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7:00 p.m., E.S.T.
March 7,1990
Please return
A MONETARY POLICY FOR THE 1990s
W. Lee Hoskins, President
Federal Reserve Bank of Cleveland
The Money Marketeers
New Yorf<, New York
March'1,,"1.990
to Mr. Guffey.
A MONETARY POLICY FOR THE 1990s
INTRODUCTION
We live in an age where information is critical. Households and businesses
invest considerable amounts of time and other resources monitoring economic and
business developments. These market participants incorporate their expectations of
the future into their decisions. Expectations, based on accumulated information, are
used to help resources find their highest financial rate of return.
People work hard to form correct and unbiased opinions about future events,
including government policies. "Fedwatching" is a good example of an industry
devoted to processing information about government policy. The value-added by
Fedwatchers shows up in market expectations about the direction of Federal Open
Market Committee (FOMC) policies, affecting financial contracts and spending and
savings decisions throughout the economy. Uncertainty and mistaken expectations
reduce the quality of those decisions and our economic well-being.
How much, when, and what kind of monetary policy information the FOMC
should release has been a controversial issue for some time. The conventional
approach to these questions addresses them in the context of our existing policy
environment. This evening,I would like to contrast this conventional approach with
an alternative one, by asking what information would we want to release and would
you want to receive in an "ideal" monetary policy environment. I hope to convince
you that the opportunities for improving information about poticy are greater from
clarifying the goals of policy than from greater and more timely information about the
-2Present policy process. I also hope to convince you that releasing additional
information about the conduct of current policy would contribute very little to
creating that ideal policy environment.
An ideal monetary policy is simply a credible and predictable commitment to
an appropriate long-term policy goal. I have spent a lot of time recently explaining
why long-term price stability is the optimal goal of monetary policy. By aiming at that
goal, monetary policy can make its greatest contribution to long-term real growth and
stability of the economy. Setting a goal of price stability and committing to
a
timetable for achieving that goal will reduce market uncertainty and allow markets to
allocate resources more productively, today and in the future.
POLICY INFORMATION IN THE CURRENT SETTING
In the 1950s and much of the 7960s, the Federal Reserve seemed to provide
less information than
it does today, but the information provided generally was
adequate because price level stability was the generally expected norm. The inflation
of the 7970s left in its wake a doubt about whether price stability was the basic
objective of monetary policy. Despite the progress we've made, inflation has not been
eliminated and many can legitimately question our commitment to eliminate
it.
Three
decades ago, inflation uncertainty five years out was probably confined to a range of 0
to 3 percent. Today the range is obviously wider, perhaps 0 to 7 percent.
Markets have become more integrated and efficient in processing
information. Information is probably no more important today than in the past, bttt it
certainly is more readily available and processed more efficiently. This has changed
the short-run policy trade-off faced by the Federal Reserve. We have less opportunibv
to buy excess output and employment before the inflationary consequences are
incorporated into prices and long-term interest rates.
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POLICY INFORT\4ATION Monetary policy information comes in two forms:
poliry
actiotts and
policy intentions. Policy actions refer to changes in open market
operations. They might also include discount rate and reserve requirement changes,
but I will restrict my comments this evening to cl'ranges in open market operations.
The FOMC describes these actions as decisions to maintain or change the degree of
reser:ve pressure, a characterization that at present is generally interpreted
in terms of
its effect on the level of the federal funds rate.
Policy intentions, sometimes called the "policy reaction function," refer to
potential future policy actions in response to evolving economic and financial
conditions. Knowledge of policy intentions helps rational agents plan and carry out
their market activities with minimum losses due to surprises.
Monetary poliry intentions are difficult to characterize because the FOMC
has discretion in formulating policy
within the scope of its multiple objectives. The
Federal Reserve Act, the Employment Act of 1.946, and the Humphrey-Hawkins Act
each suggest objectives that might guide FOMC management of monetary policy over
various time horizons. High employment, maximum growth in output, balance of
payments equilibrium, exchange rate stability, and price stability are all cited as
relevant objectives.
