FRBSF Economic Letter
2001-13; May 4, 2001
The Science (and Art) of Monetary Policy
During most of the 1990s, the United States experienced exceptionally
good times, and the Federal Reserve received some of the credit for the
booming economy and low inflation. Figure 1
shows the marked decline in the civilian unemployment rate from a peak
of 7.8% in June 1992 to a low of 3.9% in September 2000. In May 1997,
the unemployment rate fell below 5% for the first time since 1973—and
it stayed there for the rest of the decade. Although some were concerned
that inflation would re-ignite because of tight labor markets, instead
it remained in check. In fact, the inflation rate, measured by the Consumer
Price Index (CPI), actually declined through most of the 1990s.
When the more volatile food and energy components of the CPI are removed,
the resulting measure of inflation has remained below 3% since 1993.
The last eighteen months, however, have presented the Federal Reserve
with particularly difficult policy decisions. In the summer of 1999, concerned
that inflation was threatening, the Fed raised its target for the federal
funds interest rate. From a level of 4.74% in May 1999, the funds rate
rose as a result of Fed policy until it peaked at 6.54% in August 2000.
As 2000 drew to a close, increasing signs of economic slowing led the
Fed to cut interest rates, lowering its target for the funds rate twice
in January, once in March, and once in April.
This swing in interest rates, together with some criticism that the Fed
might have raised rates too much in 2000 and not cut them enough in 2001,
raises the question of whether there are any guiding principles that the
Fed has followed, or could have followed, in making its decisions. Are
there rules for designing and implementing good monetary policy that all
economists agree on? Or is policymaking inherently a subjective task,
one that depends critically on combining both good economics and insightful
judgment?
Is monetary policy a science?
A recent article by three leading monetary economists, Rich Clarida,
Jordi Gali, and Mark Gertler, is titled "The Science of Monetary Policy."
The word "science" in the title suggests that economists now have all
the knowledge they need to design and implement good monetary policy.
If that were so, the public's focus on Alan Greenspan as the Chairman
of the Federal Reserve would be misplaced—monetary policy would not depend
on an individual's judgment. Instead, just as sending a rocket to Mars
or building a bridge depends critically on the input from scientists and
engineers, implementing the science of monetary policy would require only
a staff of good economists.
Currently, many economists are in agreement with three basic principles
that form the core of the "scientific" approach to monetary policy. Each
of these principles is designed to guide central bankers.
Principle 1: Focus on the output gap. A huge literature in the
1980s and 1990s showed how excessive inflation can result if a central
bank aims for output objectives that are too ambitious. If, for example,
the central bank engages in expansionary policies in an attempt to keep
output above potential, the net result will only be a higher average rate
of inflation. Well-meaning central banks could find themselves generating
rates of inflation well above what they had wanted without any gains in
long-term output.
Many solutions to this problem have been suggested. The simplest is to
have the central bank adopt a realistic output objective. Specifically,
the central bank should strive to stabilize output around potential output,
sometimes also called full-employment output. This objective is usually
expressed by saying the central bank should stabilize the output gap,
the difference between actual real output and potential. In the words
of economist Lars Svensson, "...there is considerable agreement among
academics and central bankers that the appropriate [monetary policy objective]
both involves stabilizing inflation around an inflation target and stabilizing
the real economy, represented by the output gap" (Svensson 1999).
Principle 2: Follow the Taylor Principle. The second principle
in the "scientific" approach to monetary policy is to follow the Taylor
Principle. This principle states that the central bank's policy interest
rate should be increased more than one for one with increases in the inflation
rate. Named after Stanford University economist John Taylor, the Taylor
Principle ensures that an increase in the inflation rate produces a policy
reaction that increases the real rate of interest—the interest rate corrected
for inflation. The rise in the real interest rate reduces private spending,
slows the economy down, and brings inflation back to the central bank's
inflation target. Conversely, if inflation falls below the central bank's
target, the Taylor Principle calls for a more than one for one cut in
the central bank's policy interest rate. This reduces the real rate of
interest, stimulates private spending, and pushes inflation back to its
target level.
Policies that violate the Taylor Principle can lead to serious problems.
If a rise in inflation is met by a less than one for one increase in the
policy rate, then real interest rates actually fall. This fuels further
economic expansion, pushing inflation even higher. Rather than acting
to bring inflation back down to its target level, such a policy can cause
inflation to spiral out of control.
One way to implement the Taylor Principle is to follow a Taylor Rule,
also named after John Taylor, which specifies exactly how much to change
the federal funds rate in response to changes in inflation and the output
gap.
Principle 3: Be forward-looking. Monetary policy actions affect
the economy with a lag. An interest rate cut may not have its maximum
impact on real output for twelve or even eighteen months, and the effects
on inflation may take longer still. Central banks cannot wait to act until
inflation has increased or the economy has gone into a recession. These
lags mean that central banks must be forward-looking. For example, when
the Fed raised interest rates in 2000, inflation was still quite low,
once the volatile food and energy components were removed. The Fed acted
because it was concerned that inflation would otherwise begin to rise.
