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Ohio State Uni.versity, Colmn"b\.ls, Ohio
Distinguished Lecture Series
March 2, 1972 - Willis J. Winn
SOME RANDOM THOUGHTS ON CENTRAL BANKING:
THE ART AND SCIENCE OF MONETARY POLICY L.~ TRAI';SITION
It is a genuine pleasure to be here this afternoon to participate in
the University's Distinguished Lecture Series on Banking and Monetary
Policy.
1viy associates in this Series certa:.nly provide any measure of
humility I might need.
As a former Dean and now as a participant in the
monetary pdlicy p!"ocess, I am painfully aware of the explosion of economic
knowledge over the last several years, although I have to admit there is a
considerable portion of it that I have difficulty reading; some that I
have read, but have difficulty understanding; and much of which I haven't
even attenlpted.
The real coro..fidence I have is the feeling that I approach
my topic froUl a position of studied igno::tance and it's been m.ore than a bit'
presumptuous of r.n.e to accept this assignUlent.
In addition, myacadernic
'c."
interests over the years \-vere focused prilnarily on the capital market
area, and my strong biases will undoubtedly show through this afternoon,
After having served 10 years as a Director and Chairman of the
Federal Reserve Ba!lk of Philadelphia and being reasonably familiar with
the Systeln, I'd like to share the general obeen-ation that there is considerably more to the job of being President of a Federal Reserve Bank than
form.ulation of Ulonetary policy.
·of paper, problerns1 and ideas.
I find myself literally drowned in the flow
In my varied role, I range tro!n the
conscience of the conlUlunity to Rotary Club entertainer, while eJso dealing
with 1,400 incli.viduals all with
hur{l~"'1.
cares
~"'1.d
concerns.
As a
-2-
corporation executive, I face nearly 500 stockholders with their individual
problems.
frightening.
Sometimes my problems a.re humorous and sOI'r"$times
For example, I was recently called upon in the middle of the
night to arrange bail, because a stranger heard the Bank is a public
institution with a legal staffo
My first ~eaction to the System was that its complex makeup bears
a great deal of resemblance to a University structure o Consequently, I
felt right at home.
The seven member Board of Governors in Washington
acts much like a central administrative authority in a University, and the
12 banks and their 24 branches are scattered much like individual schools, each
with its own strivings for independence and autonomy.
The Open Market
Cornrnittee is, of course, a major vehicle for developing !!wnetary policy.
The seven Governors and 12 Presidents are talented individuals..,extremely well qualifiecl--and they generate both ideas and sometimes
confusion.
In many respects it seems a little like being back at faculty
meetings.
Some come in with predetermined positions; some come ready
to vote depending on the persuasiveness of the arguments presented.
all committees the differences often dissolve at the voting stage.
differences that
Like
The
you will observe from time to time, however, may not
mean what they seem--m.embers vote against a recommended action because a move did not go far enough, not that they were opposed to the
nature of the action.
After my hectic first six months .on .the inside, I appreciate this
opportunity to step back and take a look at the econornic framework and
-3-
linkages through which stabilization policy, particularly monetary policy
operates.
Specifically lId like to sketch some random thoughts on central
banking • . Obviously, Pm the first to recognize that these conclusions may
be significantly different in another six months.
Overall, though, central banking is exciting.
must keep abreast of changing time s.
.
Operationally, we
In fact, we must do more than keep
.
abreast, we must anticipate and initiate change.
daily operations and in our policy activities.
This applie s both in our
For example, a program of
computer entry for Treasury securities is eliminating an enormous volume
of paper storage and handling to permit more efficient Fiscal Agent and
bank service operations.
In a broader context, we are in the process of
establishing regional check processing centers--possibJy including On<:>
here in Colurrlbus--that will allow one-day clearing of almost all checks
written in the United States.
These changes in the payments mechanism
are one more step in the evolution toward electronic money flows--science
fiction is becoming reality.
In a different area, decisions made in
regulating and supervising member banks have a major influence on nlarket
structure and the future character of the banking business.
But my major concern this afternoon
.
is with monetary policy.
A
simple statement of the complex problem I want to consider is: How can
the central bank decide what policy actions to take?
One of the complexities
involved in this question is a pluralism in our concept of the national
economic policy goals of a central bank.
On the one hand, the central bank
-4-
is thought of as a. conservator of orderly markets--meaning financial
markets in which prices and quantities are tolerably stable and dependable
in the short- run.
