View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For release on delivery
12:30 p.m. E.S.T.
February 25, 1988

Address by
Manuel H. Johnson
Vice Chairman

Board of Governors of the
Federal Reserve System
before

Conference on Dollars,
and Trade

Deficits,

Sponsored by the Cato Institute

Washington, D.C.
February 25, 1988

"Current Perspectives on Monetary Policy"
It is a pleasure for me to address this sixth Annual

Monetary Conference of the Cato Institute.

The focus of the

conference--on deficits and trade as well as on consequences and
rules of alternative exchange rate regimes--is important and

certainly timely.
The title of my talk listed in your program is

"Current Perspectives on Monetary Policy."

One way of

addressing this topic would be to discuss the specifics of the

Federal Reserve's current concerns and goals for policy in 1988.

However,

Chairman Greenspan has addressed these points at the

Humphrey-Hawkins hearing before Congress just this week and I
see no need to repeat his statement.
Instead, what I would like to talk about today relates

to the more fundamental long-term goals of monetary policy and

how we can proceed to reach these goals— particularly under

current domestic and international monetary arrangements.

Clarifying the goals of policy is especially important
in our current monetary environment in which essentially every

currency in the world is directly,

or indirectly,

on a pure fiat

standard.
We have learned a great deal about the appropriate

goals of monetary policy in recent years.

that under fiat arrangements,

We know,

for example,

price stability is an achievable

goal and should be a principal objective.

A policy that fosters

steadiness and predictability in the general price level is
essential for genuine non-inflationary economic growth.
We have also learned that sharp unanticipated changes

in monetary policy can be disruptive to the economy.

Accordingly,

the pursuit of price stability should also seek to

minimize such short-term disruptions to economic activity.

2

- -

Among monetary experts,

there probably is little

disagreement on these policy goals.

However,

there is currently

a good deal of disagreement on how to best achieve these

objectives.
there was a growing consensus

Until a few years ago,

among monetary economists that the best way to conduct policy

was to target monetary aggregates as an intermediate objective.
It appeared that the quantity of money was a superior target for
the Fed to use in order to achieve price stability and to

promote stable economic activity.

Unfortunately,

in recent years it has become evident

that the relationship between the monetary aggregates and income
has become less predictable. Various measures of the velocity of
money,

for example,

during the 1980's.

have experienced large deviations from trend

Indeed, over this period the decline in

velocity for most monetary aggregates has b een unprecedented in

the post-war era.

And,

as yet,

-3-

this decline is not fully

understood.

Consequently,

future movements in velocity remain

uncertain.

There are several factors that have contributed to
this deterioration in performance of the monetary aggregates.

While it is probably premature to draw any definite conclusions,
it appears that the interaction of deregulation,

disinflation,

and sizable movements in interest rates have worked to alter the

behavior of money supply measures.

Due to these factors, money

growth is much more sensitive to changes in interest rates and

opportunity costs than was previously the case.

Since this

increased sensitivity works to lessen the predictability of the
relationship between money and GNP,

these aggregates b ecome less

reliable as policy targets.
Admittedly,

it is probably too early to conclude that

the monetary aggregates will not b e useful in the future as

But even if stable, predictable

policy indicators or targets.

velocity re-emerges,

it will take an extended period before

enough confidence and credibility can be mustered so that money

-

4-

supply measures can be used as the sole intermediate target of

policy.
Given this

(at least temporary)

deterioration in the

performance of the monetary aggregates, what alternative

indicators are available for implementing policy?

Also, what

properties should they possess?
First, useful indicators should be accurately measur­
able and readily available.

Second, they should respond to

changes in Federal Reserve policy actions. And third, they
should be reliably related to the ultimate goals of monetary

policy.
Given these guidelines,

there has been some interest

recently in the use of nominal prices of certain financial
instruments traded in auction markets as indicators for policy.

More specifically,
of interest rates

information contained in the term structure

(yield curve),

the foreign exchange market,

and certain broad indices of commodity prices has proven useful

in the formulation of monetary policy.

-5-

all of these indicators should

Other things equal,

provide signals as to when monetary policy becomes expansionary

(easy)

or restrictive

(tight).

For example,

should one observe

the simultaneous occurrence of a steepening yield curve,
increasing commodity prices,

and a depreciating dollar,

then it

may be inferred that monetary policy most likely has b een
expansionary.
However,

this approach certainly is not foolproof and

when such indicators are followed in isolation they can

sometimes prove to be misleading.

Also,

they are not always

independent from each other and can be affected by expectations
of policy change.

Yet despite these caveats, preliminary evidence is

promising enough to suggest that these indicators may prove
useful in the formulation of policy.

If nothing else,

they

provide useful information that should not be ignored.

The use of market determined prices as policy

Indicators

(or informational supplements)

6-

is an appealing

strategy for several reasons.

First, the data measuring these

variables are readily available,

market prices provide observable,

literally by the minute.
timely,

and more accurate

information than is provided by other sources.

problems with revisions,

These

There are no

seasonal adjustment procedures,

or

shift adjustment corrections that plague guantity or volume

data.

And the strategy does not rely on unobservable variables

such as real interest rates that depend on accurate measurements
of future price expectations.
Second, the strategy is premised on the notion that

market prices encompass the knowledge and expectations of a

large number of buyers and sellers.

