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Prepared for delivery at the East Hanover Area Chamber of Commerce, East Hanover,
New Jersey
January 15, 1999

The Making of Monetary Policy
Thank you for inviting me to share lunch and a few thoughts with you today. I believe that it
is important for the actions of this country's central bank to be as transparent as possible,
and therefore I am happy to address this audience on the topic of the what the Federal
Reserve actually does and how it does it. I will also try to give an assessment of the national
and international issues affecting Federal Reserve policy.
I hope that you will conclude from this discussion that, though the process of setting
monetary policy is complex, it is nonetheless in many important ways accessible to the
average citizen. I also hope that you will agree that there are really very few secrets; we
attempt to be as open as is responsible, which is appropriate in a democracy.
History of the Federal Reserve System and the FOMC
The Federal Reserve was created by an Act of Congress on December 23, 1913. The Federal
Reserve System consists of a seven-member Board of Governors (an independent agency of
the federal government with headquarters in Washington, DC), plus a nationwide network of
12 Federal Reserve Banks and 25 branches. Congress established the Federal Reserve Banks
as the operating arms of the nation's central banking system, and they have both public and
private elements.
Neither the Board nor the Reserve Banks receive appropriations from Congress. Therefore,
they do not operate with tax revenues, but rather pay expenses out of earnings. Earnings of
the Federal Reserve Banks are derived primarily from interest received on their holdings of
U.S. government securities and the fees they charge to depository institutions for providing
services. All of the net earnings of the Banks, after expenses, contributions to surplus and
payment of other assessments, are aggregated and paid over to the U.S. Treasury. In 1998,
for example, the Federal Reserve paid approximately $26.5 billion to the U.S. Treasury.
The Federal Open Market Committee, or FOMC, is the most important monetary policymaking body of the Federal Reserve System. The FOMC makes the key decisions regarding
the conduct of open market operations (purchases and sales of U.S. government securities)
which affect the cost and availability of money and credit in the U.S. economy. The voting
members of the Committee are the members of the Board of Governors and five Reserve
Bank presidents. The president of the Federal Reserve Bank of New York serves on a
continuous basis; the presidents of the other Reserve Banks serve one-year terms on a
rotating basis beginning January 1 of each year. All the Reserve Bank presidents participate
fully in the various discussions, regardless of whether they currently have a vote in the
policy decision. By law, the FOMC must meet at least four times each year in Washington,

DC. Since 1980, eight regularly scheduled meetings have been held each year. If
circumstances require consultation or consideration of an action between regularly
scheduled meetings, members may be called upon to participate in a special meeting or a
telephone conference.
So what happens at these meetings? The order and structure of these meetings may change
over time, but has been pretty much fixed during my term on the Board. Before each
regularly scheduled meeting of the FOMC, System staff members prepare written reports on
past and prospective economic and financial developments, which are sent to Committee
participants. At the meeting itself, staff members present oral reports on the current and
prospective business situation, conditions in financial markets and international economic
and financial developments. After these reports, each Committee participant, voting and
nonvoting, expresses his or her views on the current state of the economy and prospects for
the future. After a short coffee break, we have a staff presentation on the alternatives we
face in setting monetary policy. At that point, the Chairman gives his view of the economy
and makes a suggestion for the appropriate direction of policy. Each Committee member
then responds to the Chairman's suggestion, in the process setting out a preferred choice for
policy. After this second "go-around," we take a formal vote on the target federal funds rate
for the period until the next meeting. At this point, the focus is on the voting members, who,
as I noted, include all of the Governors and five of the twelve Presidents. Generally, an
announcement of a change in interest rates, if any, is made at about 2:15 in the afternoon. A
full set of meeting minutes is made available after the subsequent meeting.
Let me turn now to a discussion of monetary policy and the outlook for the U.S. economy.
Of course, the views I shall be expressing are my own and are not necessarily shared by the
FOMC or the Board of Governors.
The Goals of Monetary Policy
Federal law establishes the goals of monetary policy. The Federal Reserve and the FOMC
are "to promote effectively the goals of maximum employment, stable prices, and moderate
long-term interest rates." Many analysts believe that achieving price stability should be the
primary goal of a central bank because a stable level of prices appears to be the condition
most conducive to maximum sustained output and employment, and to moderate long-term
interest rates. This presumably is because in times of price stability the prices of goods,
materials and services are undistorted by inflation and thus can serve as clearer signals and
guides for the efficient allocation of resources. Also, a background of stable prices is thought
to encourage capital formation because it reduces the distortion created by a tax system that
is only partly indexed for inflation. Some would argue that the remarkable period of growth
that we are experiencing is due in no small measure to the low rate of inflation that has
prevailed for some time.
The problem with the rather neat formulation that I have just given is that it does not include
an element of time. In the long run, I have no doubt that price stability underpins efforts to
achieve maximum output and employment. But, in the short run, some tensions can arise
between efforts to reduce inflation and efforts to maximize employment and output. For
example, the economy may at times be faced with adverse developments affecting supply,
such as a bad agricultural harvest or a disruption in the supply of oil, which put upward
pressure on prices and downward pressure on output and employment. In these
circumstances, makers of monetary policy must decide the extent to which we should focus
on defusing price pressures or on cushioning the loss of output and employment in the short
run, in the context of our long-term objectives. At other times, policymakers may be

