FRBSF Economic Letter
2002-10; April 5, 2002
Inferring Policy Objectives from Policy Actions
There is little doubt that when central banks, including the Federal
Reserve, set interest rates, they do so purposefully, with particular
goals and objectives in mind. But what are these goals and objectives?
And if the Federal Reserve behaves systematically, what is it systematically
responding to? These questions are important. Knowing what the goals of
monetary policy are—and how policymakers trade off different goals
when shocks hit the economy—presumably enables consumers and businesses
to make better economic decisions themselves. This Economic Letter
explores these questions by trying to infer Federal Reserve goals and
objectives from Federal Reserve policy actions.
There are several ways to infer what the goals of monetary policy are.
One approach is to examine Federal Reserve statements and what policymakers
say they are trying to accomplish. A second approach is to use statistical
methods to detect systematic relationships between the federal funds rate
and other macroeconomic variables. If policymakers behave purposefully,
with well-defined preferences for achieving different goals, then it may
be possible to recover these preferences and goals from the empirical
response of the federal funds rate to other macroeconomic variables.
Federal Reserve statements
One way to learn about the Federal Reserve's policy objectives is to
look at the Federal Reserve Act and at the policy statements the Federal
Reserve releases at the time policy decisions are implemented. The Federal
Reserve Act is examined in Judd and Rudebusch (1999); this Economic Letter
will focus on statements issued by the Federal Open Market Committee (FOMC).
Policy statements issued by the FOMC between January 1996 and January
2002 are available and can be downloaded from the Federal Reserve web
site. Between 1996 and 2000, the FOMC released statements only when the
federal funds rate target actually was changed or when the Committee's
view on economic developments underwent a significant change. Since January
2000, it has released statements announcing its stance on policy after
every meeting.
Every post-meeting statement since January 2000 contains the following
phrase, or an almost identical equivalent: "...against the background
of its long-run goals of price stability and sustainable economic growth."
From the standpoint of trying to model policy behavior, these press releases
indicate that the Federal Reserve has two goals—price stability and sustainable
economic growth—both of which are long-run goals. But are these really
two distinct goals? And what is price stability anyway? Before January
2000, the equivalent passage might have read: "...a slightly lower
federal funds rate should now be consistent with keeping inflation low
and sustaining economic growth going forward" (September 29, 1998).
Alan Greenspan, Federal Reserve Chairman, propounded this view in a recent
speech (2001): "price stability is best thought of as an environment
in which inflation is so low and stable over time that it does not materially
enter into the decisions of households and firms." Thus "price
stability" represents something closer to an inflation target than
to a price level target.
As to whether price stability and sustainable economic growth are distinct
goals, we have the following from the press releases: "The experience
of the last several years has reinforced the conviction that low inflation
is essential to realizing the economy's fullest growth potential"
(March 25, 1997). And this: "The Committee, nonetheless, recognizes
that in the current dynamic environment it must be especially alert to
the emergence, or potential emergence, of inflationary forces that could
undermine economic growth" (June 30, 1999). This language suggests
that the two long-run goals are largely one and the same, and that the
key contribution monetary policy can make to achieving sustainable economic
growth is to bring about price stability, or low inflation. Reinforcing
this view, Laurence Meyer, now a former Federal Reserve Governor, notes
(1996): "If it were easy to produce more long-run growth simply by
printing money we would have monetized our way to dramatically higher
living standards a long time ago.... Price stability is therefore the
singular and unique long-run objective for monetary policy."
While these press releases contain useful information, they fall short
from the perspective of trying to model the policy formulation process
formally. One issue floating in the background is whether there are also
shorter-run goals, such as a short-run tradeoff between inflation and
output.
Estimated policy rules
An alternative way to describe U.S. monetary policy is through an estimated
policy reaction function, or policy rule. The idea behind modeling policy
this way is simple. If the Federal Reserve has in mind a long-run goal,
or target, for inflation, then, when inflation departs from that target,
the level at which interest rates are set should reflect this discrepancy.
Of course, the degree to which interest rates respond to the deviation
between inflation and its target value will depend on what other goals
and concerns policymakers have, but the basic idea is insightful.
One of the most popular policy rules in the economics literature is the
Taylor rule. Taylor (1993) showed that the following rule tracks the federal
funds rate between 1987 and 1992 reasonably well: For each percentage
point that inflation is above 2%, the federal funds rate is raised 150
basis points; for each percentage point output is above trend, the federal
funds rate is raised 50 basis points. Building on Taylor's analysis, economists
have used econometric techniques to estimate policy rules for a range
of developed countries. For example, in Clarida, Gali, and Gertler (1998),
their descriptive rule for the U.S., which is estimated over October 1979
and December 1994, has the federal funds rate responding to expected future
inflation, the deviation between output and its trend (the output gap),
and past federal fund rate settings.
But while estimated policy rules are useful for describing how the federal
funds rate changes in relation to macroeconomic factors, they do not establish
whether the variables that the federal funds rate responds to are the
same as the variables that the Federal Reserve views as target variables.