And while it is true that

individual market participants may be irrational,

this is not

likely to be the case for the market as a whole.

Therefore,

these prices,

reflect the consensus of opinion about the current

and expected future values of these financial instruments.

such,

they serve as communicators of changing knowledge of

market conditions.

7-

As

T:hird, since there is evidence that the broader price

measures such as the CPI or GNP deflator are slow to reflect new
information,

changes in monetary policy should be reflected in

these financial auction market prices well b efore they affect

the broader price measures.

Thus,

there is reason to believe

they may give advance warning of impending change for important

concerns such as inflation.

It is worth noting that monitoring financial markets
in conjunction with one another to piece together a consistent

interpretation is not novel.

During the period when England had

gone off the gold standard in the early nineteenth century,
example.

for

Classical monetary writers monitored such indicators to

assess central Bank policy.

There is a passage in the famous

Bullion Report published in 1810 in which this is clearly

documented.

Because financial innovations had occurred and

accurate and timely monetary statistics were not available at

the time,

these monetary analysts argued that the Central Bank

should use financial market prices as guides to policy.

-8-

In the time remaining I cannot possibly give you a

detailed analysis of all the research pertaining to the yield

curve,

the foreign exchange rate,

Nor can

or commodity prices.

I provide any simple prescription on how these indicators should
be interpreted.

Suffice it to say that there are some

difficulties associated with each of these indicators as

separate forecasting tools.

But when examined together,

they

often yield valuable insights in evaluating the stance of

monetary policy and particularly in assessing movements in

expectations of inflation.
The Yield Curve

With respect to money and bond markets,

empirical

evidence suggests that expansionary monetary policy is often
reflected in a more positively sloped yield curve whereas a

yield curve that becomes inverted

(negatively sloped)

reflects a restrictive policy stance.

for example,

indeed,

often

Inverted yield curves,

have preceded most recessions in the post-war era.

the results of one recent study indicated that the

-9-

spread between the Fed funds rate and the long bond rate out-

performed three other Important variables as an indicator of the
impact of monetary policy on future real economic activity.
Most analysts do believe that there is useful

information reflected in the yield curve.

And there are

theoretical reasons and evidence to suggest that this spread

reflects expectations of future yields as determined in part by
expectations of future inflation.
course,

These observations imply,

of

that it is not the level of interest rates but the

spread that may serve as a useful indicator of the stance of

monetary policy.

But one cannot perfectly

predict the affects that a

change in policy will have on the yield curve;

hence this

indicator should not serve as a single target of policy.

The

yield curve is affected by a number of other factors such as,

changes in Treasury funding policy,

policy,

altered risk premiums,

as well as changes in liquidity preference.

-

10-

tax

Commodity Prices

There is also,

some empirical evidence to suggest that

broad indices of commodity prices respond to changes in monetary
policy and tend to lead changes in broader measures of
inflation.
The reliability as well as the quantitative importance

of these empirical relationships, however,
established.

have not been firmly

And little evidence exists that indicates the Fed

can accurately control such indices.

Moreover,

commodity prices

are volatile and are influenced by a number of factors not

related to monetary policy.

Accordingly,

commodity prices are

probably more valuable as an indicator of monetary policy than
as a target.

The Foreign Exchange Value of the Dollar

Zt has long been recognized that the foreign exchange

value of the dollar can also provide useful information for

monetary policymakers.

The exchange rate often indicates the

stance of U.S. monetary policy relative to that in other

-

11-

and therefore offers a gauge of relative monetary

countries,

expansion or contraction.

For example,

if the dollar is depreciating while the

yield curve is steepening and commodity prices are rising,
policy is likely expansionary and perhaps overly so.
On the other hand,

if the dollar is depreciating while

commodity prices and the yield curve are stable,

the dollar may

reflect restrictive foreign monetary policy or other external
factors.
Moreover,

if the dollar was declining and the yield

curve was steepening but commodity prices remained stable,

could reflect an outflow of foreign funds from the U.S.

this

bond

market for reasons other than inflationary expectations.
Monitoring exchange rate movements to supplement other

indicators,

of course,

is not foolproof.

are volatile and intervention can

signals from this market.

The exchange markets

(at least temporarily)

distort

Morever a great deal of information

-

12-

about foreign economic performance and policy is required to

properly assess this market.

It should also be pointed out that exercises in
international coordination of monetary policy—which necessarily

implies a move to more stable exchange rates— suggests that the

information content of foreign exchange rates is lessened.

While stable exchange rates are desirable,
After all,

information from this market.

stability removes

it is

(theoretically)

possible to have either rapid inflation or rapid deflation with

stable exchange rates.

Accordingly,

information provided by commodity prices

and yield curves may assume more importance in analyzing
inflationary expectations should coordination be used to

stabilize exchange rates.
Summary

To sum up,

in spite of several caveats and in the

absence of reliable alternative indicators,

-

13-

financial auction

markets can provide useful information to the process of

monetary policy formulation.

Z believe the strategy outlined

here provides a framework for focusing monetary policy on the
conditions for price stability.

And price stability is a goal

that should direct our attention to these markets.

Thank you.

-

14-