Category Archive for: Fed Speeches [Return to Main]

Wednesday, November 16, 2005

Explicit Inflation Targets and Flexibility

Fed Chair nominee Ben Bernanke reaffirmed his support of explicit inflation targets or ranges in today's confirmation hearing and one of the main questions concerning inflation targeting is how it affects flexibility. This is not a new question. Here's former Fed Governor Laurence H. Meyer at the University of California at San Diego Economics Roundtable,  July 17, 2001 with a common view on this topic:

Inflation Targets and Inflation Targeting, by Fed Governor Laurence Meyer: Retaining Flexibility with the Dual Mandate The key issue for me is whether setting an explicit inflation target would reduce the flexibility of policymakers to pursue a dual mandate and select the preferred point along the tradeoff between output and inflation variability. ... Specifically, would implementing an explicit inflation target inevitably also raise the response parameter on the inflation gap relative to that on the output gap? In my view, the answer is that this need not be the case, but I agree that there is some risk of this outcome. It seems to me, however, that it is less likely if the move to an explicit inflation target is taken in the context of a reaffirmation of the dual mandate.

Quoting Bernanke in his opening statement today on implementing explicit inflation targets:

I would propose further action only if a consensus can be developed that taking such a step would further enhance the ability of the FOMC to satisfy its dual mandate of achieving both stable prices and maximum sustainable employment.

Chicago Fed's Moskow: U.S. Economic Outlook

Here's more from the Fed today in addition to the testimony by Bernanke and the speeches by Fed governors Olson and Ferguson. This next speech is from Chicago Fed President Michael H. Moskow. Unlike the other two speeches which do not address current policy, he is fairly specific about his view of the economic outlook and where interest rates are headed in the future. The economic outlook is the standard view heard in recent Fed speeches:

  • GDP is somewhat above potential growth
  • Much of the slack in the economy has been eliminated
  • There are two risks to growth, a slowing of the housing market and high energy prices
    • He is not particularly worried about housing since the effects of a decline are slow allowing time for a policy reversal
    • He is not particularly worried about energy prices either since they've been higher in the past and are showing signs of moderating
  • Inflation is at high end of the comfortable range and inflation expectations are okay for now, but a worry going forward

The bottom line for policy: It will likely entail further removal of accommodation (code for rates are going up), and if expectations of inflation show signs of increasing, a stronger response may be needed. But like other recent speeches, there does seem to be the sense that an end is in sight even if the timing is not yet clear. Note also the key phrase "As we move into 2006 and try to determine whether we have removed enough accommodation..." implies a rate increase in December is fairly certain in his mind:

U.S. Economic Outlook, by Michael H. Moskow, Chicago Fed President: Over the last two years real Gross Domestic Product has been growing an average of 3.7 percent each year. This is somewhat faster than potential, or the rate of GDP growth that can be sustained without creating inflation pressures. ... [M]uch of the slack has been eliminated. The unemployment rate has fallen to 5 percent; ... a level ... roughly consistent with an economy operating at potential. In addition, the capacity utilization rate in manufacturing is only slightly below its historical average. This indicates that there may be some slack remaining in manufacturing, but probably not much. Finally, core inflation has changed little in recent months. Currently we're not seeing the kinds of disinflationary forces that would be associated with a substantial degree of resource slack ...

As we move into 2006 and try to determine whether we have removed enough accommodation, the FOMC will have to answer two critical questions: One, will the economy continue growing near its potential? And, two, will there be persistent pressures on core inflation? ... Abstracting from the effects of the storms, current economic growth appears to be self-sustaining because the underlying economic fundamentals continue to be sound. ... According to the Blue Chip consensus, GDP is expected to grow by 3.5 percent in 2005 and by 3.3 percent in 2006—numbers on the high side of recent estimates for potential. ... While this forecast is good, there certainly are risks. One relates to home prices. ...[M]any analysts warn that housing is overvalued. ... I am starting to hear more anecdotes ... and seeing more reports that home prices are increasing at a slower rate. If housing does prove to be overvalued and home prices fall, residential construction would be adversely affected. But history suggests that the impact on overall consumer spending would be more modest. Moreover, the changes in wealth ... likely would be gradual. ...[I]t seems likely that these gradual aggregate changes would allow time for any appropriate recalibration of policy... But, it's far from certain what will happen to home prices. ...

