain the
ability of monetary policy to offset downward shocks to the economy.
B. Nominal Rigidities
Another long-standing explanation for why low inflation might result in a deterioration in
macroeconomic performance is the possible existence of nominal wage rigidities-specifically, a reluctance to reduce nominal wages. Relative wage movements are important
signals and incentives that guide labor resources to their most highly valued uses. When
inflation is very low, achieving this variation in relative real wages depends on some wages
falling. If nominal wage cuts are rare, efficiency in the allocation of resources may decline,
and as a result, output might be lower at price stability than if there were some low rate of
inflation. And in the absence of declines in nominal wages for some workers, average real
wages will be higher, and hence average employment lower, at price stability. Although
there is some evidence of downward nominal wage rigidity, there is no evidence that this
has an effect on aggregate wage and price inflation or the natural rate of unemployment in
the postwar period--even when inflation has been very low. In addition, it is not clear how
much rigidity would remain if we achieved and sustained steady low inflation.
C. Japan's Current Experience
As I noted earlier, Japan presents a laboratory for observing an economy with low inflation.
Japan enjoyed effective price stability through most of the 1980s. In the 1990s it was hit
with a number of adverse shocks, from bursting asset bubbles and associated banking
system problems early in the decade to the financial meltdown of its Asian trading partners
in late 1997. In continuing its efforts to move the economy toward recovery, the Bank of
Japan last February lowered short-term interest rates to almost zero. Although Japan
registered surprisingly robust growth in the first half, most observers see private-sector
demand as still quite weak despite the low short-term rates.
Nevertheless, that the Bank of Japan has apparently exhausted its ability to stimulate the
economy through conventional policy. This raises two questions. How could monetary
policymakers have avoided this predicament, and once they were in it were there
unconventional forms of monetary policy that would have permitted them to provide
additional stimulus to demand?

D. How to Avoid the Problem
At the Jackson Hole conference, Mervyn King and Lars Svensson argued that a flexible
inflation-targeting regime would help policymakers avoid this problem in the first place.
While King in particular had some doubts about the zero nominal interest rate bound and
especially about the existence of nominal rigidities, both he and Svensson noted that opting
for a positive inflation rate as a target was a prudent way of avoiding testing either of these
hypotheses. Indeed, they both noted that inflation-targeting central banks virtually always
opt for inflation targets greater than zero and greater than estimates of the inflation bias in
published measures of inflation. Recent research suggests that even a cushion of 1
percentage point (above an amount equal to the expected bias in inflation measures) can go
a long way toward avoiding the problem of deteriorating cyclical performance at low
inflation rates.
The second key to avoiding this problem is to have a symmetrical inflation target. This
means one that evokes an aggressive response to both falling below and to rising above the
inflation target. One could take this further. Monetary policymakers can always choke-off
inflation by raising real interest rates, because there is no limit to how high real interest rates
can be pushed. There is a limit, however, to how low real interest rates can decline, given
the zero nominal interest rate bound. Therefore, to the degree that any asymmetry is called
for, it might be to move more quickly and more decisively with respect to downward than to
upward disturbances to aggregate demand, at least when beginning from already low
nominal interest rates. This allows policymakers to substitute speed for the magnitude of
decline when responding to downside shocks.
A third possibility is that the zero nominal bound problem can be reduced or eliminated
either by a credible price level target or by an average inflation target. If the price level falls
in response to downside shocks, a price level target will imply that monetary policy will
move more aggressively to stimulate the economy, once demand recovers and monetary
policy has regained its effectiveness, than would have been the case with a traditional
inflation target. This would ensure that a period of deflation will be followed by a
corresponding period of inflation. Assuming bondholders take into account this more
aggressive stimulus, bondholders will project that zero nominal short-term interest rates will
be maintained longer than would otherwise be the case, justifying lower long-term interest
rates today.
