Philadelphia Fed President Santomero with an Insider's Look at Monetary Policy

This is another (very) long post on monetary policy derived from a speech by Anthony Santomero, president of the Philadelphia Fed, who gives an insider's perspective on monetary policy. Many of you will not be interested in reading this in its entirety, so I will excerpt the part I believe may be of the most interest, his confidence that the transition to a new Fed chair will be smooth, and place it up front. For those who do continue reading the remarks describe, much as this speech did several years back, what goes on behind close doors at FOMC meetings. In addition, it describes some of the challenges facing monetary policy that will be inherited by Alan Greenspan's replacement. However, even though there are challenges, Santomero is confident that the transition to a new chair will proceed smoothly.  Here's that part of the speech:

I am confident that the passing of the torch from Chairman Greenspan to his successor will be smooth and seamless. For one thing, while processes may change, the Fed’s mission will not. Our dual mandate of fostering full employment and a stable price environment remains firmly in place. For another, ... In addition to the Chairman, the policy process also includes the other six members of the Board of Governors and the 12 Reserve Bank Presidents. All ... participate in the discussions, and contribute... The result is a dynamic mix of keen insight and intellect, of economic analysis and interpretation, and of stewardship and policymaking from some of the best economic minds in our nation. ... Media reports ... cite widespread concern over large fiscal budget and international trade deficits, ... growing inflationary pressures, and ever-present political uncertainties. They lament the passing of the baton from Alan Greenspan... A leading Wall Street economist recently called him “the world’s most revered central banker” and credited him with “...saving the world from financial collapse.” When I read this quote, I had a strong sense of déjà vu. I remember when Paul Volcker left the Fed. A New York Times article expressed a similar concern, saying: “The markets had incredible confidence in Paul. Investors saw him as the one guy with the knowledge, guts and skill to stop inflation and hold the system together… Indeed, some economists are saying that one reason there is growing fear of an economic catastrophe is that the Reagan administration let Volcker go, replacing him with the less-experienced and less-well-known Alan Greenspan.” In short, despite the challenges posed by any transition, I have no doubt that the Federal Reserve will continue to grow and evolve under its new leadership...

I agree. Now, on to the description of the FOMC policy setting procedure.

There is also a lot in the article on the institutional features of the Fed such as how board members and the chair are chosen, how long they can serve, the history of the FOMC, etc., but that material was cut since this is pretty long already:

The Evolving Role of the FOMC: An Insider’s Perspective on Monetary Policy, Presented by Anthony M. Santomero, President, Federal Reserve Bank of Philadelphia: ...I would like to relate to you what I have learned on my journey from academia to the trenches of policymaking. And, I would like to share with you an insider’s perspective on the inner-workings of the Fed’s monetary policymaking activities as a current voting member of the ... Federal Open Market Committee. I will discuss the actual making of monetary policy, providing a glimpse into what goes on behind closed doors in Washington. Then, I will describe some of the challenges faced by monetary policymakers... In the end, I believe you will share my view that the Federal Reserve and its Federal Open Market Committee have proven to be very effective mechanisms for making sound monetary policy decisions.

The Federal Reserve
Let me begin with the observation that the Federal Reserve is an enigma to many. ...  Ask who in the Fed makes these decisions, or how they decide, and most people will say, “Alan Greenspan decides where interest rates should be. ” But in reality, it is actually a committee decision. Now that I am on the inside, I can ... provide insight on the Fed body that Congress has entrusted to direct monetary policy — the Federal Open Market Committee, or the FOMC...

The Mechanics of the FOMC Currently, the FOMC has eight scheduled meetings per year. ... During scheduled FOMC meetings, we follow a standard agenda. ... Perhaps most important to the meetings and adding immense value to the process is the diverse professional experience of the participants. With backgrounds ranging from banking, to finance, to economic forecasting, to academia, each participant brings his or her own perspective to the issues...  

Let me be more specific. Most meetings are one-day events, running from 9:00 a.m. to about 1:00 p.m.  Although roughly twice a year, we meet for two days ... The policy portion of every meeting begins with a review of recent events in both financial and foreign exchange markets, and a review of the details of open market operations since the last meeting. ... Next, the director of research and statistics at the Board of Governors presents the state of the national economy and the Board staff’s forecast of where the economy is headed. He includes considerable detail ... using our large-scale econometric model of the U.S. This is then supplemented by an overview of the international situation by the head of the international division at the Board of Governors. A thorough exchange of views, with questions and answers, debate and discussion, is all part of the process of sharing views and increasing understanding.