concerned that expectations of inflation will get built into decisions about wages and prices,
become a self-fulfilling prophecy, and result in temporary losses of output and employment.
Countering this threat of inflation with a more restrictive monetary policy could risk small
losses of output and employment in the short run but might make it possible to avoid larger
losses later should expectations of higher inflation become embedded in the economy.
The press tries to categorize FOMC members as "hawks" and "doves." These labels are an
effort to simplify, in fact, oversimplify, the complex choices that each member of the FOMC
must make in deciding how to trade off the risk that action, or inaction, on our part will lead
to inflation heating up to unacceptable levels, as opposed to having an inadequate creation
of jobs. But I believe that all members of the Committee recognize that the major
contribution the Federal Reserve can make to higher standards of living over time is to
promote price stability.
It is generally thought that monetary policy takes many months to have most of its effect on
growth and employment, while of course it has an immediate impact on financial markets.
Because of the long time frame for effect on the real economy, I believe that it is important
for policy to look ahead one to two years as it aims at promoting stable prices and a
sustainable GDP growth path, along which the economy is at full potential. Given that we
need to be forward-looking, or "preemptive," as it is often put, one potentially important
element in making monetary policy is the forecast or likely outlook for economic growth,
unemployment and the price level for the next year or two. Fortunately, as we make
monetary policy we have the advantage of several forecasts. The staff of the Board of
Governors, private sector economists, and the staffs of the Federal Reserve Banks all make
forecasts. Some individual Governors and Reserve Bank Presidents also have considerable
experience and expertise in forecasting.
To be useful for monetary policy, forecasts of the future health of the economy need to be
reasonably reliable. Good forecasts rest on the identification of empirical regularities that
can be confidently relied upon to provide guidance. Regrettably, some previously reliable
empirical relations have not proven so of late. As one example, the failure of price inflation
to pickup as labor markets have become tighter is not consistent with older empirical
observations. Moreover, factors outside of economists' models have provided some
surprises, such as the Asian economic and financial turmoil and the collapse of oil prices.
If forecast relationships are less certain, it becomes more challenging to be "preemptive." In
these circumstances, I believe, it is appropriate to put greater weight on incoming data to
determine whether the stance of monetary policy should be changed. Some of the variables
relevant in this regard are: 1) the level of unemployment and the rate of job creation, 2) the
rate of change in wages or prices or early signs of emerging inflation, 3) the rate and
composition of GDP growth (inventory, trade flows, consumption, investment, residential
and commercial construction, etc.), and 4) international developments. Economists refer to
these variables as being from the "real" side of the economy. Another set of variables to be
considered in making monetary policy are financial variables, such as money supply, interest
rates, exchange rates, credit flows, and conditions in bank lending or in the debt and equity
The last two years, 1997 and 1998, gave an interesting case study of the interplay between
these different variables and the degree of forward-looking behavior in the making of
monetary policy. From March of 1997 through much of 1998, pleasant surprises in the
performance of inflation and the general absence of early signs of inflation, and uncertainty

about the relationship of inflation to changes in the level of production, kept the FOMC from
tightening. We did not tighten despite the economy being beyond most estimates of its
potential and despite many forecasts of rising inflation. Put another way, the FOMC could
have "preemptively" tightened monetary policy, based on forecasts, but recognizing the
uncertainties about empirical relationships chose not to do so.
But in the fall of 1998, you may recall, there was concern regarding the performance of the
debt markets, especially the bond market and market for commercial paper. These concerns
were centered around the fact that corporate borrowers could no longer raise funds in the
bond or commercial paper markets at reasonable prices or, at some times and for some
borrowers, at all. In this case, we were reasonably confident that constraints on the ability of
corporations to borrow would eventually have a negative effect on their willingness to invest
in productive capacity and therefore on their ability to provide goods and services and to
create jobs. A related concern was that weakened foreign economies might have adverse
consequences on future domestic activity. Under those circumstances, the FOMC thought it
appropriate to ease to offset a likely significant impact on future domestic spending and
Finally, no discussion of monetary policy and financial markets would be complete without
reference to the equity markets. I believe that the Fed cannot target specific levels in equity
markets. However, equity markets have spillover effects into the real economy and hence
send important signals to policymakers. As you know, economists often speak of the "wealth
effect," and econometric modeling indicates that consumers tend to raise the level of their
spending about 2-to-4 percent of incremental wealth, after 2 or 3 years. Through the
so-called wealth effect, equity valuations can and do have an effect on consumption and on
macroeconomic performance. Additionally, equity markets are a source of investment
capital, and valuations in the stock market are one determinant of the cost of capital for
businesses. Therefore, equity prices have an influence on business fixed investment, along
with consumption, the major drivers of our economy. Finally, equity markets are of interest
to policymakers because we have a responsibility for macro-stability. We have seen in other
economies that bubbles and busts in financial markets can create unsettled conditions that
impair real economic activity. Therefore, while it would be incorrect to say that
policymakers target the equity markets or that market concerns "tie the hands" of the Fed,
the markets are an important consideration in macroeconomic analysis.
These are just some of the factors that might go into making monetary policy. The interesting
part of the job is that the relative importance of these factors--forecasts, current
macroeconomic conditions, financial market conditions and others--are often in flux. For
those who seek to monitor our actions, the good news is that through a reading of FOMC
announcements and minutes, speeches by Governors and Presidents, and interviews, an
observer can get a pretty good handle on which variables are uppermost in each
policymaker's mind at any given time. Often, however, many factors are relevant, and we
cannot indicate precisely the relative weights the FOMC may be applying to them in making
policy. After all, the economy is influenced by all of the factors I have outlined, and the
FOMC's emphasis on specific factors varies over time as economic conditions change.
Outlook for 1999
With this general statement of the factors that go into setting monetary policy, let me turn to
the outlook for 1999. Recent economic data have been stronger than many had expected. It
now appears to many forecasters that real GDP growth for 1998 was 3.5 percent or more on
a fourth-quarter-to-fourth-quarter basis. The consensus, as represented by the most recent