The FOMC's semiannual Humphrey-Hawkins report to Congress provides
information about policy intentions for money and credit growth within a 12-to-18
month horizon. The official Committee position--the only one on which an explicit
vote is taken and recorded-is a set of growth ranges, currently for M2 and M3, and for
debt. The report also states the central tendency of FOMC members' expectations
about performance of the economy over the next year or more, althottgh it specifies
-4-
neither the policy assumptions required to produce these outcomes, nor the policy
reactions to be implemented should these outcomes not come to pass.
INFORMATION CONTENT OF THE DIRECTM The domestic policy
directive voted on at each FOMC meeting represents a combination of an immediate
policy action and a statement of intention about how policy should be implemented
through open market operations until the next meeting. Typically, the operative
sentences in the directive communicate the Committee's decision without stating an
explicit funds-rate objective. However, both the direction and the amount of a change
become known almost immediately by the nature of open market operations at the
trading desk as interpreted by many of the people in this room. In effect, you are the
vehicles for timely release of information about FOMC actions, in part because the
policy directive itself is not released for about six weeks.
There was a time when the FOMC quantified its short-run policy intentions
in terms of target paths for money: the FOMC would raise or lower the federal fundb
rate as weekly and monthly money numbers rose or fell relative to the target path.
Flowever, money growth no longer plays this pivotal role in capturing and recording
policy intentions. StiU, vestiges of monetary targeting remain, in the expected
short-run growth rates for M2 and M3, and in a 4O0-basis-point range outside of which
the funds rate would have to trade to trigger another meeting. At present, however,
neither the short-run money growth rates nor the federal funds rate specifications
convey much information about FOMC intentions, as can be seen in the obvious
indifference of the money market to the weekly money supply announcements now,
as compared to L0 or 15 years ago.
FOMC intentions now are captured by the "mights" and "woulds" fotrnd in
the second sentence of the directive. To quote the intention in October, 7989,
-5-
"Taking account of progress toward price stability, the strength of
the business expansion, the behavior of the monetary aggregates, and
developments in foreign exchange and domestic financial markets,
slightly greater reserve restraint might or slightly lesser reserve
restraint would be acceptable in the intermeeting period."
What information is contained in such a statement? Knowing the "mights" and
"woulds" may at least suggest the Committee's predisposition toward raising or
lowering the federal funds rate before the next meeting. But how useful is that
statement? None of the contingencies is defined in terms of an available measure of
conditions in the various sectors of the economy/ making it difficult to know how
much weight to attach to the unemployment rate relative to the change in payroll
employment, for example. Nor are the relative intensities of concern for the five
sectors indicated, so it's hard to know how the Committee
signals in the short
will respond to mixed
run. Nonetheless, in the current setting, this statement
suggests
the likely direction of the next policy action, given the state of affairs suggested by the
emerging internal and external view of the economy.
WHY IS THE COMMITTEE SO,VAGUE ABOUT ITS INTENTIONS?
Vague statements of policy intentions are nothing new. Except for the period
when the FOMC pegged minimum securities prices during and after World War II,
and except for the brief period of explicit M1 targeting that ended in late 1982, the
FOMC always has been vague about its intentions. The typical, but incorrect
explanation for our vagueness is that it confirms a fundamental theory of bureaucratic
behavior: If you can hide your intentions, then no one can evaluate your actions.
The correct explanation, I think, is more ftrndamental: even though each
individual FOMC member may have policy intentions, the FOMC as an
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official body has not specified either its ultimate objectives or its intended reaction to
new information. And, in the context of multiple goals, it is not always clear in
advanbe how the Committee
will respond to new information about the economy, or
how the Committee will decide how fast or slow poticy should move to correct
deviations from those goals.
