Alan Greenspan opened the conference in Jackson Hole, Wyoming with remarks reviewing how monetary policy has changed since the Fed’s inception, and more particularly, changes over the last eighteen years. Most of his remarks are retrospective, but there are notable passages. First, Greenspan went further down the path of acknowledging that the Fed must pay attention to and respond to asset price inflation than he has in the past. He also issues a warning we have heard before, that investors may be accepting risk compensation that is too low due to the period of relative stability we have had recently, periods that have historically been followed by periods of high volatility. Here’s the relevant passage:
Reflections on central banking, by Alan Greenspan: …our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. ... Our forecasts and hence policy are becoming increasingly driven by asset price changes. ... Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. … The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. ... Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. ... But what they perceive as newly abundant liquidity can readily disappear. … history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
Greenspan also talked about risk management in the face of model uncertainty, the subject of this recent post:
Despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many critical linkages is far from complete and, in all likelihood, will remain so. Every model, no matter how detailed or how well conceived, designed, and implemented, is a vastly simplified representation of the world ... Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve … risk management. ... The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. ... In effect, we strive to construct a spectrum of forecasts from which, at least conceptually, specific policy action is determined through the tradeoffs implied by a loss-function. In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates. The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. .... Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs.
The last part is consistent with the Cogley and Sargent paper on Fed policy in the face of model uncertainty linked above. On the policy front, Greenspan also discussed, indirectly, the debate over flexible policy versus commitment to an inflation targeting rule such as a Taylor rule. As has been widely noted in the past, Greenspan prefers to retain flexibility:
At various points in time, some analysts have held out hope that a single indicator variable--such as commodity prices, the yield curve, nominal income, and of course, the monetary aggregates--could be used to reliably guide the conduct of monetary policy. If it were the case that an indicator variable or a relatively simple equation could extract the essence of key economic relationships from an exceedingly complex and dynamic real world, then broader issues of economic causality could be set aside, and the tools of policy could be directed at fostering a path for this variable consistent with the attainment of the ultimate policy objective.
He then goes on to explain why the Fed dropped monetary aggregates as policy targets:
M1 was the focus of policy for a brief period in the late 1970s and early 1980s. That episode proved key to breaking the inflation spiral that had developed over the 1970s, but policymakers soon came to question the viability over the longer haul of targeting the monetary aggregates. The relationships of the monetary aggregates to income and prices were eroded significantly over the course of the 1980s and into the early 1990s by financial deregulation, innovation, and globalization. For example, the previously stable relationship of M2 to nominal gross domestic product and the opportunity cost of holding M2 deposits underwent a major structural shift in the early 1990s because of the increasing prevalence of competing forms of intermediation and financial instruments.
He notes the importance of anchored expectations for monetary policy and gives Paul Volcker credit for making substantial progress on this front:
Our appreciation of the importance of expectations has also shaped our increasing transparency about policy actions and their rationale. We have moved toward greater transparency at a "measured pace"… monetary policy itself has been an important contributor to the decline in inflation and inflation expectations over the past quarter-century. Indeed, the Federal Reserve under Paul Volcker's leadership starting in 1979 did the very heavy lifting against inflation. The major contribution of the Federal Reserve to fashioning the events of the past decade or so, I believe, was to recognize that the U.S. and global economies were evolving in profound ways and to calibrate inflation-containing policies to gain most effectively from those changes.
Finally, Greenspan issued two warnings, one about protectionism as a hindrance to the flexibility needed to deal with economic shocks and the other about rising budget deficits:
The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks. If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment.
[Update: The Washington Post has a summary of the paper "Understanding the Greenspan Standard," by Alan S. Blinder and Ricardo Reis of Princeton University. Also, the WSJ reports on Blinder's remarks.]