On the other hand, the central bank is
though~
of as the
implementor of broader national economic policies seeking price stability,
economic growth, full employment, balance of payments equilibrium, etc.
These two major roles rarely conflict in the long run, but much of the art
of. central b~nking lies in arranging a comfortable combination of the two
in the short run.
As you are painfully aware, the desired levels of these
broader economic variables are not always mutually consistent,and trying
to bring them into a common focus can produce a bad case of schizophrenia.
A second related complexity involves the mix of judgment and rule, or
art and science, or horse sense and quantification, or perhaps just p,ne.
luck used in policy decision making.
As the science of economics has
progressed, so the art and SClence of central banking have
These two themes--the plural objectives of central banking
changed~
and the
transition and the current status of central bank decision making--are the
focus of my remarks today.
The multiple role of central banking in the United States c an be
traced historically from the century preceding creation of the Federal
Reserve System through the evolution of the Federal Reserve to ita current
position.
During the 19th century, the gold standard mechanism.
represented an automaticinstrUlnent, which may be thought of as the historical
counterpart of modern Federal Reserve Open Market operations.
Gold
-5-
flows had a domir-ant influence on the stock of high- powered money
and
thereby influenced national economic condi tions, but the flows were conditioned .b y market forces and the happenstance of mineral discoveries
rather than by any focus on national goals.
Moreover, it was left to the
several states to address the problem of creating and rnaintaining orderly
financial markets.
.
After the demise of the 1st and 2nd banks of the United
.
States, and even after the National · Banking Act, the only available tool
was the Treasury's manipulation of its cash balance, which was largely
ineffective in preserving orderly financial markets during periods of cash
shortages and stringency.
After the panic of 1907, concern for financial and economic stability
led to establishmer-t of the Federal Reserve.
The Systcm was designed
to prevent financial panics and economic instability by establishing a
discount luechanism that would provide an elastic supply of currency in
response to seasonal or erratic needs.
That is, the founding of the Federal
Reserve gave the country a dependable lender-of-Iast-resort, prepared
to lend at the discount rate.
The level at which this rate was set was the
Fed's principal policy instrument.
During the early years of the Federal
Reserve and the latter years of the gold standard, the price at which the
Fed would lend--the discount rate--was based primarily on international
considerations, especially on the flow of gold into and out of the country.
However, the collapse of the gold standard system during and after World
War I soon made gold flows irrelevant as a guide to policy action.
The
-6theory behind this approach proved faulty on other scores, as you well
know.
By 1923, the Federal Reserve recognized the necessity for replacement of this gold standard approach to policy determination, by then the
tools included both the level of the discount rate and newly developed Open
Market operations.
As evidenced in the System's Tenth Annual Report, the new
basis was that policy be set with the aim of influencing national economic
conditions.
Admittedly, Fed policy statements were strongly influenced
by the "Real Bills Doctrine" during this period, but the point I wish to
make is that policy was to be set on the basis of economic conditions. It was presumed the result would be best if the Fed monitored information from all sectors
of the economy and then responded on the basis of the collective judgment
of the policy maker s.
The possibility of conflict between preserving order in particular
fin~ncial
markets (the original aim of the Federal Reserve) and pursuing
other national economic goals--in particular, an adequate rate of growth
of output--became a painful reality in the latter years of the 1920's.
The
System. was caught on the horns of the dilemma of restraint to dampen
speculation in the stock market and stimulus to counteract sluggish
business conditions.
needs no comment.
The outcome for the stock market and for the economy
One result of the experience was the later legislation
adding margin requirements to the tool kit of the System.
In passing, , let
me add that other regulatory changes have occurred that affect less visible,
-7-
but still important, goals of the System.
For example, Regulation Q and
the extension of reserve requirements to a broader class of liabilities
have equity implications for banks and other financial institutions.
As a
result of the accumulation of regulatory devices since 1913, the Federal
Reserve is now in a slightly better position to pursue multiple objectives
because it can match tools and goals slightly better than it could by relying
on any single mechanism.
However, some of the additional regulations
may in fact be neutralizing, leading to demands for their elimination and
a return to simplicity.
The depression era, between 1931 and 1941, was one that at least
superficially would seem to have caused the System little difficulty in
jointly pursuing the objectives of orderly marketsand other national
economic goals.
Perhaps we can be criticized for our lack of aggressive-
ness in this period.
