FRBSF Economic Letter
2000-31; October 13, 2000
Monetary Policy in a New Environment: The U.S. Experience
This Economic Letter is adapted from a presentation by Robert
T. Parry, President and CEO of the Federal Reserve Bank of San Francisco,
to the conference "Recent Developments in Financial Systems and Their
Challenges for Economic Policy" sponsored by the Bank for International
Settlements and The Deutsche Bundesbank September 29, 2000, in Frankfurt,
It's a pleasure to have this opportunity to give you a U.S. perspective
on the challenges of conducting monetary policy in an environment of structural
change. In the U.S., there is, of course, no modern-day parallel to the
historic events in the financial sector here in Europe. The formation
of a monetary union and a multinational central bank poses precedent-setting
challenges for policy. At the same time, the U.S. has seen massive
and rapid changes in its financial sector. I'll argue, however, that while
these changes in the U.S. financial sector have posed challenges,
they have not posed significant problems for the Fed's conduct
of monetary policy for quite some time.
Of course, financial change was a major issue in policy 20 years
ago. At that time, financial deregulation and innovation undermined the
stability of the monetary aggregates, which were a central part of Fed
policymaking. Since that history is probably familiar territory to you,
I plan to review it only briefly. The bottom line is that by the mid-1980s,
we had relegated the monetary aggregates to a minor role. Since then,
the Fed has been able to accommodate ongoing deregulation and respond
to shocks in the financial sector by focusing on adjustments in the federal
More recently, the challenges for the Fed have been on the real
side of the economy--and here I'm referring especially to a technology
shock. While a technology shock that boosts productivity is a wonderful
thing, it also has created uncertainty about the proper course for policy.
As I understand it, productivity growth rates have not yet begun to accelerate
in Europe. However, it would seem to be only a matter of time before the
European Central Bank will face the challenge of responding to a comparable
technology shock. In any event, I'd say that our recent experience makes
a good case study in conducting monetary policy in the face of great uncertainty--an
issue of importance to any central bank.
Let me start with a brief look at the history of our experience with
financial change. In the late 1970s, the buildup of U.S. inflation pushed
nominal interest rates up against the legal interest rate ceilings on
most bank deposits. As a result, the market began to circumvent the ceilings
by creating new instruments, and pressure began to mount to remove them
altogether. In 1980, the Monetary Control Act did just that by phasing
out the ceilings. Importantly for monetary policy, the act also permitted
banks to pay interest on some checking accounts.
Once deposit interest rates began to vary with market rates, the demands
for M1 and M2--the primary guides to monetary policy--became unstable.
So, by the early 1980s, the Fed had de-emphasized M1. And by the mid-1980s,
M2 had met the same fate. In the 1990s, we continued to establish annual
ranges for these aggregates, as we were required to do by law, but they
played almost no role in our deliberations. The legal requirement to set
ranges expired this year, and in late June we decided to stop setting
This step was taken with some reluctance, because using interest rates
as the main policy tool does pose well-known dangers (see Poole 1970).
But in the absence of reliable monetary aggregates, the Fed has operated
reasonably well in an environment of significant ongoing financial deregulation
and sizable financial shocks.
Let me give you some examples. In terms of deregulation, barriers to
interstate banking were eliminated, and recently a new financial modernization
law allowed depositories to expand into activities like insurance and
investment banking. In terms of shocks, we dealt first with the so-called
credit crunch in the late 1980s--which was due in part to the collapse
of many savings and loans--then with the turmoil set off by the Asian
currency crisis in 1997-1998, and finally with the unexpected run-up
in equity values in the second half of the 1990s.
During this period, the Fed has looked at a large number of economic
and financial indicators in an attempt to control inflation and smooth
the business cycle. And, as I said, the Fed responded reasonably well
to these events with fairly modest changes in its interest rate settings.
Many among you are in a much better position than I am to know how much
the U.S. experience applies to Europe. I do want to mention, however,
that an economist at our Bank, Glenn Rudebusch, recently did some research
with Lars Svensson (Rudebusch and Svensson 2000) that questions the usefulness
of monetary targeting in Europe.
Now let me turn to the challenges for U.S. monetary policy over the past
five years or so. As I mentioned, these have been primarily on the real
side of the economy. And while the developments in the U.S. economy have
been quite favorable, they've also been unanticipated, which has added
substantially to the uncertainty we face as policymakers. The current
economic expansion is now in its tenth year. It has lasted longer than
any other in U.S. history, and it has been remarkably strong. Real GDP
growth averaged 4-1/2 percent over the past four years and 6 percent over
the past four quarters! The unemployment rate continues to hover around
4 percent, near its lowest level in thirty years. And core consumer inflation
has averaged between 1-3/4 and 2-1/2 percent over the past four quarters,
depending on the measure used. Finally, U.S. productivity has been truly
remarkable. After averaging about 1-1/2 percent from the 1970s to about
the mid-1990s, productivity growth has increased sharply. Over the past
year and a half, it averaged around 4 percent!
These developments have raised challenges for the Fed in conducting monetary
policy because there's more than one plausible explanation for what's
been driving economic events. One obvious explanation for the combination
of strong output and low inflation is that there has been a surge in aggregate
supply due to technological change. Supporting this view is the fact that
firms have been investing heavily in information processing equipment
and software. For example, annualized growth rates in real investment
for this category have ranged from 15 to 30 percent over the past five
years. And there's certainly no shortage of examples of technological
developments that have improved efficiency.