As you can imagine, there is a lot of material here. The forecast is assembled into a book ... often referred to as the Green Book... After the presentation of the staff forecast, the fun really starts. With the exception of the Chairman, each member — that is, six Governors and 12 Presidents — presents his or her views on their local regional economy and the national economy. The Bank Presidents generally provide in-depth and real-time information regarding developments in their own Districts... This discussion provides valuable “tone and feel” information about economic activity throughout the country.  As a regional Bank President, I spend a good deal of my time collecting up-to-date intelligence on current and likely future economic conditions ... around the Third District, as well as my everyday contacts...

Next we move to the most crucial stage of the meeting: the discussion of policy options and a policy action. To focus the discussion, the director of the Division of Monetary Affairs, who is secretary to the Committee, outlines the options before us. ... He is not supposed to second guess the committee or to make a recommendation for a particular policy action, but rather to present a clear and objective case for the range of actions the Committee may wish to consider, offering both the pros and cons surrounding the policy under consideration. Typically, three options are considered, most often centering on should interest rates be moved up, down, or kept the same. This analysis too is sent to the FOMC participants in advance in a second book known as the Blue Book for its traditional blue cover.

At this point the Chairman weighs in. After hearing all the arguments and data and weighing people’s views, he offers his perspective on where the economy is, what the risks are, and what appears to be the appropriate policy going forward. This is followed by a second go-round in which all of the participants react to both the policy options presented and the Chairman’s proposal. At times this can be lively, as the Committee tries to converge on a consensus. It is common for some differences of opinion to remain; yet the decision is most often one that all can support. This is then followed by the formal vote. ... Up until this point we may have decided what to do, but now we must direct the operating parts of the Fed to take action consistent with the policy decision, and we must inform the public of our actions. The first is reasonably straightforward. The System Open Market Desk is instructed to ... cause the fed funds rate to move to the ... target ... Next, the FOMC considers its public announcement. When the Committee votes on the policy action, the press release is discussed at some length. Our goal here is to inform the market of not only what we decided but why...

Before adjourning, the FOMC breaks so that the members of the Board of Governors may convene to vote on requests they have received from Reserve Bank’s boards of directors to bring the discount rate in line with the new fed funds target...

A Period of Transition
...But you may be asking yourself – will this soon change?  As many of you know, Alan Greenspan’s term at the Fed is coming to a close. ... as the Greenspan era draws to a close, we look ahead at the challenges we face under a new Chairman in an increasingly complex economic environment. The new leader of the Fed may have his or her own way of doing things. So, some aspects of the process of policymaking may change as a new Chairman directs both the Board of Governors and the FOMC. Under new leadership, processes and policies are often reviewed and restructured.  This can mean simple things: for example, perhaps a move toward electronic dissemination of documents, or more substantive things, like a move to inflation targeting, which some FOMC members, myself included, support. Nonetheless, I am confident that the passing of the torch from Chairman Greenspan to his successor will be smooth and seamless.  For one thing, while processes may change, the Fed’s mission will not. Our dual mandate of fostering full employment and a stable price environment remains firmly in place. For another, our nation’s central bank is more than one person. In addition to the Chairman, the policy process also includes the other six members of the Board of Governors and the 12 Reserve Bank Presidents. All attend FOMC meetings, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options. The result is a dynamic mix of keen insight and intellect, of economic analysis and interpretation, and of stewardship and policymaking from some of the best economic minds in our nation.

...Media reports endlessly dissect the upcoming transition of leadership at the Fed. They cite widespread concern over large fiscal budget and international trade deficits, as well as concerns over potentially growing inflationary pressures, and ever-present political uncertainties. They lament the passing of the baton from Alan Greenspan, who, during his chairmanship, became one of the most venerated figures in economic history. A leading Wall Street economist recently called him “the world’s most revered central banker” and credited him with “achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. ”

When I read this quote, I had a strong sense of déjà vu. I remember when Paul Volcker left the Fed. A New York Times article expressed a similar concern, saying: “The markets had incredible confidence in Paul. Investors saw him as the one guy with the knowledge, guts and skill to stop inflation and hold the system together… Indeed, some economists are saying that one reason there is growing fear of an economic catastrophe is that the Reagan administration let Volcker go, replacing him with the less-experienced and less-well-known Alan Greenspan. ” In short, despite the challenges posed by any transition, I have no doubt that the Federal Reserve will continue to grow and evolve under its new leadership.

