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Saturday, October 15, 2005

St. Louis Fed President Poole Describes the Fed's Monetary Policy Rule

William Poole, president of the St. Louis Fed, gave a speech today at the Cato Institute. Here are quotes from his remarks after the speech as reported by Bloomberg followed by the speech itself. Poole believes that Fed predictability is an important factor in macroeconomic stabilization. In his speech, he describes in detail the rule the Fed follows in setting monetary policy. He says the rule is too complicated to represent through a simple mathematical equation, but it is still a rule.  His goal in analyzing and describing the Fed's current monetary policy rule is to enhance the transparency and predictability of Fed behavior and in the process promote further macroeconomic stabilization:

Fed Successor Should Keep Predictability, Poole Says, Bloomberg: Federal Reserve Chairman Alan Greenspan's successor should maintain his policy of ''consistent and predictable'' moves in the benchmark U.S. interest rate, St. Louis Fed President William Poole said. ... ''We should be hopeful that consistent and predictable Fed policy is likely to continue into the future.'' ... Poole didn't comment on the near-term outlook for interest rates or the economy. The ''highly predictable'' nature of Fed policy in recent years will ''be seen as one of the hallmarks of the Greenspan era,'' said Poole ... On Sept. 20, the Federal Open Market Committee voted to raise the benchmark U.S. interest rate to 3.75 percent and repeated a statement that suggests the rate will continue to rise at a ''measured'' pace. ... ''In due time, the language is going to change,'' Poole said today ... ''What we want to do is make sure we do not have expectations build'' for inflation, Poole told reporters... ''What we are trying to do is to prevent increases, which we have seen from energy, from passing through'' to core inflation and ''becoming a generalized inflation problem.'' ... ''Policy actions should be unpredictable only in response to events that are themselves unpredictable. The response function itself should be as predictable as possible.'' While the Fed can strive to keep inflation at a certain level when averaged over a period of several years, it would be a ''losing game'' to try to eliminate short-term fluctuations, Poole said ... Going after short-term fluctuations ''may have important side effects on financial markets, and indeed employment and output, that are undesirable,'' he said. ''What you need is a central bank framework that produces a high degree of certainty about the average inflation rate over a span of a couple of years, and then you let the market handle all the short-run stuff.'' Fed actions won't affect the rising prices of natural gas, Poole said. ... ''Monetary policy is not going to be able to help restore natural gas production in the Gulf of Mexico,'' Poole said...

Here's the speech itself.  I cut a bit, then added the graphs to the text to avoid having them on a separate page as in the original, so this post is relatively long.  But for those interested in the nuts and bolts of monetary policy and how to interpret Fed actions, it's worth it.  For example, at a recent meeting several regional banks did not propose increases in the discount rate.  Poole discusses how to interpret such events, how to interpret what's written up in press releases and minutes, what the Fed considers in setting the target federal funds rate, and so on. The footnotes and references are in the original linked document:

The Fed's Monetary Policy Rule, by William Poole, president, St. Louis Fed: ...I’ve chosen a title designed to be provocative, for I suspect that few consider current Federal Reserve policy as characterized by a monetary rule. My logic is this: There is now a large body of evidence, which I’ll review shortly, that Fed policy has been highly predictable over the past decade or so. If the market can predict the Fed’s policy actions, then it must be the case that Fed policy follows a rule, or policy regularity, of some sort. My purpose is to explore the nature of that rule... Before digging into specifics, consider what the “rules versus discretion” debate is about. Advocates of discretion, as I interpret them, are primarily arguing against a formal policy rule, and certainly against a legislated rule. They believe that policy will be more effective if characterized by “discretion.” Discretion surely cannot mean that policy is haphazard, capricious, random or unpredictable. ... My view has evolved over time to this general position: Monetary economists have not yet developed a formal rule that is likely to have better operating properties than the Fed’s current practice. It is highly desirable that policy practice be formalized to the maximum possible extent. ... monetary economists should embark on a program of continuous improvement and enhanced precision of the Fed’s monetary rule. It is possible to say a lot about the systematic characteristics of current Fed practice, even though I do not know how to write down the current practice in an equation. It is in this sense that I’ll be describing the Fed’s policy rule. And given that, as far as I know, there is no other effort to state in one place the main characteristics of the Fed’s policy rule, I’m sure that subsequent work will refine and correct the way I characterize the rule...