One policy framework that satisfies these three principles is inflation
forecast targeting. Under an inflation forecast targeting procedure,
the central bank is concerned with stabilizing inflation at low levels
and with stabilizing the output gap. Because of the lags in policy, the
emphasis is on responding to the central bank's forecast of future inflation.
If the forecast says inflation will rise, the central bank should act
to slow the economy down—it doesn't wait until inflation actually has
increased. Because inflation forecast targeting is based on the three
policy principles, it has gained many adherents among academic and central
bank economists.
Economists have significantly advanced their understanding of the principles
of good monetary policy in recent years. Yet the public clearly believes
that implementing monetary policy is not something that can be delegated
to unknown government economists in Washington. The public believes leadership
matters, and that it matters that Federal Reserve Chairman Alan Greenspan
is in charge of policy. Is there more to achieving good monetary policies
than simply following the economist's scientific principles?
Is monetary policy an art?
Perhaps the public believes Alan Greenspan's leadership matters because
they believe monetary policy is, in part, an art. It requires the fine
touch of a master policymaker, one whose feel for the correct moment to
change interest rates cannot be reduced to a few scientific principles.
But if making policy isn't a science, what exactly is nonscientific about
it? The best way to understand the "art" of policymaking is to revisit
our three policy principles.
How can we focus on the output gap when we don't know what it is?
It's all very well to tell central banks to focus on the output gap,
but how are they supposed to know what the gap is? When major shifts in
productivity growth occur—as happened in the 1970s with the productivity
slowdown and again in the 1990s with the productivity speedup, measuring
the output gap can be difficult. The output gap is the difference between
something we can measure (real GDP) and something we can't (the economy's
potential output level). Trying to determine how new information technologies
would affect productivity growth and whether the growth speedup would
be sustained was a major issue confronting policymakers in the 1990s.
As the economy grew rapidly during the second half of the decade, economists
were uncertain whether real output was rising above potential, in which
case interest rate hikes would be called for, or whether both actual and
potential output were growing more rapidly, leaving the output gap stable.
A similar problem had beset the Fed during the 1970s. Then, the problem
was the productivity slowdown. Some economists have argued that the Fed
failed to recognize at the time that potential was growing more slowly
than before. As a consequence, the Fed interpreted the slowdown in actual
growth as a reflection that output was falling below potential. In fact,
both actual and potential declined relative to their previous trends.
Because the gap had not fallen, policy was too expansionary in the early
1970s, helping to fuel inflation.
Implementing the Taylor Principle. The Taylor Principle calls
for adjusting the policy interest rate more than one for one with changes
in inflation. But how much more? If inflation rises by 1 percentage point,
should the federal funds rate be increased by 1.5 percentage points? 2
percentage points? Or 1.01 percentage points? The Taylor Principle alone
does not offer guidance.
Responding strongly to changes in inflation will help keep inflation
more stable around a low average level, but it also will result in larger
fluctuations in output and employment. A weaker response results in greater
fluctuations in the inflation rate but more stable output and employment.
Hence, there is a trade-off between inflation stability and employment
stability. Making the right trade-off requires good judgment.
The art of forecasting. Implementing inflation forecast targeting
means the central bank has to be able to forecast future economic conditions.
This is not an easy task. Last summer, economic forecasts did not foresee
the growth slowdown that began during the third quarter. The Fed had to
respond quickly in early 2001 as signs of an economic slowdown developed.
Good forecasts are based on good data, good economic models, and
good judgment. Mechanical forecasts based on a few key indicators inevitably
ignore information that might be relevant. While statistical models provide
a baseline for developing economic forecasts, good forecasters always
supplement the models' predictions with judgmental adjustment.
Conclusion
Economists have contributed much to making the design of monetary policy
more scientific. From the articulation of general principles for good
policy to the construction of small models that can be used to simulate
the impacts of alternative policies, recent research by academic and central
bank economists has contributed to our knowledge about monetary policy.
Despite these advances, however, conducting policy is far from routine.
General principles are important, but they're not sufficient—policymakers
also need quantifiable guidance. They need to know whether the current
output gap is +2% or -2%. They need to know whether the funds rate should
be increased by 150 basis points or 200 for every 1 percentage point rise
in inflation. And they need to know how much inflation will rise or fall
over the next six months. This level of guidance is still missing from
the science of monetary policy. The art of conducting policy lies in the
ability to translate the general principles into actual policy decisions.
There is a long tradition of trying to take discretion out of monetary
policy—Milton Friedman's proposal that the Fed should just ensure a constant
annual growth rate for the money supply was an example of a policy designed
to remove the role of the individual policymaker. While economists have
identified broad principles to guide policymakers, making policy is not
a science. Good policy will probably always require good policymakers,
as it requires combining the science of the economist with the art of
the practitioner.
Carl E. Walsh
Professor of Economics, UC Santa Cruz,
and Visiting Scholar, FRBSF
References
Clarida, Richard, Jordi Gali, and Mark Gertler. 1999. "The Science of
Monetary Policy: A New Keynesian Perspective." Journal of Economic
Literature 37 (December) pp. 1,661-1,707.
Svensson, Lars E. O. 1999. "How Should Monetary Policy Be Conducted in
an Era of Price Stability?" In New Challenges for Monetary Policy,
pp. 195-259. Federal Reserve Bank of Kansas City.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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