A similar result could be achieved by an average inflation target. If inflation was zero for a
while, bondholders would project a period of inflation above the long-run inflation target-for example, 3 percent or 4 percent instead of 2 percent--until the average inflation rate
returned to 2 percent. This would lead to expectations that short-term interest rates would
remain low for a longer period and contribute to a decline in real long-term rates today.
E. What To Do If Nominal Rates Fall to Zero?
If a target for price level, positive inflation rate, or average inflation rate had not been
implemented and made credible before a central bank was confronted by zero nominal
interest rates, the central bank could, of course, introduce them at that time. However, such a
move might lack credibility. It might be seen as an emergency program that might not be
sustained once the economy recovered and moved away from the zero nominal bound.
Moreover, with prices falling and the economy in recession, one could imagine a good deal
of skepticism about the ability of the central bank to meet its objective.

Paul Krugman has urged the Bank of Japan to move to a positive inflation target as a way of
lowering real interest rates and stimulating the economy. The Bank of Japan has resisted,
arguing that, given its inability to increase aggregate demand, there would be little
credibility in setting a positive inflation target. Even if the Bank of Japan today cannot
expect to stimulate demand and thereby raise inflation, they will almost surely have this
opportunity well before today's long-term bonds mature. They could therefore commit today
to maintaining a positive inflation rate when it becomes possible and thereby raise inflation
expectations today and lower real interest rates. However, such a distant increase in inflation
might not have much impact on the real cost of borrowing today, so I continue to be
skeptical that initiating an inflation targeting approach, once confronted by the zero nominal
bound, offers a reliable way out of the zero nominal bound problem.
A second approach would be to undertake unconventional monetary policy operations.
Conventional monetary policy is implemented, as I described, by employing open market
operations concentrated in repurchase agreements or in the short end of the government debt
market. An alternative approach, sometimes referred to as a monetization strategy, focuses
on increasing the money supply rather than on the level of short-term interest rates. At
Jackson Hole, Allan Meltzer offered a clear framework for the way such a policy direction
might allow additional stimulus after conventional operations had lowered nominal shortterm interest rates to zero.
In the typical model, money and bonds become perfect substitutes at some low interest rate,
perhaps zero, and we have a liquidity trap where monetary policy loses its power to add
further stimulus by lowering interest rates on bonds. Meltzer suggested this result reflects
more the limits of the typical model than the limits on monetary policy. He suggested that in
a more realistic model incorporating multiple assets--for example, long-term as well as
short-term government bonds, private as well as government debt, and equities as well as
bonds and money--there are two ways in which the economy can escape from the apparent
liquidity trap. In an activist approach, monetary policy would increase the sum of the money
supply and short-term government debt--the assets that have become perfect substitutes--by
widening the scope of open market operations to include purchases of long-term
government debt and perhaps private debt and foreign exchange. Such operations might
lower interest rates on long-term and private securities and/or result in a depreciation of the
currency, in all cases stimulating aggregate demand.
A more passive approach would allow deflation to raise the real value of the sum of money
balances and short-term debt. This will be the outcome of deflation as long as the central
bank does not let the nominal money supply decline as the price level falls. An increase in
the real money supply would then result in increased purchases of a wide array of financial
assets, including longer-term government bonds and private debt and perhaps even equities.
The net result will be lower interest rates on long-term and private securities and higher
values of equities that, in turn, will stimulate spending, over and above the stimulus that
results from the wealth effect associated with increased real money balances.
This analysis raises an interesting set of questions about which reasonable people can
disagree. Theory would seem to leave open the possibility that such wider operations might
provide incremental stimulus, but I read the empirical evidence and historical experience as
raising doubts about the effectiveness of such actions. Important questions relate to both the
theoretical structure of asset demands and empirical evidence about portfolio behavior and
asset markets. The issue of whether relative supply of short and long-term bonds affects the

term structure of interest rates is crucial.