Another risk to the outlook relates to energy prices. ... Higher energy prices have had some effect on growth in the U.S., but to date, it's been relatively modest. ... [because] solid productivity growth and accommodative monetary policy have offset some of the negative effect of rising oil prices. ..., the increase in crude prices, after adjusting for inflation, is smaller than during the 1970s, and the level remains well below the peak reached in 1980 ..., [a]nd ..., the U.S. economy is less dependent on oil today. ...

In addition to the risk to growth, rising energy prices are a risk to the outlook for inflation. ... The latest reading of the core price index for personal consumer expenditures, the Fed's preferred measure of inflation, shows an increase of 2 percent over the last 12 months. This is at the upper end of the range that I feel is consistent with price stability. One question about inflation is whether businesses will pass through the recent increases in energy costs to the prices ... [U]nless energy costs continue to rise, such pass-through would just result in a one-time increase in prices and a temporary spike in the core inflation rate, not a sustained higher rate of core inflation. ... Furthermore, although energy prices are still high, they have been falling recently... There is another worry however. If we indeed start to see a string of higher inflation numbers, then people may begin to expect permanently higher inflation. Such expectations could become self-fulfilling ... And this would have adverse effects on longer term economic performance. Fortunately, current financial market data and consumer surveys suggest that long-run inflation expectations remain contained.

Nonetheless, it will take appropriate monetary policy to keep inflation and inflation expectations well contained. For me, at this time such policy likely entails further removal of policy accommodation. And if inflation expectations did become unhinged, this might require a stronger response. ...

Asset Prices and The Great Moderation

Ben Bernanke's wasn't the only person talking about monetary policy today. There were also two Fed speeches (neither addresses the future course of monetary policy). The first speech by Fed Vice Chair Roger W. Ferguson looks at whether recent declines in GDP and inflation volatility have increased asset values or decreased their volatility and notes that it's hard to find a solid connection between macroeconomic fundamentals and changes in the level or volatility of asset prices. Variation in the discount rate shows up as a much more important factor. The reasons for the Great Moderation and its effects on variables such as asset prices are not settled areas and the speech has quite a few useful references on these topics. The references are included in the continuation frame below:

Asset Price Levels and Volatility: Causes and Implications, by Fed Vice Chairman Roger W. Ferguson: The variability of real activity and inflation in the United States has declined substantially since the mid-1980s--a development often termed the Great Moderation. ... [T]he decline does not appear to be the result of a long-term downward trend but appears to conform more to a structural break around the mid-1980s. The moderation is substantial: The standard deviation of the quarterly growth rate of real gross domestic product from 1985 to 2004 ... is only about one-half its standard deviation from 1960 to 1984. ... A variety of explanations for this Great Moderation have been put forth, ... First, the U.S. economy might have been lucky, ... Another explanation is that firms may have adopted information technologies that allow them to more efficiently manage their inventories ... Better conduct of monetary policy could also lead to lower inflation and economic volatility ... Finally, financial innovations, such as risk-based loan pricing and expanded securitization, may have enhanced the ability of households to borrow, which would make them less sensitive to fluctuations in income... Importantly, equity valuation ... has been higher in the past two decades than in the two decades before that. ... The rise in equity valuations at the same time that macroeconomic volatility fell is circumstantial evidence of a link between the two. ...

Does volatility of real activity affect the level of asset prices? ... [A]lthough the data are suggestive, tests based on asset pricing models have not firmly established an empirical link between reduced macroeconomic volatility and higher asset prices. ... A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. ... Rather, existing research suggests that asset price volatility remains largely a reflection of variation in investors' discount rates rather than of changes in forecasts of fundamentals. On a micro level, financial innovations and new types of market participants appear to have led to greater market efficiency and liquidity. ...

