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
1:45 FH EST
Wednesday, October 30, 1985

Monetary Policy Over the Next Decade
Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System
The Committee on Developing American Capitalism
Fairfield, Connecticut
October 30, 1985

Monetary Policy Over the Next Decade
Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System
The Committee on Developing American Capitalism
Fairfield, Connecticut
October 30, 1985
Life in the American electronic village of today is characterized by
an infinite variety of information and by a focus on our immediate problems.
There is a virtual obsession with the very short run and with the risk and
danger that confront us now.

Confidence in our institutions is buffeted by

waves of data whose validity is subject to question because of frequent
revisions and adjustments.

Forecasters and econometric model builders seem to

be confounded by subsequent events — the range of error around the consensus
forecast has widened so much that it sometimes appears their computers cannot
even identify the direction of change.

It is thus important to extend our

view to a multi-year horizon, to review the more fundamental trends affecting
the institutional underpinnings of our economy and financial system.

Only in

this way can we dispel some degree of the uncertainty about the future and
about the appropriate policies to promote long-run stability and growth.

One aspect of the uncertainty is the revolutionary changes in the
financial environment.

Monetary policy operates through financial markets,

which are today constantly in flux.

In this country — and lately also in

London, Tokyo, and other financial centers — new financial instruments and
institutions arise almost monthly.

An important part of the central bank's

responsibility is to maintain the integrity of the financial system in this
rapidly changing landscape.

With the internationalization of financial

2

markets in recent years and the integration of the U. S. economy into an
interdependent world economy, the concerns of the Federal Reserve and U. S.
Treasury also extend to the safety and soundness of the international monetary
system.

It is not an exaggeration to say that both the domestic and

international financial systems are undergoing a transformation.

In implementing monetary policy, we must be aware that the rules of
the game are frequently changing and must adapt our strategy in light of those
changes.

The difficulties are intensified by the strains on the financial

system caused first by a significant acceleration of inflation and then by the
necessary financial and nonfinancial adjustments to disinflation, which was
not fully anticipated by the markets.

In this environment, it is even more

tempting to focus on the problems and challenges of the day, postponing
consideration of tomorrow's problems.

To paraphrase the Scriptures,

"Sufficient unto the day is the challenge thereof." Too often we have
contented ourselves with such short-run thinking regarding policy
alternatives.

I submit that today's world no longer permits that luxury.

Thus, let

us avail ourselves of this opportunity to step back from the immediate
concerns and to take a longer run view of the trends shaping the environment
in which monetary policy is conducted. We do so not only to prepare for the
future but also to understand the present and appreciate the past.

It is in

this spirit that I approach a discussion of monetary policy over the next
decade.

3

You will appreciate that the most appropriate starting place is our
historical base.

What might have been said on long-range monetary policy in

1975? The U. S. and world economies were just emerging from the stagflation
following the first oil shock.

In part as a response to America's first bout

with double-digit inflation combined with a severe recession, Congress had
adopted a resolution requiring that the Federal Reserve report its monetary
growth objectives.

The Federal Reserve first announced money growth targets

in the midst of a major shift in money demand.
1985, was why Ml was growing so slowly.

The question then, unlike

The "Case of the Missing Money" in

the mid-1970s in my view was never solved despite the best efforts of the
Sherlock Holmeses and HercuLe Poirots of monetary economics.

Slow monetary growth during this period helps explain why Federal
Reserve policy seems, in retrospect, to have been overly accommodative in the
late 1970s.

Some argue that this accommodative policy allowed inflationary

pressures to build and the exchange value of the dollar to decline.

Of course

many factors other than monetary ones contributed to that inflation.

Several

developments led to the decline in productivity growth, among other examples.

The inflation of the 1970s also set the stage for a wave of financial
innovation and deregulation.

Think how far we have come since 1975.

Interest-bearing checking accounts were then confined to New Eirgland; thrifts
and banks were then more easily distinguishable by the composition of their
balance sheets; financial futures and options were not yet prevalent; and
despite the severe recession, the financial health of all major sectors seemed

4
not just secure, but rock-solid.

Review the economic and financial literature

of that day and you find that, when asked to assess the outlook for monetary
policy over the next decade, yesterday's experts almost to a man would have
expressed a relatively sanguine view.

And remember this was a time when

policy makers thought the economy could be "fine tuned".