At the same time, it's also likely that events have been driven by a
strong demand shock--in part because of the incredible gains in the stock
market over the last few years that may have generated a large wealth
effect. In the U.S., consumer spending has advanced at a phenomenal pace,
and, as a consequence, the personal saving rate is at a record low. Add
strong business investment to this, and we have total private domestic
spending that has been large enough to produce a strong economy, even
while fiscal surpluses and a growing trade deficit have put a drag on
demand for domestic product. Normally, a demand shock risks igniting inflation.
But some important developments besides the technology shock held prices
in check. First, import prices were held down by a strong dollar and by
weakness in some of our trading partners. In addition, from late 1997
through early 1999, oil prices were falling.
Even though there's uncertainty about which of the two shocks has been
dominating, we do know with more certainty that interest rates
would have had to rise sooner or later in either case. If we were dealing
mainly with excess demand, of course, the reason for tightening is obvious.
But even if we were dealing mainly with a technology shock, the Fed still
would have had to raise the federal funds rate eventually.
I would point to three reasons for eventually raising the policy rate
in response to a technology shock. The first reason has to do with the
effect of higher productivity growth on equilibrium real interest rates.
Since higher productivity growth raises the rate of return on investment,
it also raises the level of equilibrium real interest rates. Thus, just
to maintain the stance of policy, interest rates would have to rise. In
simple models, there is a one-to-one relationship between the increase
in trend productivity growth and the increase in the equilibrium real
interest rate. Of course, things are not usually this simple. For
example, in the U.S. economy today, two developments have tended to mitigate
the increase in equilibrium rates. The large federal budget surplus has
increased the supply of national saving, while the rising trade deficit
was matched by an increased supply of capital from abroad. But overall,
it appears that we would have been contributing to an inflationary monetary
policy if we had tried to hold real rates at their old levels.
The other two reasons support an actual tightening of the stance of policy.
Inflation tends to decline initially when productivity accelerates in
response to a technology shock, because increases in labor compensation
tend to lag behind increases in productivity growth. Eventually, though,
the shock wears off, as the rate of productivity growth stops increasing
and wages accelerate to catch up. So a technology shock is a "golden
opportunity"--initially, it gives us lower inflation without a slowdown
in growth or a rise in unemployment. However, to lock in the benefits
and keep inflation at the new lower level, monetary policy would have
to tighten. After all, in the end, inflation is determined by monetary
policy, not by productivity growth.
The final reason has to do with the "permanent income hypothesis."
A technology shock raises the prospect that incomes will continue to be
higher in the future: in other words, permanent income may increase. This
could mean that we will see an increase in spending before the
additional capacity comes on line. In addition, a technology shock also
may give a boost to stock prices by raising expectations about future
corporate profits. As a result, a wealth effect also may stimulate spending
before the economy's capacity to produce has expanded.
To sum up, we know that the funds rate had to increase to contain inflationary
pressures, regardless of whether the economy was being dominated by demand
effects or supply effects. But the uncertainty arises when we have to
decide how much to tighten and when to start. This uncertainty boils down
to the question of where FOMC actions should be along the spectrum of
approaches ranging from strongly pre-emptive--based mainly on forecasts
of future developments--to more cautious--based mainly on emerging data.
Ideally, policy should tend more toward the pre-emptive end of the spectrum
because of the long lags between policy actions and their effects on inflation.
If a central bank reacts early and correctly to an inflationary threat,
it can alter inflation expectations and cut off the rise in inflation
before it gets started. It looks like that's what happened in the U.S.
in 1994. At that time, we were dealing with forecasts of higher inflation
that were based not only on increasingly tight labor markets but also
on low short-term real interest rates. So the Fed responded by raising
interest rates substantially. In that case, inflation didn't take off,
and the economy moved smoothly into the favorable environment we've enjoyed
in recent years.
But when there's a high degree of uncertainty about forecasts as has
been the case in recent years, it could be best to tend toward the more
cautious end of the spectrum--because a somewhat delayed action could
be preferable to running the risk of tightening when it's not warranted.
Therefore, since most forecasts of output and inflation, including my
own, have been off the mark for several years, it has made sense to place
less weight on the forecasts than we normally have in the past. It's true
that we began tightening policy before we saw any upward inflationary
trend. And in that sense we were pre-emptive, in part because we knew
interest rates would have to go up to some extent regardless of whether
a demand shock or a supply shock was dominating. But the tightening phase
started only a little more than a year ago, even though many forecasts
have predicted rising inflation for several years. Moreover, we've been
fairly cautious in raising rates by a total of only 175 basis points.
I'd like to conclude by touching briefly on the issue of central bank
credibility because I believe it's been an enabling factor in our taking
a cautious approach. Over the last twenty years, the Fed has built a reasonably
good reputation for containing inflation. This credibility has allowed
us some flexibility to delay raising interest rates--despite many forecasts
that inflation would soon rise. Without this leeway, we might have faced
a jump in inflation expectations with adverse reactions in financial markets.
Going forward, we intend to maintain our credibility by continuing to
keep inflation under control.
Robert T. Parry
President and Chief Executive Officer
Rudebusch, Glenn D., and Lars E.O. Svensson. 2000. "Eurosystem
Monetary Targeting: Lessons from U.S. Data." Federal Reserve
Bank of San Francisco Working Paper No. 99-13. http://www.frbsf.org/econrsrch/workingp/wp99-13.pdf.
Poole, William. 1970. "Optimal Choice of Monetary Policy Instruments
in a Simple Stochastic Macro Model." Quarterly Journal of Economics
84(2) (May) pp. 197-216.
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