The second speech is by Governor Olson and discusses the development and unification of the payments system within the U.S. and where it is headed in the future. If you are interested in this topic, there is a lot of useful information and detail in the linked speech:

Perspectives on the Development of a Unified National Payments System in the United States, by Fed Governor Mark W. Olson: ...This morning, I would like to discuss the development of a unified national payments system, or single payments area, in the United States. I will sketch the foundations of the contemporary U.S. payments system and remark on the history of U.S. banking. ... I will then discuss some of the challenges in the U.S. experience, as well as some thoughts on the future of the U.S. payments system. The overarching theme of my remarks is that the United States has evolved toward an increasingly unified national payments system, through both market-driven development and some specific public-sector actions. ...

Continue reading "Asset Prices and The Great Moderation" »

Tuesday, November 15, 2005

The Grass is Always Greener at Home ... But I'm Biased

Federal Reserve Chair Alan Greenspan discusses the current account balance and the role that two factors, a decline in home bias and a relative increase in U.S. productivity, have played in allowing such a large deficit to persist. Noting that the growth in the deficit cannot persist indefinitely and adjustment will occur at some point, he believes the key to a smooth adjustment is economic flexibility. Economic flexibility, which requires a hands off approach from government, gives economies the best chance to withstand shocks and to provide the stability needed for economic growth:

Stability and Economic Growth: The Role of the Central Bank, by Fed Chair Alan Greenspan: International finance presents us with a number of intriguing anomalies, but the one that seems to bedevil monetary policy makers the most as they seek stability and growth ... is the seemingly endless ability of the United States to finance its current account deficit. To date, despite a current account deficit exceeding 6 percent of our gross domestic product (GDP), we ... are experiencing few difficulties in attracting the foreign saving required to finance it... Of course, deficits that cumulate to ever-increasing net external debt ... cannot persist indefinitely. At some point investors will balk at further financing. ...

In all instances, a current account balance is essentially the product of a wide-ranging interactive process ... To the extent that an economy harbors elements of inflexibility, so that prices and quantities are slow to respond to new developments, the deficit-adjustment process is likely to adversely affect the levels of output and employment. ... The rise of our deficit and our ability to finance it appears to coincide with ... a major acceleration in U.S. productivity growth and the decline in what economists call home bias, the parochial tendency to invest domestic savings in one's home country. ...[S]tarting in the 1990s home bias began to decline discernibly. ... The decline in home bias reflects a number of recent factors that ... lessen restraints on cross-border financial flows as well as on trade in goods and services. ... [T]he advance of information and communication technologies has effectively shrunk the time and distance that separate markets around the world. ... Technological innovation and ongoing deregulation and tariff reductions have driven the globalization process by ... lowering the cost of transacting across borders. The effect of these developments has been to markedly increase the willingness and ability of financial market participants to reach beyond their national borders to invest in foreign countries...

The decline in home bias has clearly enlarged sources of finance for the United States. ...  How much further home bias can decline is obviously conjectural, ... Federal Reserve staff studies indicate that ... U.S. and foreign portfolios still exhibit marked home bias. ... Presumably, well before the practical lower limits of home bias are reached, effective constraints on deficit funding, and hence on the deficit itself, are likely to come from foreign investors' fear of portfolio concentrations of claims on the residents and government of the United States. Concentration and other risks in holding dollar balances seem to have become a consideration at least for some investors. ... What could be the potential consequences should the dollar's status as the world's reserve currency significantly diminish...? Most analysts would contend that U.S. interest rates were lowered by the world's accumulation of dollars. Accordingly, in the event of a significant diminishing of the dollar's reserve currency status, U.S. interest rates would presumably rise. ...