It may be that these variables appear in estimated policy rules not because
they are targeted themselves but simply because they provide information
that is useful for setting policy. Thus the output gap's presence in estimated
rules does not necessarily translate into the Federal Reserve's having
an output gap target. The Federal Reserve may respond to the output gap
when setting interest rates because a positive output gap today can lead
to higher inflation in the future.
Estimating the Fed's goals and objectives
Implicit in the discussion so far is the idea that the Federal Reserve
has a set of goals and objectives in mind that are not necessarily of
equal priority, and that it sets monetary policy to meet these goals and
objectives, given the economic environment it faces. The solution to this
optimization problem—best meeting its goals subject to the economic environment—leads
to a decision rule, which describes how the federal funds rate should
be set given the economic environment. Viewed from this angle, estimated
policy rules implicitly contain information about target values and the
relative importance, or weights, placed on different goals. To extract
information about these target values and relative weights from the data,
it is necessary to formalize the setting of the federal funds rate and
model the Federal Reserve's optimization problem.
The monetary policy literature usually thinks about policy goals and
objectives through a quadratic objective function. In a quadratic objective
function it is the squared deviation between a target variable and its
target value that policymakers are concerned with, and different target
variables are assigned weights reflecting that variable's relative importance.
For example, if inflation and output are targeted in the objective function,
and the relative weight on output is 2, then this means that policymakers
are twice as concerned about deviations in output from target than about
deviations in inflation from target, for a deviation of a given size.
Once a policy objective function for the Federal Reserve is specified,
it is possible (under certain conditions) to work backward from the way
the economy evolves over time to recover the target values and relative
weights that are most likely to have generated the economic outcomes actually
observed.
We can apply this approach to U.S. data using the macroeconomic policy
model presented in Rudebusch and Svensson (1999). This model contains
equations that summarize the evolution of inflation (GDP chain-weighted
price index) and real GDP (relative to trend) over time. The federal funds
rate enters the model through its influence on real GDP. Next, we assume
that the policy objective function is quadratic and that it contains targets
for annual inflation, output, and the change in the federal funds rate.
Including a target for the change in the federal funds rate accommodates
the possibility that the Federal Reserve may smooth interest rates.
Following the approach described in Dennis (2001), the implicit inflation
target over 1982:Q1-2000:Q2 is estimated to have been about 1.4%, and
the relative weights on output and interest rate smoothing in the objective
function are estimated to be approximately 2.2 and 3.4, respectively.
These estimates suggest that the economy's behavior through time is consistent
with the Federal Reserve having a long-run inflation target, while also
dampening the volatility of output relative to trend and the magnitude
of interest rate changes.
Some caveats to these results are in order. To estimate the inflation
target and the relative weights, a quadratic policy objective function
has been assumed. It is sometimes thought, however, that policymakers
are not symmetric in their behavior, and that they may respond to situations
where output is below trend differently from those where output is above
trend. If policymakers do behave asymmetrically, then a procedure that
assumes they behave symmetrically is likely to miss some of the finer
details in the policy formulation process. Similarly, the results above
rely on the Rudebusch-Svensson model for its description of how output
and inflation evolve over time. Using a different model for output and
inflation would likely produce different results. In choosing the model
to use, however, it is important that it fit the data well, for the model
dictates what monetary policy can feasibly achieve.
Conclusions
This Economic Letter has described three complementary approaches
that can be used to uncover information about the Federal Reserve's policy
goals and objectives. These three approaches differ in how much economic
structure they bring to the problem. The first approach is to look at
Federal Reserve policy statements. This approach is relatively straightforward,
but it yields the least information. The second approach is to assume
that the policy-setting process can be summarized in terms of a rule,
and then estimate that rule. Estimated policy rules indicate how monetary
policy responds to macroeconomic fluctuations, but they do not pin down
what the underlying reasons for these policy responses are. The final
approach requires modeling the way the economy evolves over time jointly
with the monetary policy decisionmaking process. While requiring more
economic structure than the two previous approaches, this procedure provides
information about the Federal Reserve's implicit targets and the relative
importance it places on its different goals. Applying the latter approach
to the U.S. over 1982:Q1-2000:Q2, we estimate the implicit inflation target
to be 1.4%, along with substantial weight on output and interest rate
smoothing relative to inflation stabilization.
Richard Dennis
Economist
References
Clarida, R., J. Gali, and M. Gertler. 1998. "Monetary Policy Rules
in Practice: Some International Evidence." European Economic Review
42, pp. 1,033-1,067.
Dennis, R. 2001. "The
Policy Preferences of the U.S. Federal Reserve." Federal Reserve
Bank of San Francisco Working Paper 2001-08 (revised April 2002).
Greenspan, Alan. 2001. "Transparency
in Monetary Policy." Remarks delivered (via videoconference)
to the Economic Policy Conference, Federal Reserve Bank of St. Louis (October
11).
Judd, J., and G. Rudebusch. 1999. "The
Goals of U.S. Monetary Policy." FRBSF Economic Letter
99-04.
Meyer, L. 1996. Remarks
to the National Association of Business Economists 38th Annual Meeting,
Boston, Massachusetts (September 8).
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