The most widely accepted theory of the term structure, called the pure expectations model,
holds that long-term interest rates are a weighted average of current and expected future
short-term rates. This approach leaves no room for relative supply effects and is consistent
with the term structure trap that I have associated with Keynes. There is, however, a
competing theoretical model, often referred to as the market segmentation approach, which
allows for the effect of relative supplies. I have never given much weight to the role of
relative supply effects in affecting the term structure or exchange rates, given the failure of
empirical studies to find much evidence of such effects. Of course, at the extreme, the Bank
of Japan could set the price and hence interest rate on long-term bonds if it was prepared to
take all these assets onto its balance sheet. But such operations almost certainly blur the
distinction between monetary and fiscal policies.
Another reason for skepticism is that the domestic channel through which monetary policy
works in Japan operates very importantly through the banking system. The continuing
banking sector problems suggest that this channel remains weak, if not inoperative.
Specifically, if additional reserves were injected into the banking system, a larger share of
them would likely be held as excess reserves rather than to be lent out. In this case, attention
shifts to the effect of monetization on exchange rates and to the recommendation that the
Bank of Japan raise the money supply by purchasing foreign currency, an operation
sometimes referred to as unsterilized exchange rate intervention.
There is a case in which unsterilized intervention has a more powerful effect on exchange
rates than sterilized intervention (where the central bank absorbs any reverses introduced as
part of exchange rate intervention). But this incremental effect arises because unsterilized
intervention is expected to lower the country's interest rates and the lower interest rates
would, in turn, put downward pressure on the country's exchange rate. If the interest rate
channel does not operate because of a liquidity trap, this could raise questions about the
effect of unsterilized foreign exchange intervention.
Even in this context, however, there may be some positive effects of unsterilized
intervention. This operation, like open market operations conducted in long-term securities,
is a way of raising the sum of money and short-term government securities. As portfolios
are rebalanced, the increase in the money supply may result in purchases of long-term
government securities, private securities, and foreign currency denominated assets. This
could affect a range of interest rates and the exchange rate. Though once again there is a
question about the degree to which relative supplies of assets have an important bearing on
relative rates of return.
Moreover, such a strategy faces other obstacles. First, in Japan, foreign exchange operations
are at the discretion of the Ministry of Finance. Therefore, implementing a monetization
strategy in this way would appear to shift the decision about the timing and magnitude of
monetary policy from the newly independent central bank back to the Ministry of Finance.
Second, pursuing a stimulus program focused on yen depreciation might exacerbate tensions
related to the already wide current account imbalances in Japan and the United States as
well as possibly interfere with the recoveries under way among Japan's Asian trading
So I remain skeptical that there is much leverage in the monetization approach.

Nevertheless, if the Japanese economy fails to respond to the policies now in place, one
could argue for some experimentation in this direction, given the absence of other options
for monetary policy.
Finally, in cases of a nominal interest rate bound, fiscal policy could and should carry more
of the stabilization burden, as has been the case in Japan recently.
III. Asset Market Bubbles and Monetary Policy
Let me move to the challenge of how monetary policy should respond to suspicions of asset
market bubbles. An asset market bubble refers to an extended increase in the price of assets
not justified by the fundamentals. Such movements might be associated with waves of
optimism or pessimism that become self-perpetuating.
There is not a complete agreement as to the usefulness of the concept of asset bubbles. I do
find it plausible that market prices might sometimes, and for some period, depart from
values that are justified by fundamental forces. Over longer periods, markets will converge
back to fundamental value. However, when large departures occur, there is potential for a
sharp correction that, in turn, can have damaging consequences for the real economy. There
are two asset markets that are of special importance. The first is the equity market and the
second the market for real property--land and buildings.