[T]here are ... lessons to be learned from the experience of sterling as it faded as the world's dominant currency. ... Many wartime controls were maintained ... immediately after World War II. ... The experience of Britain's then extensively regulated economy provides testimony to the costs of structural rigidity in times of crisis. Any diminution of the reserve status of the dollar ... is likely to be readily absorbed by a far more flexible U.S. economy than existed in Britain immediately following World War II. ... Governments today ... are rediscovering the benefits of competition and ... beginning to recognize an international version of Smith's invisible hand in the globalization of economic forces. ... We appear to be revisiting Adam Smith's notion that the more flexible an economy, the greater its ability to self-correct after inevitable, often unanticipated disturbances. ... Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset. The impressive performance of the U.S. economy over the past couple of decades ... offers the clearest evidence of the benefits of increased market flexibility. ...

Flexibility is most readily achieved by fostering an environment of maximum competition. A key element in creating this environment is flexible labor markets. Many working people equate labor market flexibility with job insecurity. Despite that perception, flexible labor policies appear to promote job creation. An increased capacity of management to discharge workers without excessive cost, for example, apparently increases companies' willingness to hire without fear of unremediable mistakes. ... Protectionism in all its guises ... does not contribute to the welfare of workers. At best, it is a short-term fix for a few workers at a cost of lower standards of living for a nation as a whole. Increased education and training for those displaced by creative destruction is the answer, not a stifling of competition. ...

See Kash at Angry Bear for more comments. I would also add that sometimes government intervention is required to make markets work. Does anyone doubt that the protection of property rights by the government is necessary for markets to flourish? It's hard to bring goods to market if they are stolen along the way. Monopolies are easy to create if the most powerful can block the gates to the market. Governments and other institutions make markets work in both obvious and subtle ways, a lesson learned most recently by formerly socialist countries attempting to transform to market economies.  As we go down the path to less government regulation, a path justified in most cases, we should be careful not to undermine rather than promote competition.

Thursday, November 10, 2005

William Poole: A Hard Landing is Unlikely

St. Louis Fed president William Poole looks at the the likelihood that growing global imbalances will cause a hard landing for the U.S. His view is that so long as the U.S. pursues sound monetary and fiscal policy, a hard landing is unlikely. The reason, Poole argues, is that any adjustment is self-limiting because the U.S. is in the unique position of having most of its debt denominated in dollar terms rather than in a foreign currency and this changes the equation relative to a typical financial crisis. That is, because 95% of U.S. debt is denominated in dollar terms, a declining dollar will not increase the U.S. debt obligation to any substantial degree and thus will not precipitate a crisis. In addition, because the majority of U.S. assets held abroad are denominated in foreign currencies, these investments appreciate in dollar terms as the dollar declines further undermining the chance of a hard landing:

How Dangerous Is the U.S. Current Account Deficit?, by William Poole, St. Louis Fed President: The U.S. current account deficit has attracted considerable attention from academics, policymakers and market participants. So also has the U.S. international investment position—the difference between U.S.-owned assets abroad and foreign-owned assets in the United States. The net position has become increasingly negative as current account deficits have accumulated over time. ... [A] situation in which the U.S. net international investment position becomes ever more negative as a percentage of GDP is inconsistent with long-run equilibrium. So, the question is not whether the U.S. current account deficit will fall in the future but whether the inevitable adjustment is likely to be painful and disruptive of U.S. economic growth and stability—a hard landing. My answer is that a hard landing is very unlikely provided that U.S. monetary and fiscal authorities maintain sound policies. ...

It is sometimes said that the United States has become a “net debtor” nation, and that this situation increases the risk that currency depreciation might lead to financial crisis. Indeed, ... some have drawn comparisons with countries such as Argentina, Brazil, Mexico and other countries that at times have experienced severe balance-of-payments crises. I consider it highly unlikely that such a crisis will befall the United States. ... In fact, about 95 percent of international claims on the United States are denominated in dollars. A country with most of its debt denominated in its own currency is in a very different situation from one whose debt is denominated in other currencies. The familiar crises experienced by several Asian countries ..., by Mexico ..., and by numerous other countries have all involved situations in which the impacted countries have had large external debts denominated in foreign currencies. ... Consider what typically happens to a country suffering a balance-of-payments crisis. As the foreign exchange value of its currency depreciates, the value of its foreign liabilities ... increases, as does the burden of servicing its international debt. Recognizing this implication of a crisis, international investors respond by paring back their positions further, engendering even greater currency depreciation. Hence, the combination of foreign-denominated debt and a depreciating currency has proven to be something of a vicious circle—compounding and accelerating a crisis.