However, by 1937 it appeared--probably mistakenly--
that disorder had a new guise, in the form of sloppy markets - - specifically,
too many excess reserves in the banking system.
Raising reserve require-
ments was the obvious way to remove the problem, and this was probably
a contributing factor in the ensuing recession of 1937-1938.
During and after World War II, the Treasury's concern for floating
debt at low cost was the basis for a ten-year period when the Federal
Reserve temporarily forsook any continuing concern for other national goals
and concentrated almost exclusively on maintaining stable price s and yields
on U. S. Government Securities.
With the exception of minor adjustments
-8-
in the support prices at which the System operated in the market, it was
not until the "Accord" in 1951 that the Federal Reserve once more could
actively pursue other national economic goals--as by then set forth in the
Employment Act of 1946--with only an over-the-shoulder glance to assure
itself that there were no disorderly market conditions to be corrected.
Since 1952, the Federal Re serve has continued to pur sue a shifting
combination of goals by a qualitative, judgmental decision process that has
brought movements toward ease or reEitraint as dictated by whatever goals
were being pur sued.
Now, twenty years after the "Accord", the debate
over an appropriate decision-making process still continues, both within
the central bank
and between central bankers and academicians.
However,
the debate has taken on a new aspect within the last decade; and I would now
like to explore this new aspect in SOlne detail •
.
Until the 1960 1 s, the central bank had to use a marginalist decision
process such as I have just alluded to, a process of Illeading against
the wind."
That is, if conditions called for stimulus, the System would
o
ease incrementally, wait, and see whether conditions were responding; if
conditions were not judged to be responding adequately, it could then ease
some more, if the behavior of related variables allowed further ease.
But
experience was beginning to point up the problem that the winds might be
blowing in several different directions more or less simultaneously.
Now,
however, as a result of an outpouring of imaginative quantitative macro
economic research, the System is being urged to adopt a fundam.entally
-9different approach to decision making.
Instead of moving incrementally
"against the wind" - -and tornadoes require rapid shifts in position- -until
the wind dies down and goals are achieved (or overshot), the System is
urged to estimate the size of policy action required to get the economy
back on 'track'
and to move straightaway to take that action.
Instead of
deciding the direction in which incrernental policy steps should be taken,
the System is urged to decide on the direction and Sluantity of action to
achieve national economic goals.
This urging is not the same as that of the proponents of a simple
"rule".
A "rule" is the antithesis of discretionary policy
and requires
a conviction that the economy would be more stable if policy were stable
than if discretionary policy atterrJ.pted to offset instauility in uGler secturs,
The more recent development does not envision abandoning discretionary
policy, but substitutes a quantitative decision rule for the traditional
marginal adjustment process.
This distinction, between a marginal policy decision rule and a
•
quantitative policy decision rule, is perhaps less clear-cut than my simplified statement of it implies, primarily because the adjustrnent of financial
and real business conditions to policy actions is not instantaneous, nor does
it operate through mechanical1inkages.
This is one reason why policy
sometimes seems to have a tendency to "over shoot" cyclical turning points;
by the time the turning point is recognized, a change in direction of policy
is overdue--perhaps long overdue.
Estilnates of the length
-10of lag in the impact of monetary policy are crucial if timing of policy is
to be improved.
The econometric models that have been developed to
provide such estimates for a marginal decision process may be the same
models one would use· to estimate the quantity of policy actions needed
under a quantitative decision rule o
In addition, given that the effects of
policy lag behind policy actions, there can be no guarantee that a marginal
policy decision process will adjust in large enough increments to catch up
with or modify rapidly changing economic conditions.
For example, in a
situation of rapid economic expansion, marginal upward adjustments in
the rate of growth of money and credit may be smaller than required to
accommodate the expcUlsion, and prematurely constrain the growth
of income and output.
Sonle quantitative estim.ate of policy action is
.
required to avoid this problem; therefore, an inte1Hgent marginal
decision process must rely on econometric models.
However, a useful distinction can still be made between a marginal
decision process that.employs human judgment, inform.ed by models, and
a quantitative decision process that employs
by some human judgment.
models, perhaps informed
The thrust of much of the criticism of centr?.!
banking--especially in the United States--suggests that the central bank
should adopt some quantitative indicator--such as a measure of interest
rates,
bank reserves, or some other aggregate--and that policy action
be designed to achieve the value of the adopted indicator because an econometric model sho",.. s that a particular goal variable can thereby be achieved--
-11frequently, the rate of growth of output.