My mid-1970s mythical economist, Kenneth Keynes, almost certainly
would have limited his outlook to domestic considerations.

Despite concern

about the recycling of petrodollars through the Eurodollar market, which
itself was thought to be somewhat of an aberration, the U. S. economy and
financial system were still more or less insulated from their counterparts
abroad.

Exports and imports were thought to be so negligible that they played

a minor role at most in forecasting U. S. economic growth.

Ken Keynes

invariably included only a few sentences at the end of his forecast alluding
to international matters.

The record of policy actions of the Federal Open

Market Committee in that period reflected this domestic orientation,
containing few references to international considerations other than the price
of oil.

Then came the shocks and discontinuities of the last decade.
Accelerating inflation in the late 1970s led to a run-up of gold and other
commodity prices and to a decline in the exchange value of the dollar.
fall of 1979, financial markets were gripped with inflation fever.

By the

In

response, the Federal Reserve announced a major change in operating procedures
and an intensified commitment to monetary control as a means of containing

5

inflation.

Soon thereafter, President Carter's announcement of a budget with

a "whopping" projected deficit of $16 billion rekindled the anxiety in
financial markets, especially exchange markets.

The response was to impose

credit controls, treating the symptoms but not the causes of our economic
problems.

A more substantial response began in late 1980, when the Federal
Reserve embarked on a policy of sustained monetary restraint.

Because of

uncertainties surrounding the introduction of nationwide NOW accounts in 1981
and the associated redefinition of the monetary aggregates, the effective
degree of monetary restraint was difficult to measure.

Real interest rates

soared, commodity prices plunged, and the U. S. economy suffered through a
prolonged recession — all of which contributed to unprecedented strains in
the international financial system, including the severe debt-servicing
problems of LDC debtors.

On the plus side of the ledger, we achieved our

objective of disinflation:

monetary restraint contributed to rapid progress

in bringing inflation down from 13 percent in 1979 to 4 percent in 1982.

Nor did the turmoil end with the easing of monetary policy beginning
in late 1982.

The declining interest rates in late 1982 and early 1983 were

followed by an unexpectedly rapid fall-off in the velocity of money.

At the

time, many commentators, including Milton Friedman, predicted that the
acceleration of Ml growth in 1982-83 would inevitably lead to a commensurate
increase in inflation.

Others attributed the rapid Ml growth to the buildup

of precautionary balances in NOW accounts, which are generally recognized to

6

have both transactions and savings characteristics.

Subsequently, models were

developed that helped explain the rapid Ml growth as resulting from heightened
interest sensitivity of money demand due to inclusion of NOW accounts in Ml.
The operative word here is subsequently. As one involved in monetary policy
decisions at the time, I will concede that the reasons for the shift in the
public's demand for liquidity are still subject to analysis and review.

Even

now, we can't be sure of the reasons for the atypical behavior of Ml in the
1982-1983 period.

The important point is that the POMC's decision to rebase

the Ml target for 1983 to accommodate the increased demand for liquidity was
vindicated:

inflation did not accelerate.

Some thought inclusion of accounts with market-related rates would so
reduce the interest sensitivity of money demand that the Federal Reserve would
lose control of Ml.

But the rates on Super NCWs have proven to be sticky, so

the interest sensitivity of Ml has remained high.

What effect has the

introduction of Super NOWs and money market deposit accounts had on the
monetary aggregates? We now have enough experience with the new accounts to
be reasonably confident that Ml growth remains very responsive to changes in
market interest rates.

Furthermore, the continued progress against inflation led to a
downward revision of inflationary expectations that contributed to another
major reduction in interest rates over the last year.

Even those of us who in

1983 foresaw a slowing of economic growth did not anticipate the full extent
to which the accompanying decline in interest rates would stimulate Ml growth

7

and lead to the unprecedented declines in velocity experienced this year.

The

decision to rebase the Ml target for 1985 was based, in part, on our judgment
that rapid Ml growth through the summer would not be inflationary because it
resulted from portfolio adjustments due to declining interest rates.

After we

rebased, Ml growth continued at double-digit rates for reasons not fully
understood, leading to another sharp decline in velocity in the third quarter.
To the unsolved Case of the Missing Money in the mid-1970s, we now must add an
equally puzzling Case of the Missing Velocity in the 1980s.