Blue Chip Economic Indicators, is that real growth in 1999 will moderate, perhaps to slightly
over 2 percent, again on a fourth-quarter-to-fourth quarter basis (nearly 2.5 percent on a
year-over-year basis). This consensus outlook, if accurate, would eventually produce a "soft
landing" with growth near the economy's potential and inflation remaining low. The range of
forecasts that compose this so-called consensus is large, perhaps indicating that forecasters
are cognizant of the fact that it's not hard to imagine risks to both sides of this scenario. I
should also note that this is a repeat of earlier forecasts that growth will moderate, and the
economy has surprised many forecasters with its resilience. I can see that 1999 will require a
continued high level of vigilance for policymakers.
Not surprisingly, many of the forces and uncertainties that seemed to shape so much of last
year's discussion are present in the outlook. Tight labor markets are putting pressures on
wages, but competitive markets are limiting pricing leverage and causing profits to be
squeezed. Under these circumstances, will businesses become more cautious in their
spending and hiring plans? Rising stock prices continue to point to strong consumer demand,
but valuations are high by historical standards and one wonders whether this stimulus will
remain so strong. The downturns in some of the troubled economies of Asia seem to be
bottoming out, at least outside of Japan, but the risk of spreading distress in Latin America
creates another element of international uncertainty.
Recent events in Brazil have made this concern more evident. It is now even more important
that Brazil move as quickly as possible to implement a clearly sustainable fiscal position and
regain the confidence of international markets and investors. The Federal Reserve will
continue to monitor closely international developments and their potential effect on
domestic activity.
At the same time, U.S. inflation has been contained, at least until recently, by a number of
factors, such as a rising exchange rate for the U.S. dollar through much of last year,
well-contained health care costs, and declining prices for oil and other commodities, which
may prove to be short-lived. The ability of businesses to pass on price increases has been
constrained, in part, by international competition. Will the restraint on pricing power remain
as strong or weaken? If the latter, at what pace? Will the special factors I mentioned above
continue to mitigate inflationary pressures arising from labor markets? Are there other,
longer-term forces at work damping price pressures that we have not yet identified?
A new factor that I find most interesting as we start this year is the likely impact of the
upcoming century date change. As you may know, I am Chairman of the Joint Year 2000
Council, which is a group of financial regulators that has spent the last nine months focusing
on the Year 2000 computer problem. In an international context, the Year 2000 is likely to
have differing impacts across different regions. Here in the United States, my colleague
Governor Mike Kelley has stated that we are likely to see some disruptions to economic
activity because of Year 2000 problems but the effects are likely to be temporary and
quickly reversed. This outcome also seems likely to me. Overseas, the early signs are that
Europe has successfully converted their computer systems to the euro, but there were some
periods early in the transition when the settlement of some cross-border transactions in
Europe did experience end-of-day glitches. It is now important for senior management of
major European institutions to turn their attention to preparations for the Year 2000. Asian
financial and other business firms, too, should focus energy on preparing for Year 2000 even
as they are restoring fundamental financial soundness. Indeed, the events of the last eighteen
months have probably distracted their attention from this problem. It is in everyone's interest
that we not become complacent as we enter this last twelve months before the start of the

new millennium.
The Federal Reserve has an important role to play in our economy. However, our role in the
economy should be kept in perspective. We control just a few of the levers that drive the
economy. We observe consumption, investment and labor market decisions and try to adjust
monetary policy to the signals that we receive so that our nation's economic welfare is not
threatened by inflation or by growth that is below the economy's potential. However, it is the
decisions and actions that you take as consumers and business managers that ultimately
determine the health of the United States economy. Despite difficult periods, 1998 turned
out to be a very good year because of a mix of private action and economic policy. I hope
that 1999 will be as good to us all.

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