Richmond Fed President Lacker: Interest Rate Policy After Greenspan

Here's another speech from a Federal Reserve governor or bank president, this time by Jeffrey Lacker, president of the Richmond Fed. By my count, this is the eighth speech this week alone (Pianalto, Kohn, Fisher, Geithner, Santomero, Yellen, Ferguson), and there was also a speech by Greenspan. [Update: There's yet another speech by Atlanta Fed president Guynn - see the update at the end of the post.] The speech does not address the future course of monetary policy except indirectly by indicating that natural real rate of interest may have risen recently for reasons noted below. This implies a higher federal funds rate is needed to remove accommodative policy. He did, as reported by Bloomberg, make these comments after the speech:

''My concern about inflation is distinctly higher now,'' Lacker told reporters ... ''We're facing the prospect now of the possibility of the energy price surge passing into core prices.''

''Core inflation's drifted to the upper end, on a year- over- year basis, of a range that I find comfortable,''

''Inflation expectations have been downgraded from well-contained to contained and I wouldn't like to see a further downgrade,''

What's new here is an extended discussion of interest policy after Greenspan, the title of the talk. A main point of the speech is that it is wrong to view the Greenspan Fed, often noted for its "flexibility," as following discretionary policy:

To identify discretionary policy setting in the Kydland and Prescott sense as the hallmark of the Federal Reserve under Chairman Greenspan is to seriously misconstrue the historical record, in my opinion.

This is important because it establishes credibility for the institution rather than the individual and makes a smooth transition to a new chair more likely. Another point of the speech is that even in a stable inflation environment, monetary policy still needs to be active in responding to factors that change the real interest rate:

Interest Rate Policy After Greenspan, by Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond: Early next year, we will experience an event that happens rarely in the Federal Reserve — the retirement of the Chairman of the Board of Governors. ... At the end of a policymaker’s term in office, it is natural to look back to appraise the conduct of policy during their tenure, and this task is considerably more pleasant when the results have been favorable.

One distinguishing characteristic of Fed policy under Chairman Greenspan that has been identified by some observers is “flexibility,” ... These observers see the flexibility ... as contrasting with adherence to a monetary policy “rule,” or with adoption of a numerical inflation target... This observation calls to mind the economics literature on “rules vs. discretion” in policy-making, ... Kydland and Prescott showed that ... a central bank can achieve better outcomes today by convincing markets that they will avoid inflationary temptations in the future. This is why central banks have come to focus so heavily on inflation expectations... To achieve superior outcomes, however, the central bank’s promise has to be believable, that is to say “credible.” One way to do so is ... to explicitly commit to a formula that determines the target level of the federal funds rate as a simple arithmetic function of a few macroeconomic variables, such as inflation and unemployment. ... But the benefits of policy credibility can be achieved without a mechanical formula, as long as the central bank adheres to a consistent, predictable pattern of behavior that the public understands. The term “rules,” in the sense used by Kydland and Prescott, is best understood in this broader sense... To identify discretionary policy setting in the Kydland and Prescott sense as the hallmark of the Federal Reserve under Chairman Greenspan is to seriously misconstrue the historical record, in my opinion. ... To my mind, building monetary policy credibility has been the true hallmark of the Federal Reserve under Chairman Greenspan’s leadership. ... Communication ... and ... greater transparency serve to enhance the public’s understanding of how the Fed is likely to respond to economic conditions ... in other words, to help the public form expectations consistent with our future behavior.

Now ... let me turn now to talk about the future. .... To facilitate that discussion ... I ... ask you to suppose that the Fed continues its recent success in maintaining stable inflation expectations... how should we conduct interest rate policy in such a world? First, let me remind you that any interest rate ... has three parts. One is simply compensation for ... expected inflation... A second part is a premium to compensate lenders for inflation risk. The remainder is the “real interest rate,”... If the public is convinced that the central bank will not allow inflation to move persistently outside of some low target range, then expected inflation will not move around a lot ... either. ... Does this mean that the Fed would never have to change interest rates if inflation was fully stabilized? The answer is an emphatic, “No.” The reason stems from the fact that ... real interest rates need to fluctuate in a healthy, well-functioning economy. ... A real rate ... represents a relative price — the price of current resources relative to future resources. In a market economy, relative prices will generally fluctuate in response to shifts in demand and supply. For example, ... Two successive hurricanes have caused devastation ... in the last two months. ... Setting aside the energy price increases, ... A disaster like this ... makes current resources scarcer relative to future resources. In addition, the heightened demand for reconstruction resources places further strain on current capacity. For both reasons, one would expect real interest rates ... to be ... higher than otherwise in the short run... The only caveat to this prediction is the possibility of an offsetting reduction in demand. But what would cause such a demand effect? A catastrophic event can certainly affect ... consumer confidence... But consumers and producers also can ... understand, from the history of such events, that the disturbance to economic activity is likely to be relatively short-lived. ...

To take another example from today’s headlines ... oil price increases can be expected to have implications for real interest rates. ... If the increase is expected to be temporary, its effects are analogous to a disaster-induced reduction in productive capacity, making current production more costly relative to future production. An increase in real interest rates is needed ... to reflect the relative scarcity of current and future resources. Energy prices figured prominently in the economic events of the 1970s... The proper lesson from the 1970s is not that energy price shocks induce major recessions; it is that monetary policy that reacts to energy price shocks by accommodating the rise in inflation and then subsequently has to fight inflation can induce major recessions. Thus, sharp energy price increases are not, by themselves, reasons to ease policy... Productivity trends seldom make the headlines, but ... When a sustained increase in productivity comes to be widely recognized by households and firms, the effect is to increase the demand for current resources relative to supply. ... If real interest rates do not change, a step-up in productivity growth would raise current demand by more than current supply. Thus, real interest rates have to rise... All three of my examples thus far have required real interest rates to rise. ...[A]n example in which real interest rates must fall ... is an independent fall in investment spending. This is different from my other examples because a change in investment spending reduces the demand for current resources rather than the supply... I hope I have convinced you that there is more to monetary policy than responding to inflation scares or “emerging inflation pressures.” Real shocks that alter the relative balance of current and future resource utilization will require appropriate adjustments to real interest rates over time...

So, what will interest rate policy look like in an after-Greenspan world ... The Fed will have to constantly monitor the state of the economy, understand the shocks that are affecting the economy’s growth, and form an assessment of the appropriate implications for real interest rates. In other words, not that different from recent Fed policy. It’s important to remember that... models will never be perfect. ... This may be one reason why rule-like policymaking may never take the form of the simple arithmetic formulas that are so handy for research purposes... Is the Federal Reserve in danger of losing its hard-won reputation with the upcoming change in leadership? ... I don’t think so. I anticipate a stable transition ... My confidence in the institutional continuity in the conduct of monetary policy rests in large part on what we have learned from ... the Greenspan era ... [about] expectations and the importance of consistent behavior ...[This is] now widely understood in the central banking and academic worlds...

[Update: There's yet another by Atlanta Fed president Jack Guynn who says policy remains accommodative. Quoting:

That ... suggests ... that we should continue to move toward a neutral setting for monetary policy. The Fed already has moved interest rates a long way toward a more normal level... By most conventional measures, however, policy is still accommodative. ... In evaluating the costs of a potential drop in the rate of output growth or an unwelcome rise in inflation, I believe that a significant acceleration of inflation would be the larger and more troubling outcome in the period ahead.]