What conclusions can we draw from our experience over the last decade
for monetary policy in the next decade? One is that monetary and reserve
aggregate targets serve a useful purpose in the fight against inflation.
Focusing on financial quantities rather than on interest rates imposes
discipline on monetary policy.

Central bankers are cautious by nature — they

hesitate to change their policy stance until it becomes clearly necessary to
do so. When the stance of policy is characterized mainly by the level of
short-term interest rates, this cautious tendency can lead to artificially
high or low interest rate objectives, especially when financial change and
other shocks confuse the signals from incoming data.

By the time it becomes

clear that a policy change is necessary, it may be too late.

In contrast,

monetary targets by their very nature focus attention on the long-run
objective of price stability, leaving interest rates to be determined by
market forces.

8

Nevertheless, our experience indicates that rigidly adhering to
monetary targets would also be unwise, especially in a rapidly changing
financial environment.

What would have happened, for example, if we had

pursued policies that allowed interest rates to rise in late 1982?

How

important was achieving our Ml target in the midst of a severe recession and
of Act I in the international debt crisis? We didn't take that unnecessary
risk, and subsequent developments have, in my view, vindicated our decision
then to relax the degree of restraint.

I am frank to admit that a great deal of uncertainty is likely to
persist regarding what the monetary aggregates are telling us until we have a
great deal more evidence on how the new array of deposits and certificates
will be utilized.

How will financial institutions compete for deregulated

deposits? What forms of deposits will be available? What preferences will
depositors themselves demonstrate? The incomplete answers to these questions
at this time do not support the monetarist proposal that monetary growth be
the exclusive, or at least the preeminent, guide for the conduct of monetary
policy over the next decade.

It may be that the aggregates in some future

period will be reliably enough related to our goal variable to warrant renewed
emphasis on monetary growth in policy implementation.

Meanwhile, the

information content from the monetary aggregates will be useful but not
decisive in the conduct of monetary policy.

Then what other alternatives are available as policy guides? A
number of concepts have been put forward for alternative monetary policy

9

targets or objectives, with a strong undercurrent of a desire for the Federal
Reserve to conduct monetary policy according to some simple "rule." If a
single, reliable indicator could be found, such a rule would have the
advantages of being easily understood by the public and readily used by
Congress in holding the Federal Reserve accountable.

A rule might even be an

anchor that could reduce uncertainty about future price levels.

Let me go

through several of the possibilities; but I will tell you in advance that each
has serious drawbacks.

The eclectic approach is likely in the end to be

preferable to any of the proposed rules.

One proposal would orient policy to the growth of total debt.

As

changes in the public's asset preferences began to distort the monetary
aggregates, it was suggested by some that we turn our attention to the
liability side of the public's balance sheet and focus on a credit aggregate.
Research from Federal Reserve staff and from leading academics suggested that
the ratio of GNP to total credit — a counterpart to the velocity or turnover
rate of money — had been virtually constant over long periods.

The FOMC did

establish an annual range for total credit beginning in 1983, but
characterized it as a monitoring rarige in part because of uncertainty about
the durability of the relationship.

That skepticism seems to have been justified.

Since 1981, the

historical relationship between debt and GNP has broken down.

Expansion of

debt has vastly outpaced that of GNP; the "velocity" of debt has plummeted.
One reason, of course, is the explosive growth of government budget deficits

10

in recent years and the associated inflow of capital from abroad.
debt has also grown unusually rapidly during this expansion.

Private

One could argue

that the debt to GNP relationship will return to normal after the
unprecedented budget deficits and capital inflows diminish.

However, it is

precisely when you are navigating turbulent waters that you rely most on your
rudder.

Variables that are predictable only in normal times are not, in my

judgment, strong candidates for monetary policy targets.

Another proposal is to target nominal income or nominal GNP growth
directly.

In the absence of external shocks, inflation can't get out of hand

if nominal income growth is kept near the economy's long-run growth potential.
The main problem I see with this approach is that it promises more than can be
delivered.

Nominal income growth is not sufficiently controllable over

horizons of a year or less to be a reliable criterion for the public or the
Congress to judge monetary policy.
policy, affect nominal income.

Many other factors, including fiscal

Moreover, the noninflationary growth rate of

nominal income is uncertain because there is so little consensus today on the
long-run "trend line" growth in potential output.

On a pragmatic level, the

POMC members' projections for real growth, the unemployment rate, and
inflation are even now sometimes misinterpreted as goals rather than
forecasts.