Policy Predictability—A Summary of Findings I’ve discussed the predictability of Fed policy decisions on a number of occasions, most recently in a speech on October 4, 2005 entitled, “How Predictable Is Fed Policy?” Let me summarize the main findings. Over the past decade, the FOMC has undertaken a number of steps towards greater transparency that have greatly improved the ability of markets to predict future policy actions. ... As I have noted previously, I believe that the evidence supports the conclusion that these steps towards increased transparency have brought the markets into much better “synch” with FOMC thinking about appropriate policy actions...

Policy Goals ...The dual mandate in the Federal Reserve Act ... provides for goals of maximum ... price stability, and maximum employment. There are two aspects to achieving the employment goal. First, achieving low and stable inflation maximizes economy’s growth potential and, probably, maximizes the sustainable level of employment. Second, the Fed can enhance employment stability through timely adjustments in its policy stance. ... The Fed has gravitated to a specification of the inflation goal stated in terms of the core PCE index. In the FOMC meeting of December 21, 1999, Chairman Greenspan provided a clear statement of the case for focusing on the PCE price index rather than on the CPI.

The reason the PCE deflator is a better indicator in my view is that it incorporates a far more accurate estimate of the weight of housing in total consumer prices than the CPI. The latter is based upon a survey of consumer expenditures, which as we all know very dramatically underestimates the consumption of alcohol and tobacco, just to name a couple of its components. It also depends on people’s recollections of what they spent, and we have much harder evidence of that in the retail sales data, which is where the PCE deflator comes from.(6)

There is evidence that the goal is effectively 1-2 percent annual rate of change, averaged over a “reasonable” period whose precise definition depends on context. ... I regard inflation stability as the primary goal not because it is more important in a welfare sense than maximum employment but because achieving low and stable inflation is prerequisite to achieving employment goals. Inflation stability also enhances, but does not guarantee, financial stability. I take note, but will not further discuss here, the ongoing debate as to whether the inflation goal should be formalized as a particular numerical goal, or range.

Characteristics of the Fed Policy Rule The Fed policy rule has a number of elements that can be identified, and in many cases quantified. I’ll now discuss the most important of these.

The Taylor Rule. Statements and testimony of Chairmen ... and other FOMC participants, supplemented by the transcripts and minutes of FOMC discussions ... clearly indicate that the long-run objective of Federal Reserve monetary policy is to maintain price stability... In the short run, policy actions are undertaken with the intention of alleviating or moderating cyclical fluctuations, as Chairman Greenspan has noted:

… monetary policy does have a role to play over time in guiding aggregate demand into line with the economy’s potential to produce. This may involve providing a counterweight to major, sustained cyclical tendencies in private spending, though we can not be overconfident in our ability to identify such tendencies and to determine exactly the appropriate policy response.(8)

Over 10 years ago, John Taylor (1993) noted that these characteristics of FOMC policy actions could be summarized in a simple expression:

i = p + .5 (p - p*) + .5y + r* = 1.5 (p - p*) + .5y + (r * + p*)

where i is the nominal federal funds rate
p is the inflation rate
p* is the target inflation rate
y is the percentage deviation of real GDP from a target, and
r* is an estimate of the “equilibrium” real federal funds rate.

Under this characterization of the systematic or “rule-like” character of FOMC policy actions, the funds rate is raised [lowered] when actual inflation exceeds [falls short of] the long-run inflation objective and is raised [lowered] when output exceeds [falls short of] a target level. In Taylor’s example, the target for GDP was constructed from a 2.2 percent per annum trend of real GDP starting with the first quarter of 1984. In subsequent analyses this target has been interpreted as a measure of “potential GDP.” When inflation and real GDP are on-target, then the policy setting of the real funds rate is the estimated equilibrium value of the real rate. ... Taylor showed that his equation closely tracked the actual federal funds rate from 1987 through 1992 except around the stock market crash in October 1987. For such a rule to be operational, data on the inflation rate and GDP must be known to the FOMC. In practice, the equation can be specified with lagged data on inflation and GDP. More generally the equation can be written:

where is the previous quarter’s PCE inflation rate measured on a year-over-year basis, yt–1 is the log of the previous quarter’s level of real gross domestic product (GDP), and yPt–1 is the log of potential real GDP as estimated by the Congressional Budget Office. In order to ensure a “nominal anchor” for the economy, the coefficient a must be greater than 1.0.