This does not seem to me to be
an appropriate policy decision process--not because it is impossible to
implement, but because it is inappropriate, for reasons I will spell out
in some detail.
How could the central bank implement an explicit quantitative decision
rule?
The modern theory of
lI
policy sci ence ll provides a useful guide that,
with some heroic computational work, might be illustrated in the following
steps:
First, so we are told, we must specify our goals.
Second, we must estimate our model.
Third, we must solve the model for the values of instruments
required to achieve our goals, subject to constraL'1.ts en the values of instruments and certain other econOlnic variables such as an orclerly market
range for rates of change in interest rates.
My point is that in attempting to follow this prescription, we
encounter critical unresolved problems in the process.
we seek?
use?
What instruments should we employ?
What constraints should we impose?
What goals should
What models should we
These problems form the basis
of the reasons why I feel we cannot adopt a mechanical quantitative policy
making process.
Let's consider them one-at-a-time.
Goal Specification.
Our first problem is that some goals conflict
and some are complementary.
Occasionally it may be possible to achieve
conflicting goals by using policy instruments with differential iInpacts --
....
-12-
margin requirements tnight have been a valuable weapon in the late 1920 1 s -but, in general, monetary policy is a single policy weapon that cannot achieve
conflicting goals.
Hard choices or painful compromises must be made among ·
conflicting goals requiring sensitivity to the national mood.
conflicting goals change over time.
Trade-offs among
For example, as economic conditions
change, financial market participants may react differently to policy actions
in the short-run; as fiscal or exchange rate policies change, the economy
will respond differently to monetary policy actions.
There would be an enormous research and cqmputational burden involved
in estimating, and re-estimating every few weeks, the trade-offs among
goals, among constraints and goals, among instruments, and I suppose, among
models.
cation of relationships
and UnifOrlTI treatment of diverse events and conditi::ms.
We do not know precisely who is helped and hurt by policy actions; what real
and financial markets will respond, with what lag, to policy action.
Given
what we do know, as represented by our data collecting and econometric
abilities, we cannot foresee events in sufficient detail to ignore impressions
and judgments, unstructured reports and "feel" of current events for me to
trust a quantitative decision process, simple or complex, exclusively.
ever, Ido not wish to overemphasize this aspect of the complexity.
How-
Within
the Federal Reserve System extensive policy simulation with econolnetric
models takes place, and more will take place as time goes on.
In addition,
the wealth of competing models, goals, instruments, and constraints suggests the
-13
fertility of this whole field for research by at:::ademic economists as well as
by the central banking staff.
I would hope that some of those in the audience
will continue to join us in investigating how policy d.ecisions should be made.
Model Estimation.
The first problem here is that there are competing
models from which we are unable to choose.
There is probably broad
agr eement in theory about the policy proces s:
The instrmnents of policy--
Open Market operations, discount rate changes, etc. --influence a broad
range of intermediate financial variables--interest rates, money supply,
other credit aggregates--and these in turn are
of policy--unemployrn.ent, prices, etc.
rel~ted
to the ultimate goals
However, no model can be declared
objectively !fright", because reality is incapable of perfect modeling, at least
to date.
Each model, in effect, calls for a different setting of policy instruments
in order to achieve any given goal.
Given the current state of statistical
testing it is impossible unambiguously to choose the best model--that is,
best in terms of its ability to foresee the future--from among a number of
competing models.
Thus, honorable men disagree, simply on the basis of
o
their predilection about the ~ priori structure of models, in their choice of a
model appropriate to the central bank decision process.
some critics urging us to use
~l
Therefore, we find
as a basis for our decisions; others prefer
M2; others prefer interest rates; but none has a monopoly on the truth, and
none has the sole responsibility of making the policy decision.
A second
pl~oblem
here is that we
know ~that
instrument and goal is variable over time.
models include error terms.
the linkage between
In econometric language, the
By definition, one cannot predict the error
-14-
in the forecast of the next
observation~
By experience, we know that there
are errors in forecastjng, so we must make rational decisions--or at
least decisions --under conditions of uncertainty.
Decision making under
conditions of uncertainty requires the policyrnaker to look at more than
one variable--for example, both aggregates and interest rates--in order
to build into a judgmental decision making process some feedback that
p·rovides information about the current
l'
eliability of model forecasts.
In a somewhat different vein, variability in the linkage between
instrurnent and goal arises because models have built-in obsolescence.