Such an approach would put the Federal Reserve in the position of

attempting to fine tune policy to achieve short-run values for real economic
outcomes, objectives for which monetary policy is particularly ill-suited.
Remember Milton Friedman's caveat that fine tuning is an example of the "best
being the enemy of the good."

In the real world environment in which policy

11

decisions are made, I fear that nominal income targets, far from helping us
contain inflation, would make controlling inflation even more difficult and
would thus impair efforts to achieve sustainable real growth.

Some analysts argue that the Federal Reserve should target an index
of commodity prices, which are thought to be a good leading indicator of the
general price levels.

One reason monetary policy can't stabilize the

aggregate price level in the short run is that many wages and prices are
administered rather than market determined.
example, set wages for two or three years.

Most labor contracts, for
Because of these institutional

rigidities, monetary policy affects prices of goods and services only after a
substantial lag.

In contrast, commodity prices are set by supply and demand

forces in the markets and thus could be quickly affected by monetary policy
actions.

Some advocate using an index of commodity prices as a short-run

proxy for the overall price level, claiming also that stabilizing commodity
prices would reduce cyclical fluctuations.

I have reviewed extensive empirical evidence on the properties of
commodity price indices in the 1970's, ranging from prices on raw materials to
prices of goods headed for the shelves, and including the Federal Reserve's
own commodity price index.

One conclusion from my review is that various

commodity price measures do provide information useful in understanding
inflationary — or deflationary — forces.

Surges in food or energy prices,

for example, can be significant as precursors to an increase in the overall
inflation rate.

However, none of these price indices for commodity baskets

12

consistently leads the general price level.

Consider the past few years’

experience — consumer prices have increased at a moderate and nearly constant
rate even though commodity prices first increased sharply and than deflated
almost as sharply.

Statistical evidence over longer periods confirms that

commodity prices are not closely enough related to either overall inflation or
economic growth to serve as a simple price rule for monetary policy.

And the

relation of commodity prices to general inflation and economic performance is
likely to be even more tenuous in the future as the U. S. economy moves
increasingly from an agricultural-manufacturing- extractive industrial base to
an information-finance-service orientation. A commodity price rule just does
not seem practical.

Can commodity prices nonetheless provide useful

information for monetary policy? Of course they can.

Literally two decades of inflation has stimulated many to turn to the
idea of a return of major trading nations to a gold standard.

Under the

previous gold standard, the participating countries attempted to fix the
prices of their currencies in terms of a specified amount of gold.

Led by the

Bank of England, the central banks of the leading countries at least part of
the time followed the rules of the game — they adjusted the rates of growth
or contraction of their domestic money supplies and the adjustment of price
levels to external gold flows.

The game was centered on the Bank of England's

"field." The 1870 to 1914 period was the heyday for the gold standard.
However, even then some countries did not follow the agreed on rules of
financial behavior, often "sterilizing" gold flows so that the domestic money
supply would not be contracted or expanded thereby.

13

Would the leadership in one of today's political economies long
permit gold to be freely exported and imported in a manner that would
significantly affect domestic prices, investment, and consumption as did the
Bank of England in the 19th century? Would a specific price for gold be
maintained if that price were associated with actual deflation, falling
prices, in an economy? Obviously not.

However, it is not possible simply to

dismiss gold as a possible anchor to a modem monetary system by citing
inflationary or deflationary trends that occurred in gold standard countries
prior to World War I or during managed gold standards in the 1920s.

Likewise,

it is not practical to disregard the information arising out of changes in
gold prices in today's markets.

One cannot ignore changes in the attitude of

investors and speculators toward the holding of gold.

It is much more

difficult, however, to argue for complete and sole reliance cm gold or any
other single commodity for the guidance of monetary and other stabilization
policies.

A fourth alternative target for monetary policy is the exchange value
of the dollar.

The proposal to base monetary policy on a targeted exchange

rate has obviously arisen because of the extreme volatility and misalignment
of the dollar in recent years.

Furthermore, exchange rates are given high

priority by other central banks in Europe and Japan.

It is argued by some

that monetary policy should remove the uncertainty of volatile exchange rates
and the large trade deficits resulting from an "overvalued" dollar by pegging
the exchange value of the dollar.

Indeed, the dollar exchange rate has

recently been characterized by Otmar Emminger, former President of the
Deutsche Bundesbank, as "the most important price in the world economy."