Of course, Chairman Greenspan and the Greenspan era have been special. ... How did he accomplish so much?It should be remembered that Alan Greenspan is first and foremost an extraordinary economist. ... But if Alan Greenspan is an extraordinary economist, he is also an extraordinary leader. He will also be remembered as a consensus builder and a developer of talent. It shows in the strength of the organization and the strong consensus that has been achieved at our monetary policy meetings. Unanimity is the rule, not the exception, in spite of strong voices and difficult circumstances. This is a testament to his leadership and the prognosis for a strong Fed for years to come.

Transparency
Yet, I think that historians will probably remember the Greenspan era most for the changes we have made to the transparency of Fed policymaking over the past decade. This openness has been the defining aspect of recent monetary policy under the current Chairman. The FOMC has been moving in the direction of greater transparency for some time, and its communication with the markets has improved greatly over the past decade. Information about the Fed's policy goals, its assessment of the current economic situation, and its strategic direction are increasingly part of the public record.

The goal of all these steps is to inform markets about where the FOMC sees the economy today and where it thinks the economy is headed in the future. This has proved to be useful information that has improved the markets’ understanding of our view of the economy and offers them insights into the direction of possible future policy actions. All of these actions are steps in the right direction. It is important for the FOMC to be as open as possible. ... And the record shows it. I believe it is fair to say that monetary policy over the past 15 years has dampened economic volatility even while it has maintained the Fed’s commitment to a stable price environment. Notwithstanding the recent recession, the U.S. economy has performed quite well over the past decade or so; I think the Fed deserves at least some of the credit.

Challenges to Monetary Policy
However, although we can take comfort from past FOMC actions, the Committee’s task going forward is not without its share of challenges. I would like to close my formal remarks by taking a few minutes to reflect on the limits and limitations that we continue to face when conducting real-time monetary policy.

However, before I list these on going challenges, let me put them in context. I believe that Fed policy since the Great Inflation has demonstrated both the value of, and the Fed’s commitment to, a stable price environment.  Another thing we have learned — and it has been an expensive lesson — is that the best the Fed can do is cushion the economy. It cannot in and of itself force stronger growth than the economy is capable of delivering. Trying to push an economy beyond its potential may temporarily accelerate growth, but it also creates imbalances and increases inflationary pressures that must be addressed, and so boom leads to bust. So looking ahead, I am confident the Fed will take policy actions consistent with economic fundamentals and keep its focus on long-run objectives. ... The appropriate conduct of real-time monetary policy requires policymakers to gauge how strong or weak the economy is at any moment in time, what its most likely trajectory appears to be, and how that trajectory aligns with its long-run potential. This requires a detailed appraisal of data and, importantly, of real-time data on the current state of the economy. Unfortunately, these data often give very noisy signals of what is really going on, and our ability to affect the economy is limited by a few very real technical factors. So, I will close by listing just a few challenges we face in this regard.

Uncertain Measurement
The first challenge is our limited capacity to precisely measure and forecast economic conditions in an economy as large and complex as ours. Lags in data reports, on-going data revisions, and the imprecision of the large-scale economic models - all of these things significantly limit our ability to use the tools of economic analysis. In other words, we work with data that are released with a lag and subject to revisions. ... Indeed, the data on which we rely in real time can be imprecise enough to distort the tenor of our policy deliberations and the apparent wisdom of alternative policy actions.

Uncertain Policy Lags
The second challenge in contemplating future policy actions is the long and variable lags associated with the impact of our monetary policy actions. It has been estimated that it takes six to 18 months for monetary actions to fully impact the economy. Unfortunately, we never know for certain exactly how long the policy lag will be in any given situation, and waiting to find out is not an option. This is why I argued that the FOMC must focus its efforts on sustaining the expansion and gearing its monetary policy toward long-term growth objectives...

Expectations
A final challenge facing monetary policy relates to the role that expectations play in the U.S. economy. ... the recent past has demonstrated that expectations matter a great deal. As consumers and businesses alter their expectations of the future, their behavior changes. If their views change dramatically, this can cause a significant change in real demand. ... The Fed cannot and should not try to manage public expectations. However, it can help stabilize them by being as transparent as possible in its own decision-making. It also must recognize that variations in expectations can have real economic effects that may warrant response... 

Conclusion
With this I will close. I hope ... you will share my view that the FOMC has proved to be an effective mechanism for making sound monetary policy decisions. Not necessarily perfect, but effective.