The fundamental value of a stock is the present value of the expected earnings stream of the
firm in question, derived by applying a discount factor that accounts for both the interest
rate on safe assets and a risk factor appropriate to the uncertainties about the expected future
earnings stream. The fundamentals underpinning the price of equities are therefore the
expected increase in earnings and the discount rate that transforms expected earnings into a
price for the asset. Equity prices could rise above their fundamental value if investors hold
unrealistic expectations about earnings growth, if they assume that the earnings stream is
more stable than it will turn out to be, or if they otherwise believe there is less risk
associated with holding the equities than turns out to be the case. In these cases, reality will
at some point disappoint relative to expectations and force a reappraisal of the value of
equities. A similar process underlies the price of real property.
Monetary policy, as I emphasized earlier, focuses on price stability and damping
fluctuations around full employment. Should it also focus on encouraging asset prices to
return toward perceived fundamental value, if asset prices appear to depart significantly
from policymakers' perception of that fundamental value? That is another question tackled
at the Jackson Hole conference. It is one motivated by at least two recent experiences. First,
the Japanese economy is often described today as suffering from a burst in an asset bubble.
During the 1980s, the Japanese economy registered very strong growth, low inflation, and
soaring equity and property prices. In 1989, following a tightening of monetary policy, there
was a sharp collapse in asset prices. Equity prices fell by 60 percent and urban land values
by more than 75 percent.
In addition to direct effects via the decline in wealth on consumer spending, the collapse of
asset prices had a devastating effect on the banking system. Real property dominates the
collateral underlying many of the loans of most banking systems. A collapse in real property
values, therefore, leaves most loans without adequate collateral support. In addition, in
Japan, the banks hold considerable equities in their portfolios. Japanese banks therefore
suffered a double blow in the collapse of equity and property prices. As a result, with the

capital of the banking system severely depleted, banks had to restrict their lending, leading
to a severe credit crunch that added to the forces depressing the Japanese economy.
The second experience hits closer to home. Many have viewed the surge in equity prices in
the United States over the past four years as evidence of a bubble. The Economist magazine
is a leading proponent of this view, and many others subscribe in varying degrees to this
characterization. It is true that the rise in equity prices--averaging 25 percent to 30 percent a
year over the last four years--is unprecedented and that current values challenge previous
valuation standards. But one could argue that structural changes in the economy have raised
the sustainable level and growth of earnings and lowered the volatility of earnings or
otherwise reduced the perceived risk in equities. Such structural changes could, in principle,
justify at least a substantial portion of the rise in equity prices. But the question at issue here
is whether policymakers should substitute their judgment about fundamental value for the
market's assessment and use monetary policy to encourage a convergence back to their own
estimate of fundamental value.
The paper by Bernanke and Gertler at the Jackson Hole conference addressed this question.
They used a methodology that has proved valuable in studying a number of other questions
related to the strategy of monetary policy. They first construct a small model of the U.S.
economy and then subject this model to a series of disturbances that reflect the economy's
historical experience. They observe the resulting variability of inflation and output relative
to their respective targets. The base model includes a policy rule according to which shortterm interest rates are adjusted in response to economic developments. Bernanke and Gertler
examine whether an attempt by policymakers to return equity prices toward their estimate of
fundamental value improves macroeconomic performance, judged in terms of inflation
variability and output variability. Confidence in their conclusion is, of course, affected by
how well one believes the model captures the performance of the economy. Nevertheless,
their methodology is well designed and it is worth considering their conclusions.
They find that policymakers cannot improve the outcomes by responding directly to
suspected deviations of equity prices from fundamentals, but that a policy focused on
achieving price stability and damping fluctuations around full employment will mitigate the
adverse consequences of equity market bubbles. That is, a monetary policy focused on price
stability and output stabilization will respond to the effects of higher equity prices on
aggregate demand, real economic activity, and inflation. This will generally dampen
movements in equity prices, while contributing to meeting the broader macroeconomic
objectives of monetary policy. However, given the difficulty in distinguishing between
changes in asset prices dominated by fundamental forces and those driven by nonfundamental forces, policymakers should not target asset prices or try to guide them to the
policymakers' estimate of fundamental value.
