FRBSF Economic Letter
2004-04; February 6, 2004
U.S. Monetary Policy: An Introduction
Part 4: How does the Fed decide the appropriate setting
for the policy instrument?
This
is the last of four issues
devoted to our updated and
expanded Q&A on monetary
policy: (1) "How is the
Federal Reserve structured?" and "What
are the tools of U.S. monetary
policy?" (2) "What
are the goals of U.S. monetary
policy?" (3) "How
does monetary policy affect
the U.S. economy?" and
(4) "How does the Fed
decide the appropriate setting
for the policy instrument?" The
revised text will appear in
a pamphlet soon.
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The Fed's job of stabilizing output in the short
run and promoting price stability in the long run involves several
steps. First,
the Fed tries to estimate how the economy is doing now and how
it's likely to do in the near term—say, over the next couple of
years or so. Then it compares these estimates to its goals for
the economy and inflation. If there's a gap between the estimates
and the goals, the Fed then has to decide how forcefully and how
swiftly to act to close that gap. Of course, the lags in policy
complicate this process. But so do a host of other things.
What
things complicate the process of determining how the economy is doing?
Even the most up-to-date data on key variables like employment,
growth, productivity, and so on, reflect conditions in the past,
not conditions today; that's why the process of monetary policymaking
has been compared to driving while looking only in the rearview
mirror. So, to get a reasonable estimate of current and near-term
economic conditions, the Fed first tries to figure out what the
most relevant economic developments are; these might be things
like the government's taxing and spending policies, economic developments
abroad, financial conditions at home and abroad, and the use of
new technologies that boost productivity. These developments can
then be incorporated into an economic model to see how the economy
is likely to evolve over time.
Sounds easy—plug the numbers into
the model and get an answer. So what's the problem?
There are lots
of problems. One problem is that models are only approximations—they
can't capture the full complexity of the economy.
Another problem is that, so far, no single model adequately explains
the entire economy—at least, you can't get economists to agree
on a single model; and no single model outperforms others in predicting
future developments in every situation. Another problem is that
the forecast can be off base because of unexpected, even unprecedented,
developments—the September 11 attacks are a case in point. So
in practice, the Fed tries to deal with this uncertainty by using
a variety of models and indicators, as well as informal methods,
to construct a picture of the economy. These informal methods can
include anecdotes and other information collected from all kinds
of sources, such as the Directors of the Federal Reserve Banks,
the Fed's various advisory bodies, and the press.
So now are we
in a position to compare the Fed's estimates with its goals?
Not
so fast. Coming up with operational measures of the goals is harder
than you might think, especially the goal for the rate
of maximum sustainable output growth. Unfortunately, this is not
something
you can go out and measure. So, once again, the Fed has to turn
to some sort of model or indicator to estimate it. And it's hard
to be certain about any estimate, in part because it's hard to
be certain that the model or indicator the estimate is based
on is the right one. There's one more important complication in
estimating
the rate of maximum sustainable growth—it can shift over time!
What
problems does a shift in the rate of maximum sustainable growth cause?
The experience of the late 1990s provides
a good example of the policy problems caused by such a shift. During
this period,
output and productivity surged at the same time that rapid innovation
was transforming the information technology industry. In the
early stages, there was no way for the Fed—or anybody else—to
tell
why output was growing so fast. In other words, the Fed had
to
determine how much of the surge in output was due to unusually
rapid technical progress and whether this implied an increase
in the economy's trend growth rate.
This was a crucial issue
because policy would respond differently depending on exactly why
the economy was growing faster. If
it was largely due to the spread of new technologies that
enhanced worker and capital productivity, implying that the trend
growth
rate was higher, then the economy could expand faster without
creating inflationary pressures. In that case, monetary policy
could stand
pat. But if it was just the economy experiencing a more normal
business cycle expansion, then inflation could heat up. In
that
case, monetary policy would need to tighten up.
The Fed's
job was complicated by the fact that statistical models did not
find sufficient evidence to suggest a change
in the trend
growth rate. But the Fed looked at a variety of indicators,
such as the profit data from firms, as well as at informal
evidence,
such as anecdotes, to conclude that the majority of the evidence
was consistent with an increase in the trend growth rate.
On that basis, the Fed refrained from tightening policy as
much
as it would
have otherwise.
Does the trend growth rate ever fall?