A rotating committee of 12 people pursuing multiple objectives surely would
be expected to have difficutty trying to reach agreement both on a single,
unambiguous policy intention and on a policy action consistent with that intention. In
effect, the Committee must reach agreement at each meeting on current policy
acceptable to most members with unstated and not necessarily the same policy goals
or reaction functions. Reaching agreement on an immediate, explicit policy action at
each meeting has been the official ground on which the 12 members have reconciled
their individual longer-run intentions until the next meeting.
IMPROVING THE POLICY PROCESS
An ideal monetary policy would produce a credible, predictable commitment
to stabilizing the price level. I
will not repeat my zero-inflation
speech, presenting all
the powerful arguments for stabilizing the price level, for I'm sure you know them.
Inflation wastes resources, and uncertainty about the future rate of inflation wastes
even more resources. It is by avoiding such waste that monetary policy strengthens
real growth and stability of the economy.
The lack of credibility and predictabilify of the policy process is the problem.
The more credible the commitment to the policy goal, the fewer wrong decisions
be made by the markets. The more predictable the policy reaction to unforeseen
economic events, the more limited
will
be the market reaction to tllose events.
will
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Yet, with the disintegration of the monetary aggregates as intermediate policy guitles,
discretionary monetary policy actions may seem especially hard to predict because
policyobjectives are unclear. The existing policy process, with its focus on immediate
policy action, does not provide clear objectives or credibilify.
A LEGISLATED GOAL How could we change the process to reinforce the
credibility of a consistent goal? I think the most secure way would be to give the
FOMC a legislative mandate to meet a consistent, attainable, and unchanging
economic goal. Passage of House foint Resolution 409, introduced by Congressman
Stephen Neal, would provide that crucial reinforcement.
The Neal Resolution simply directs the Federal Reserve to make price
stabilify the primary goal of monetary policy. History gives us little basis for
expecting price stability or even a stable rate of inflation because the FOMC has had
no mandate to produce that result. Giving the FOMC that mandate, knowing that the
FOMC had the intention of stabilizing the inflation rate at zero, would provide one
gigantic piece of policy information to any ratíonal decision maker in any
dollar-denominated market. The System would remain independenÇ it would retain
complete discretion about how to carry out policy. The only change is that Congress
would provide more direction about basic policy objectives.
The Neal Resolution would make the Federal Reserve's legislated jurisdiction
more like that of West Germany's Bundesbank, which is also independent. More than
one goal is specified by law for the Bundesbank, but German law states that the goal
of price stability is to be given highest priority whenever another goal might conflict
with it. This legislated priority is one reason why West Germany's inflation
experience has been more favorable than our own.
The FOMC could deliver lower inflation, too. Of that you shottld have no
doubt! Inflation is a monetary phenomenon, and the FOMC is the sole
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custodian of the quantity of money in the United States. Short-term deviations from
zero inflation may occur, but, one way or another, the FOMC can provide a stable
price environment.
A SELF-IMPOSED GOAL An alternative to legislation is simply for the
FOMC to adopt the price stability goal. As many scholars have urged, the FOMC
might impose a "rule" on itself, tying policy actions to some intermediate target
variable by an agreed-upon formula that should assure achieving price stability.
These days, the most popular candidates for an intermediate policy target seem to be
nominal GNP and M2, either of which is thought capable of producing reasonable
price stability. Another approach would be for the Committee to specify that
achieving the ultimate policy goal is the rule, using discretion in choosing actions to
achieve the goal.
Of course, having today's FOMC adopt an explicit rule tying an instrument
to a goal is not a foolproof way to assure achieving an official policy goal. Credibilify
would have to be earned through predictable actions consistent with the goal, To
adopt an explicit rule, at least a majority of today's FOMC members not only must
agree on an overriding macroeconomic goal, btrt also must renounce some discretion
to pursue other goals. Moreover, tomorrow's FOMC could decide to change the goal
and hence the rule. In the current policy regime, there is no way today's policy choice
can bind tomorrow's. Unless directed by society through specific mandate,
tomorrow's FOMC always has the discretion to change the goal.