The U.S. situation is completely different. To the extent that the foreign exchange value of the dollar declines, ... Dollar-denominated U.S. liabilities remain unchanged in domestic value, which means that debt service in dollars and relative to the size of the U.S. economy does not change. Moreover, holdings of U.S. investors abroad, about two-thirds of which are denominated in foreign currencies, appreciate in dollar terms. The composition of the U.S. international investment account, therefore, contributes to stability rather than to instability. ... If the capital markets view is correct—and I obviously think it is—the ... transition to a sustainable long-run path [will not] necessarily require wrenching adjustments in domestic or international markets or in exchange rates. ... The United States has created for itself a comparative advantage in capital markets, and we should not be surprised that investors all over the world come to buy the product.

Finally, for those looking for a statement about the future course of interest rates, Bloomberg reports remarks made after the speech:

Federal Reserve Bank of St. Louis President William Poole said the risk of inflation is still ''skewed toward the high side'' after 12 consecutive interest- rate increases. ... ''I would put a higher probability on an upside surprise than on a downside surprise,'' he told reporters today following a speech... ''That in my mind calls for the Federal Reserve to make sure that policy is risk-averse with respect to that outcome.'' ...

And Cleveland Federal Reserve Bank President Sandra Pianalto, as reported by Reuters, remarked after her speech today (discussed here):

The Federal Reserve does not have a set goal for how high it wants to push up short-term U.S. interest rates and will be guided by economic conditions... "There is no numerical target because where ... we adjust it to ... depends on economic conditions," ... Pianalto... noted the Fed has been taking stimulus away from the economy... "Our statement says we are continuing to remove that accommodation," she said... "Where we determine we are no longer accommodative again depends on economic conditions." ... Pianalto also ... acknowledged ... that households could face a harder time servicing debts as rates rise. "As we start to see an increase in interest rates will that cause the consumer problems?" she asked rhetorically in response to a question. "I think it depends on whether that's gradual and how consumers adjust to that." "...we'll have to ... keep our eye on this situation as the conditions change," ...

Cleveland Fed's Pianalto: Education is a Key Factor for Economic Flexibility

Sandra Pianalto, president of the Cleveland Fed, discusses how to minimize the negative consequences of structural change. For example, the Cleveland Fed District has experienced a decline in manufacturing activity and other changes related to globalization. How can the region overcome this decline? The key, according to president Pianalto, is innovation. And what is the key to innovation? Continuing a recent theme from Fed officials (e.g., Chicago Fed), and a recurring theme at this site, the key is education. With all the recent post on this topic, this may be a bit repetitive, but it's an important topic, I've been trying to document most Fed speeches by governors and presidents, and the it gives an indication of how policy makers are thinking about this problem:

The Role of Innovation in Economic Transformation, by Sandra Pianalto, Cleveland Fed President, November 9, 2005: At the Federal Reserve Bank of Cleveland, we spend a lot of time thinking about what factors drive economic growth and prosperity. We have found that innovation is one of the key factors in creating the kind of economic conditions that will benefit all of our citizens. Today, I would like to share my thoughts on the role of innovation in economic transformation. ...[I]n Northeast Ohio ... After a century of relying on the heaviest types of traditional industry — such as coal, steel, autos, and rubber — we have been deeply affected by global trends including rapidly changing technology and increased international trade. As I am sure you know, these trends have led to a decline in manufacturing jobs and a growing wage differential between high-school and college graduates. ... Economists call this process “creative destruction.” It is a natural part of our economic development... Economic change is as relentless as the tides, and this change will direct resources to wherever they are most productive. ... [O]ur region’s transition does not necessarily mean we have to live in a world with downsized dreams, or less productive industry, or less prosperous communities. ... Every sector of society — public and private; for-profit and non-profit; philanthropic and academic — can participate in fostering a growing regional economy in the future. The key to our shared success, I am convinced, will be our ability to foster and sustain innovation. ... I don’t think it is any exaggeration to say that innovation is the mainspring for economic renewal. ... The task now... is to educate a new generation of inventors and entrepreneurs, to encourage their creativity, to invest in their potential, and to promote their access to worldwide markets. ... To create a dynamic economy that promotes innovation in Northeast Ohio, we must find a way to do a few important things well (bullets added for emphasis):