The discussion of the paper by Rudy Dornbusch and comments by Federal Reserve
Chairman Alan Greenspan added an important additional theme related to monetary policy
and equity prices. Dornbusch took note of the setting, pointing out that the two sides of the
Teton Mountains are dramatically different. One side slopes downward gradually and
gracefully. The other side drops off quite precipitously. So it is with equity prices. On the
way up, they typically move gradually. While they sometimes also move downward
gradually, downward movements are occasionally steeper and more discontinuous than
upward movements. Monetary policymakers sometimes face additional problems in the case
of such steep declines in asset values. Credit markets may become extremely illiquid and

even fail to operate for a period. It is not simply that interest rates on private securities rise,
but that virtually all buying and selling may temporarily cease. This can create extreme
problems for those who rely on short-term financing and, in the extreme, the resulting
financial distress can threaten the solvency of some financial institutions. In such situations,
monetary policy typically intervenes to provide liquidity, until markets recover and begin to
operate more normally.
Because of this, it is sometimes alleged that monetary policy stands ready to intervene to
protect market prices in a downturn. Chairman Greenspan commented that markets are
asymmetric, not monetary policy. He emphasized that monetary policy does not operate
with a target for equity prices when they are falling any more than it does when equity
prices are rising. In both cases, monetary policy responds only indirectly to equity prices, by
taking equity prices into account in the assessment of aggregate demand. But monetary
policy has to respond quickly to the special circumstances that accompany a collapse of
asset values, specifically the extreme illiquidity and seizing up of credit markets. This
occurred both in 1987 and, more recently, in the fall of 1998.
IV. Globalization and Monetary Policy: Choosing Exchange Rate and Monetary Policy
The world economy has become increasingly globalized over the last couple of decades,
measured both by the flow of trade among countries and especially by the flow of
international capital. An important challenge facing central banks around the world is how
this globalization has affected their ability to pursue domestic objectives with monetary
policy and, indeed, whether it is even possible to preserve an independent monetary policy.
The freedom to pursue an independent monetary policy will be determined, to an important
degree, by the choice of exchange rate regime. A government that pegs its exchange rate to
another country, for example, gives up its ability to pursue an independent monetary policy.
Its interest rates must be set to support the fixed exchange rate and will generally move with
the interest rate in the country to which it is pegged. Countries pegged to the dollar, in
effect, are tied to the monetary policy pursued by the United States. Such regimes are
particularly effective ways to make a transition from hyperinflation to the low inflation rate
of the country to which the currency is pegged. For example, if the country has no history of
an independent central bank successfully achieving low inflation, the country might be
better off abandoning the attempt at independent monetary policy and buying into another
country's monetary policy and inflation outcomes. This is precisely the decision made by
Argentina, and it has contributed to maintaining low inflation, following the transition from
hyperinflation that had been achieved just prior to its decision to fix its exchange rate to the
It follows that if a country wants to have an independent monetary policy, it must choose a
flexible exchange rate regime and if it chooses a flexible exchange rate regime it must
complement it with a disciplined monetary policy. Many countries pursuing this course have
opted for flexible inflation targeting.
But, under any exchange rate regime, small open economies in general and emerging market
economies in particular are challenged by volatile international capital flows. The challenge
under an adjustable peg--a regime in which the exchange rate is fixed at any point in time
but can be adjusted over time--is particularly severe. If investors believe that a currency is
overvalued, they will engage in transactions--such as purchasing assets denominated in

other currencies or selling short the domestic currency--that will pay off if the currency is
devalued. These very transactions will make it difficult for the country to sustain its current
exchange rate.
For a while, the country may sustain its current exchange rate by buying its currency with
dollar reserves at the fixed exchange rate and raising its interest rates. But, depending on the
size of capital flows, official reserves could be quickly depleted, forcing the country to
abandon the peg altogether and float its currency. In addition, the higher interest rates used
to defend the exchange rate may threaten a sharp decline in the economy and a collapse of
the banking system. When this happens, currency values and equity prices often plunge
below appropriate levels, with resulting adverse consequences to the real economy.