CREDIBILITY AND POLICY INFORMATION
The ideal policy would improve the performance of the economy by
achieving price stability with a credible and predictable policy. The ideal information
to accompany that policy requires a credible statement of the goal, preferably
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reinforced by a legislative mandate such as the Neal Resolution, a timeframe in which
the goal
will
be achieved, and explanations of
poliry changes if they occur.
One major benefit of imposing an explicit intention on monetary policy is
that poliry actions in the money market would become far less momentous than they
now are. Currently, detecting a change in the federal funds rate target from the
pattern of open market operations is a crucial activity because those actions, when
detected, provide markets with one of the few clues as to where policy is evolving.
Canvassing individual FOMC members' positions is a way of predicting what policy
will be. Policy actions, when detected, then provide
a test of those predictions of the
direction in which policy is evolving. However, if policy intent were explicit and
credible, finding the clues in open market operations would have less significance,
Unfortunately, talking about the Neal Resolution and rules and self-imposed
price level targets may be whistling in the dark. Suppose no clarification of a basic
poliry objective or intent is forthcoming. Are there ways in which clues about the
evolution of poliry could be made more certain?
Open market operations inevitably involve some mystery about whether an
operation is simply a defensive adjustment of nonborrowed reserves that
will
maintain the level of the federal funds rate, or is an offensive intervention that will
change the level of the funds rate. Memories of Thanksgiving 1989 lead to questions
about whether the FOMC should provide additional information in order clarify the
funds-rate implications of policy. If it is better for the market to be more certain about
the immediate policy objective, perhaps we could provide additional information that
would allow Fedwatchers to replicate reserve management decisions at the trading
desk more accurately.
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I am not sure that there is a good way to provide that additional information.
Inevitably, reserve management involves a healthy dose of judgment--of art, if yotr
will--that is nonreplicable. What I mean is that, even if we were to open the books of
the Fed on a daily or hourly basis, providing the public
with every scrap of clata at our
disposal, judgment about the market factors and other uncertainties that the trading
desk inevitably must confront would still be required. Some uncertainty about the
iutention of policy would remain.
A simpler way to reduce uncertainty might be to treat the federal funds rate
just as we do the discount rate. When the funds rate objective changes, issue a press
release saying so,
with a sentence or two explaining why. Or perhaps the whole
approach to policy implementation through open mârket operations should be
scrapped. Simply have the Desk announce that it stands ready to do RP's at one price
and matched sales at another.
More information about policy actions will help markets operate more
efficiently, but except for those unusual times like last Thanksgiving, the
improvements may not be very large and may carry with them the cost of diverting
attention from the fundamental information problem. More information about
reserve restraint
will not provide more information about the goal of monetary
policy. Ideal poliry and efficient markets need that information, and to produce it,
changes in the current policy process are needed.
CONCLUSION
The ultimate goal of monetary policy must be to provide the credible and
predictable commitment to price stability required for peak performance of our
market economy. Achieving this ideal at the least cost requires that policymakers
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Provide markets with certain basic information that
will minimize trncertainty
abotrt
the commitment and about the timeframe within which it is to be accomplished.
This is in marked contrast to conventional concerns for more certainty abotrt
the current degree of reserve restraint. There are many ways we could reduce
uncertainty about the immediate funds rate implications of policy, just as there are
many time schedules by wlúch we might release the FOMC directive. Being more
certain of the immediate federal funds rate implications of policy might make
Fedwatching a bit easier, but would not do much to help identify policy intentions
beyond the shortest of policy horizons. Releasing the directive early migl'rt provide
a
slightly brighter glimmer of policy intentions, but only for a slightly longer policy
horizon. What is needed is not better information about items in the directive, but
better information about the policy goal for the long run.
More information about policy intentions is where I see the greatest
payof.f..
An explicit FOMC commitment to price stability would allow markets to shift
resources from watching the Federal Reserve to watching the economy for productive
investment opportunities.
@FedFRASER