Figure 1 shows the equation with the Taylor coefficients (a=1.5, b=.5), an assumed equilibrium real rate of interest of 2.0, and an assumed inflation target of 1.5 percent. The solid line shows the actual federal funds rate and the dashed lines the Taylor rule funds rate. The short-dashed line is the rule constructed with the core PCE inflation rate; the dot-dashed line with the PCE inflation rate.(10) The average differences between the two “Taylor Rules” and the actual funds rate over the entire period are 15 and 7 basis points, respectively. However the volatility of each of the two Taylor Rules is much less than that of the actual funds rate.

Figure 2 shows the comparison of the two Taylor Rules with a larger coefficient on the output gap (b=0.8) and a slightly higher assumed equilibrium real rate (r*=2.3 ). With these assumptions the average differences between the two equations and the funds over the entire period are two and minus three basis points, respectively, and the volatility of the two equations better approximates the volatility of the actual funds rate. My purpose here is not to try to find the equation that reveals the policy rule of the Greenspan Fed–as I stated earlier, I do not know how to write down the current practice in an equation, and the FOMC certainly does not view itself as implementing an equation. Rather, the illustrations should be viewed as evidence in support of the proposition that the general contours of FOMC policy actions are broadly predictable.

Policy Asymmetry. Under most circumstances the direction of FOMC policy actions is “biased” in a sense I’ll explain. Policy bias exists because turning points in economic activity–peaks and troughs of business cycles–are infrequent. Changes in economic activity as measured by output and employment are highly persistent. This persistence can be seen in Figure 3, which shows month-to-month changes in nonfarm payroll employment from January 1947 through August 2005. During expansions, employment changes are consistently positive; during recessions consistently negative. Changes opposite to the cyclical direction are rare and generally the consequence of identifiable transitory shocks such as those from strikes and weather disturbances. This pattern of business cycles generates strong autocorrelations in the month-to-month changes in payroll employment as shown in Figure 4.(11) Given such persistence, once it becomes apparent that a cyclic peak likely has occurred the issue is never whether Fed will raise the target funds rate but whether and how much the Fed will cut the target rate. Similarly, once it is apparent that an expansion is underway, the question is not whether Fed will cut the target rate, but the extent and timing of increases.

Data Anomalies. Fed policy responds to incoming information, as it should. Sometimes data ought to be discounted because of anomalous behavior. For example, the FOMC has indicated that it monitors inflation developments as measured by the core rather than the total PCE inflation rate. This approach is appropriate because the impacts on inflation of food and energy prices are largely transitory; the difference between the inflation rate as measured by the total PCE index and as measured by the core PCE index fluctuates around zero.

Another example ... information about real activity sometimes arrives that indicates transitory shocks to aggregate output and employment. An example of such a transitory shock is the strike against General Motors in June and July 1998.(13) Similarly, the September 2005 employment report reflects the impact of Hurricane Katrina. Transitory and anomalous shocks to the data are ordinarily rather easy to identify. ... The principle of looking through aberrations is easy to state but probably impossible to formalize with any precision. We know these shocks when we see them, but could never construct a completely comprehensive list of such shocks ex ante...