The structure of the economy
and the preferences and behavior of individuals,
change over time--not just in an erratic spread around some central tendency,
but with a drift from old patterns to new.
Models estimated on the basis of
historical evidence cannot capture these influences.
For example, inflation
of the magnitude of the past five years is outside the realm of experience
represented by most models of the U. S. economy_.
(Hopefully, the new
input or experience won't be applicable in the future.)
of wage and price controls.
The same is true
Various statistical "ad hoceries" can be
employed to try to adjust model forecasts for these major gaps, but
essentially, human judgment must be relied upon to make policy decisions
in an altered environment.
Beyond these problems of choosing among competing goals and among
competing models Witll uncertain linkages
betwee~
instrument and goal,
there are two further aspects of central bank decision making to be faced.
The first recognizes a
fund~mental
fact of the institutional design of our
-15-
central banlc
The fact is that,in typical American fashion, the Federal
Reserve System embodies people of diverse views and diverse values.
Even though each of us involved in policy decision making may choose
goals, and a rnodel, and an instrument, and constraints, we inevitably
disagree
and, therefor£) must compl"omise our differences.
Just as I do
not wish to overemphasize the research and computational problems
involved in quantifying policy choices - -lest future researchers be
discouraged--so, too, I do not want to underemphasize this point, for
whatever gains may be realized in measuring, modeling, simulating,
and forecasting, this fact--that decisions are made by a group--will
prevent--and rightly so--the implementation of a quantitative decision
rule.
(You can see that I'm basically opposed to technological change and
the introduction of modern techniques if they threaten my position--a familiar
theme ?)
Finally, even if all participants in central ba.nk decision making
could agree on goals, models, and constraints
and could in some agreed
upon way take account of the uncertainties of policy impact, there is a
final matter that requires the exercise of human judgment, essentially
in a subjective non-quantifiable framework.
Monetary policy implementation is a continuous proces s in time.
This is no different from the operation of the gold standard in the 19th
century, when gold was mined and shipped, and therefor e injected as
high-powered money continuously throughout any given year.
Market
intelligence and arbitrager s were able to smooth out the effects of most
-16irregularities in these flows, although the loss of ships at sea was sOITletiITles a shock to the systeITl.
SiITli1ar1y the Federal Reserve operates in the market for securities '
and bank reserves a1ITlost continuously, atteITlpting to offset the seasonal
and irregular shocks to the financial systeITl that, prior to 1913, ITlight
have generated stringencies and panics.
Because of this responsibility
for orderly ITlarkets, the Fed ITlust exercise judgITlent in ITlanipulating
financial ITlarkets in pursuit of other national econom.ic goals, since these
policy actions have the potential for being a ITlajor irregular shock to
financial ITlarkets.
It ITlay be iITlpoS sible to qucmtify the relation between
policy action and ITlarket reaction, at least in the short run.
Most existing
econoITletric ITlodels are not sufficiently disaggr egated on the financial side
even to begin to estimate
t..~e
relevant relations.
I seriously doubt that there
are stable relations to be estiITlated anyway, for short-run financial market
•
psychology--not just in the ITloney ITlarket but in the bond and stock and
foreign exchange ITlarkets- -is an elusive factor.
run that this factor
ha~
It ITlay be true in the long
no significance for real econoITlic activity so long
I
as orderly ITlarkets are ITlaintained.
Nevertheless, sharp swings in ITlarket
opinion have powerful real consequences on the fortunes of participants and
on the long-run efficiency of the financial sector.
Central banker s who
exercise responsibility for orderly ITlarkets ITlust ITlake judgITlents about the
ability of financial ITlarkets to accept policy actions in an orderly way.
No ITlatter how thoroughly convinced one ITlay be about the desirability
of achieving any particular rate of growth of SOITle monetary aggregate,
-17-
or level of interest rates, or other intcrlnediate or ultimate target of
policy, the central bank must move continuously, and in small or large
steps as the conditions of markets here and abroad permit.
otherwise would be irresponsible.
To do this wisely is often described
as the Ilart" of central banking, and requires judgment.
II
To do
Yet an overall
grandmotherlytl concern for orderly markets sacrifices control of
.
.
national economic goals; an overly stern disinterest in orderly markets
may be destructive of the valuable resource of a highly developed financial
system.
The horns of a dilemma--a common problem that
have had to face over a long period of time.
central bankers
@FedFRASER