Yes, it does. A good example, with a pretty bad outcome,
was what happened in the early 1970s, a period marked by
a significant
slowdown
in the trend growth rate. A number of economists have argued
that the difficulty in determining that such a slowdown had
actually taken place caused the Fed to adopt an easier monetary
policy
than
it might otherwise have, which in turn contributed to the
substantial acceleration in inflation observed later in the
decade.
What happens when the estimates for growth and inflation
are different from the Fed's goals?
Let's take the case where the forecast is that growth
will be below the goal. That would suggest a need to ease policy.
But
that's
not all. The Fed also must decide two other things: (1) how
strongly to respond to this deviation from the goal and (2)
how quickly
to try to eliminate the gap. Once again, it can use its models
to try to determine the effects of various policy actions.
And, once again, the Fed must deal with the problems associated
with
uncertainty as well as with the measurement problems we have
already discussed.
Uncertainty seems to be a problem at every
stage. How does
the Fed deal with it?
Uncertainty does, indeed, pervade every
part of the monetary policymaking process. There is as yet no set
of policies
and procedures that
policymakers can use to deal with all the situations that
may arise. Instead, policymakers must decide how to proceed
by
going case
by case.
For instance, when policymakers are more uncertain
about their reading of the current state of the economy, they may
react
more gradually to economic developments than they would
otherwise. And because it's hard to come up with unambiguous benchmarks
for the
economy's performance, the Fed may look at more than one
kind of benchmark. For instance, because it's hard to get
a precise
estimate
of the trend growth rate of output, the Fed may look at
the
labor
market to try to figure out where the unemployment rate
is relative to some kind of benchmark or "natural rate," that
is, the rate that would be consistent with price stability.
Alternatively,
it might try to determine whether the stance of policy
is appropriate by comparing the real funds rate to an estimate
of the "equilibrium
interest rate," which can be defined as the real rate
that would be consistent with maximum sustainable output
in the long
run.
These issues are far from settled. Indeed the Fed spends
a great deal of time and effort in researching various
ways to
deal with
different kinds of uncertainty and in trying to figure
out what kind of model or indicator is likely to perform
best
in a given
situation. Since these issues aren't likely to be resolved
anytime soon, the Fed is likely to continue to look at
everything.
Suggested reading
For further discussion of the topics in this
article, see the following issues of the FRBSF Economic Letter.
93-01 "An
Alternative Strategy for Monetary Policy," by
Brian Motley and John Judd.
http://www.frbsf.org/publications/economics/letter/1993/el93-01.pdf
93-38 "Real
Interest Rates," by Bharat Trehan.
http://www.frbsf.org/publications/economics/letter/1993/el93-38.pdf
93-42 "Monetary
Policy and Long-Term Real Interest Rates," by
Timothy Cogley.
http://www.frbsf.org/publications/economics/letter/1993/el93-42.pdf
97-29 "A
New Paradigm?" by Bharat Trehan.
http://www.frbsf.org/econrsrch/wklyltr/el97-29.html
97-35 "NAIRU:
Is It Useful for Monetary Policy?" by John
Judd.
http://www.frbsf.org/econrsrch/wklyltr/el97-35.html
98-28 "The
Natural Rate, NAIRU, and Monetary Policy," by
Carl Walsh.
http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-28.html
98-38 "Describing
Fed Behavior," by John Judd and Glenn
Rudebusch.
http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-38.html
99-21
"Supply
Shocks and the Conduct of Monetary Policy," by
Bharat Trehan.
http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-21.html
99-33 "Risks
in the Economic Outlook" by Robert T. Parry.
http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-33.html
2000-21 "Exploring
the Causes of the Great Inflation," by
Kevin Lansing.
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-21.html
2000-31 "Monetary
Policy in a New Environment: The U.S. Experience" by
Robert T. Parry.
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-31.html
2001-05 "How
Sluggish Is the Fed?" by
Glenn Rudebusch.
http://www.frbsf.org/publications/economics/letter/2001/el2001-05.html
2001-13 "The
Science (and Art) of Monetary Policy" by
Carl Walsh.
http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html
2003-14 "Minding
the Speed Limit" by CarlWalsh.
http://www.frbsf.org/publications/economics/letter/2003/el2003-14.html
2003-32 "The
Natural Rate of Interest" by John Williams.
http://www.frbsf.org/publications/economics/letter/2003/el2003-32.html
2003-34 "Should
the Fed React to the Stock Market?" by
Kevin Lansing.
http://www.frbsf.org/publications/economics/letter/2003/el2003-34.html
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