The conventional wisdom today is that small open economies face a choice of one of the
extremes--either a flexible exchange rate regime complemented by a disciplined monetary
policy or a very fixed exchange rate regime, characterized by a currency board or by
adopting some other country's currency, as in dollarization.
A currency board is an arrangement whereby the domestic currency of a country is required
to be fully backed by reserves held in some other country's currency, such as dollars. Hong
Kong and Argentina have currency boards. If global investors attack such a currency, the
use of official reserves to support the currency depletes reserves and requires a
corresponding decline in the supply of the domestic currency. This automatically pushes up
domestic interest rates to support the currency. The value of the currency board is that it puts
domestic monetary policy on automatic pilot, and guarantees that policy will move
aggressively to support the fixed exchange rate when it is under attack. The markets no
longer have to worry about the willingness of the policy authorities to adjust interest rates
aggressively enough to support the currency.
Dollarization--which I will use broadly to refer to the strategy of adopting some other
country's currency--takes the currency board one step further. Under a currency board, the
threat remains that the government will abandon this arrangement and devalue the currency
or let it float. Dollarization increases the commitment of a country to a fixed exchange rate.
Under dollarization, a country uses dollars for its domestic currency. It therefore faces dollar
interest rates, although these rates will not necessarily be the same as those prevailing in the
United States. Once again it has given up independent monetary policy. The advantage of
this regime is that it might reduce risk premia that remain in domestic interest rates under a
currency board that reflect the risk that the currency board might be abandoned. Of course, a
country could reverse dollarization as well, but the costs of such a move would be very
At the Jackson Hole conference, Eichengreen and Hausmann presented a discussion of the
choice between flexible and very fixed exchange rates for small open economies. They
suggested that a problem that besets many such economies is that, because of weak
institutions and a failure to pursue sound policies, neither the government nor private
citizens can borrow long-term or abroad in their domestic currency. The result is dangerous
portfolio mismatches--long-term projects are financed with short-term debt and/or domestic
projects are financed with foreign currency loans. In either case, the government and private
citizens are subjected to the risks of unexpected changes in short-term interest rates and/or
to the risks of a change in exchange rates. A currency board or dollarization arrangement, in
such a case, might reduce the risks associated with such mismatches. As a result, the country

might be able to reduce its risk premium, lower its vulnerability, and increase its access to
long-term and foreign finance.
In my view, the underlying problem, however, is often the mismatch between the speed with
which an emerging market economy participates in the global economy and the speed with
which its institutions and policies adapt to global norms. The best choice over time would
appear to be to develop robust domestic institutions and pursue sound policies, including a
disciplined monetary policy, and adopt a flexible exchange rate regime. An increased
reliance on foreign direct investment relative to short-term portfolio capital might also be
desirable. The real question is how to get there from where many emerging market
economies find themselves today.
There are, I believe, many advantages to a flexible exchange rate regime. It avoids the
problem of choosing the right level at which to fix the exchange rate. It allows exchange
rates to move in response to shocks or structural trends, alleviating the need for other
aspects of the economy--such as domestic demand or the level of wages and prices--to carry
the burden of adjustment. Floating exchange rates also serve as indicators of investor
confidence, providing feedback to policymakers as to whether they are pursuing appropriate
policies. Floating and perhaps volatile exchange rates also remind both borrowers and
lenders of the risks inherent in international finance and may militate against the
development of bubbles and excessive capital flows. Finally, where the monetary authority
is sufficiently credible and disciplined, floating exchange rates allow for independent and
perhaps countercyclical monetary policy.