14
The proposal to peg the value of the dollar fails to cut through the
confusion between real and nominal exchange rates, however.

The real exchange

rate, the market exchange rate adjusted for differences in price levels across
countries, is a major determinant of our trade balance.

It reflects the price

of our exports relative to the price of our imports — what economists call
the terms of trade.

What is true for real interest rates and other real

economic variables also applies to real exchange rates:
only a temporary effect.

monetary policy has

Therefore, if the Federal Reserve could materially

affect market (nominal) exchange rates, the result might not solve our
long-run trade imbalance, which depends on fundamental economic factors:
consumer preferences, productivity, and saving propensities.

Should the Federal Reserve adjust monetary growth to peg the dollar
exchange rate for a prolonged period?

Should we gear our monetary policy to

adjusting the U. S. inflation rate to inflation rates in the economies of our
trading partners?

In the context of the past several years, with strong

upward pressure on the dollar, this would have meant that the Federal Reserve
would have been forced to boost the U. S. money supply, tending to generate
more inflation in this country in order to keep nominal exchange rates
constant.

How could central banks avoid the trap of exchange rate pegging
causing worldwide inflation?

It has been proposed that major industrial

countries coordinate monetary policies to keep the world money supply, and
therefore the world price level, constant.

This, it seems to me, is a way of

15

simulating a worldwide gold standard with the dollar, rather than gold, as the
international medium of exchange.

What would be the probable consequences?

Under certain shocks that cause changes in real exchange rates, the United
States could be forced to follow a deflationary monetary policy to maintain
worldwide price stability.

Given the stickiness of wages and prices,

deflation in this country could have severe adverse consequences on domestic
output and employment. The Federal Reserve could thus run a real risk of a
recession to keep the nominal exchange value of the dollar from rising.

Our

"political economy" would hardly tolerate such a risk.

The problems with a pure exchange rate target would, of course, be
alleviated if there were better balance of fiscal policies across countries.
Unlike monetary policy, fiscal policy can affect real exchange rates over an
extended period.

Our experience over the last several years has been one of

expansionary fiscal policy in the United States and contractionary fiscal
policies in most other developed countries.

The accompanying appreciation of

the dollar exchange rate suggests to me that a coordination of monetary
policies across countries could be overwhelmed by a divergence of fiscal
policies.

The sluggish world economy stridently calls for greater global

balance in the mix of both monetary and fiscal policies.

This, it seems to

me, is the challenge for economic policy in the next decade.

The September G-5 agreement is a useful first step.

Especially if

the G-5 and the subsequent IMF-World Bank meetings in Seoul are followed by
government spending reductions in this country and less restrictive budgetary

16
policies in some other countries, these developments could begin to meet this
challenge.

The message I want to leave with you today, though, is to confirm
that the Federal Reserve can be expected to contribute to the progress being
made in solving the world's economic problems.

However, there is no magic

computer software program or simple rule— not monetary or credit targets, not
nominal GNP targets, not commodity price targets, not exchange rate targets —
that will solve the problems resulting from fundamental internal and external
imbalances caused by real economic factors.

We can and will contribute to

continued progress toward price stability and growth within an environment of
stability in the domestic and international financial systems.

In my view, that objective can best be achieved by continuing the
eclectic approach to monetary policy that has characterized our actions since
1982.

Of course we should use the information from exchange rates and

commodity prices, including the prices of precious metals.

But we must

continue to place primary emphasis on domestic economic and financial
developments in the conduct of monetary policy.

Some argue that such an eclectic approach does not allow appropriate
accountability to Congress and the American people.

I disagree.

should be held accountable for the results, not just the tactics.

V e can and
i
In judging

monetary policy over the next decade, you should ask yourselves the following
questions:

has monetary policy prevented reacceleration of inflation to the

17

ruinous rates of the 1970s?

Has it also fostered the greatest degree of

financial stability feasible under the circumstances? And finally, has the
Federal Reserve cooperated in efforts to provide greater balance of policies,
both domestically and internationally?

In short, has the Federal Reserve

contributed to a climate for sustained growth in output and employment both
here and abroad?

I hope that your answers to all of these questions will be in the
affirmative in 1995.

Only then will we know the extent of the contribution

monetary policy has made to prosperity in what promises to be a most difficult
decade to come.