Crisis Management. The above rules are suspended when necessary to respond to a financial crisis. The major examples of the Greenspan era are the stock market crash of 1987, the combination of financial market events in late summer and early fall 1998 culminating in the near failure of Long Term Capital Management, crisis avoidance coming up to the century date change at the end of 1999, and the 9/11 terrorist attacks. In each case, the nature of the response was tailored to specific circumstances unique to each event. ... The history of Fed crisis management since World War II is generally a happy one. ... Perhaps just as important, the Fed has not responded to certain events where it was called to do so. Examples would include the New York City financial crisis in 1975 and failure of Drexel, Burnham Lambert in 1990.(14)

Other Regularities in Policy Stance. Since August 1989, the FOMC has adjusted the intended federal rate in multiples of 25 basis points only. After February 1994, when the FOMC first began to announce its policy decision at the conclusion of its meeting, with few exceptions all adjustments have been made at regularly scheduled meetings. ... In general, the Fed can use intermeeting adjustments to respond to special circumstances, such as the rate cut on September 17, 2001 in response to 9/11, or to provide information to the market about a major change in policy thinking or direction, such as the rate cut on April 18, 2001. My own preference is to confine intermeeting adjustments to circumstances in which delaying action to the next meeting would have significant costs...

Issues to be Resolved The rules-versus-discretion debate historically was framed in terms of policy actions. ... Over the past 15 years, as central bankers, including the FOMC, have striven for greater transparency in monetary policy, communication in the form of policy statements has moved to center stage. It is clear that policy statements are just as important as policy actions, at least in the short run, because significant market effects can flow from these statements. We need to face a new question: Can policy statements become predictable? I think the answer in principle is largely in the affirmative...

Two significant elements in FOMC policy statements are the “balance-of-risks” assessment introduced in January 2000 and the “forward-looking” language introduced in August 2003. The balance-of-risks assessment was introduced to replace the long-standing “bias” statement in the Directive to the Open Market Desk. Historically, the bias statement had referred to the intermeeting period and was not even made public in timely fashion until May 1999. ... a consensus emerged among FOMC participants that the bias formulation did not provide a clear public communication. The balance-of-risks statement attempted to provide insight into the major policy concerns of FOMC members over the “foreseeable future.”... Beginning in August 2003, the FOMC added “forward-looking” language to the press statement. ... In May 2004 the Committee indicated that it “believes that policy accommodation can be removed at a pace that is likely to be measured.” At its following meeting, the FOMC raised the federal funds rate target by 25 basis points. The Committee then raised the target rate by 25 basis points through all its subsequent meetings to this writing... At a minimum, the FOMC can and should aspire to policy statements that are clear and do not themselves create uncertainty and ambiguity. ... In interpreting the FOMC’s policy statements, it is important that each statement be read against previous ones. Changes in the wording are critical to understanding the perspective of the FOMC members about future policy actions.

Rule Enforcement Obviously, there exists no legal enforcement mechanism of the current rule. Nevertheless, there are certainly incentives for the Fed chairman to follow the rule, or work to define improvements. The most powerful incentives arise from market reactions to Fed policy actions. ... It is not in the Fed’s interest to confuse or whipsaw markets, and for this reason market reactions provide an incentive for the Fed to conduct policy in a predictable fashion... Although market responses are the most important disciplining force, FOMC members other than the chairman also provide input, ... Reserve Bank directors weigh in through discount rate decisions. Since 1994, except in unusual circumstances, the FOMC has not changed the intended fed funds rate unless several Reserve Banks have proposed corresponding discount rate changes.(16) ... public opinion can play an important role in enforcing extra-legal rules, as well.

A Summing Up Federal Reserve policy has become highly predictable in recent years, and in the future this predictability will, I am sure, be seen as one of the hallmarks of the Greenspan era. Little has been institutionalized, and for this reason the current Federal Reserve policy rule must be regarded as somewhat fragile. Still, future chairmen will want to extend Alan Greenspan’s successful era and therefore it will be in the interest of future Fed chairmen to commit to pursue policy regularities that work well. I do not claim to have accurately identified all aspects of the Fed’s current policy rule. I am tempted to call it the “Greenspan policy rule,” for Alan Greenspan has surely had far more to do with its construction than anyone else. Nevertheless, I believe that most elements of the rule have become part of a general Fed culture... While it is appropriate to refer to the “Greenspan rule,” I believe that FOMC debates and staff contributions have had a lot to do with development of the rule. For this reason, ... we should be hopeful that consistent and predictable Fed policy is likely to continue into the future.

    Posted by on Saturday, October 15, 2005 at 12:24 AM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (2)


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