And, it is worth pointing out some of the downside risks associated with currency boards or
dollarization. Either a currency board or dollarization requires a strong banking system,
because, under these regimes governments lose their ability to print money and act as a
lender of last resort. Many developing countries fail to meet this prerequisite. In addition,
dollarization would not completely eliminate risk premia, because debt repayment problems
are certainly possible in fully dollarized economies. So, an important issue is how much of
the prevailing risk premia faced by small open emerging market economies is due to
exchange rate risk and how much to other considerations. Finally, lower risk premiums
could have the perverse effect of alleviating pressure on governments to pursue structural
reforms that would lead to a more lasting improvement in the economy's performance.
On balance, I continue to lean toward flexible exchange rate regimes, but now better
appreciate that there could be circumstances favorable to very fixed exchange rate regimes,
including as a transition to flexible exchange rates, once the credibility of a country's
economic policies and institutions is sufficiently developed.
V. What I Learned from the Jackson Hole Conference
I have presented today a short course that might be called the "Jackson Hole Seminar." As
any professor will tell you, the test of a seminar is what the students learn. But handing out a
test would not be a pleasant way for visitor to conclude his visit to your campus. So I will
end with some comments on what I learned at Jackson Hole.
1. There is an emerging consensus toward flexible inflation targeting. Some central banks
are more transparent about the dual objectives and some are more explicit about the inflation
target, but there is a broad agreement about what the targets should be. There is somewhat
less agreement about how monetary policy should be conducted to achieve the targets, but

some convergence here as well.
2. While there are some intriguing new ideas about price level or average inflation targets,
the consensus based on practice and recent performance around the world is that a low, but
positive inflation target remains prudent. I refer to this target as price stability plus a
cushion. The cushion mitigates the risk that monetary policy might lose its ability to provide
further stimulus before it was able to adequately damp the effect of downward shocks to the
3. The conference offered a better understanding of how a monetization option might allow
additional stimulus once monetary policy had pushed the nominal interest rate on short-term
government debt to zero. But it did not offer much confidence, to me at least, that
monetization is an effective way out of the current predicament in Japan or that initiating an
inflation target, once having encountered this problem, would be effective.
4. The conference provided some support to the conventional wisdom--at least the
conventional wisdom inside the Federal Reserve--about how monetary policy should or
should not respond to suspected asset market bubbles.
5. The conference also provided a nicely balanced assessment of the choice between the
extreme solutions for exchange rate regimes--that is, between flexible and very fixed
exchange rate regimes. While the discussion clarified the problems and choices, it still left
me still leaning toward flexible exchange rates.

New Challenges for Monetary Policy
A Symposium sponsored by the Federal Reserve Bank of Kansas City
Jackson Hole, Wyoming
August 26-28, 1999
Opening Remarks
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System
Challenges for Monetary Policy: New and Old
Mervyn King, Deputy Governor, Bank of England
John Taylor, Professor, Stanford University
What is the Appropriate Role for Monetary Policy in the Presence of Asset Bubbles and
Financial Crises?
Ben Bernanke, Professor, Princeton University
Mark Gertler, Professor, New York University
Rudiger Dornbusch, Professor, Massachusetts Institute of Technology

Practical Experience with Asset Bubbles and Financial Crises
Panelist: Arminio Fraga, President, Central Bank of Brazil
Panelist: Josef Tosovsky, Governor, Czech National Bank
Panelist: Yutaka Yamaguchi, Deputy Governor, Bank of Japan
How Should Monetary Policy Be Conducted in an Era of Price Stability?
Lars Svensson, Professor, Institute for International Economic Studies, Stockholm
Allan Meltzer, Professor, Carnegie-Mellon University
Michael Woodford, Professor, Princeton University
What International Monetary Arrangements are Appropriate in Light of the New
Barry Eichengreen, Professor, University of California, Berkeley
Ricardo Hausmann, Chief Economist, Inter-American Development Bank
Martin Feldstein, President, National Bureau of Economic Research
Overview Panelists
Andrew Crockett, General Manager, Bank for International Settlements
Stanley Fischer, First Deputy Managing Director, International Monetary Fund
Jacob Frenkel, Governor, Bank of Israel
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