  • We must fund academic research...
  • [W]e must support business startups to move innovations from the labs to production sites.
  • We must build on our existing strengths — using the industrial knowledge and workplace skills from older industries and applying them to new tasks. ...
  • But there is one more important thing that we need to do well, and that is educating our workforce for the future. In a global economy that grows more competitive every day, the words “education” and “opportunity” are becoming increasingly synonymous. Creating a civic culture that supports education is the most promising pathway to creating a base for innovation. ... Investments in education today ... can generate dramatic new productivity growth tomorrow. The fact is that Northeast Ohio lags behind many other regions of the country in levels of educational attainment, and nowhere is that more evident than in our large cities.

Making effective investments in our people must be among our foremost priorities. Investments, after all, come in many forms. ... As we look ahead, our prospects depend on our commitment to invest in intellectual capital: the knowledge base of our students, the technological skills of our workers, and the imaginative power of our inventors. ... Instead of resisting change, we must prepare for new opportunities by rethinking our approaches, retraining our workforce, and investing in new initiatives. ...

"Economic change is as relentless as the tides." As I've said before many times here, we will not stop globalization, the economic tide will move where it wants to move - but we can do a whole lot better helping those who, through no fault of their own, have the costs of globalization thrust upon them, and a key component of that effort is education.

Saturday, November 05, 2005

Globalization and Monetary Policy

Dallas Fed president Richard Fisher does not like trying to conduct monetary policy without fully understanding how the global economy feeds back into the domestic economy and affects variables like inflation, the output gap,  and unemployment. He wants an updated Phillips curve to use for monetary policy, one that incorporates the consequences of globalization:

Globalization and Monetary Policy, by Richard W. Fisher, Dallas Fed President:  ...The literature on globalization is large. The literature on monetary policy is vast. But literature examining the combination of the two is surprisingly small. ...[I]n Michael Woodford’s influential book Interest and Prices: Foundations of a Theory of Monetary Policy, the word “globalization” does not appear in the index. Nor do the words “international trade” or “international finance.” What gives? Is the process of globalization disconnected from monetary policy? Is the business of the central bank totally divorced from globalization? I think not. I believe globalization and monetary policy are intertwined in a complex narrative that is only beginning to unfold. ... Where does monetary policy come into play in this world? Well, consider the task of the central banker, seeking to conduct a monetary policy that will achieve maximum sustainable non-inflationary growth. ... Central bankers want GDP to run at no more than its theoretical limit, for exceeding that limit for long might stoke the fires of inflation. They do not wish to strain the economy’s capacity to produce. ... Until only recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more. ... The destruction of communism and the creation of vast new sources of inputs and production have upset all the calculations and equations that the very best economics minds, including those of the Federal Reserve staff—and I consider them the best of all—have used as their guideposts. The old models simply do not apply to the new, real world. This is why I think so many economists have been so baffled by the length of the current business cycle and the non-inflationary prosperity we have enjoyed over the past almost two decades. ... From this, I personally conclude that we need to redraw the Phillips curve and rejig the equations that inform our understanding of the maximum sustainable levels of U.S. production and growth. ... [H]ow can we calculate an “output gap” without knowing the present capacity of, say, the Chinese and Indian economies? How can we fashion a Phillips curve without imputing the behavioral patterns of foreign labor pools? How can we formulate a regression analysis to capture what competition from all these new sources does to incentivize American management? Until we are able to do so, we can only surmise what globalization does to the gearing of the U.S. economy, and we must continue driving monetary policy by qualitative assessment as we work to perfect our quantitative tool kit. At least that is my view. ...

Chicago Fed President Moskow: The Future of Higher Education

These remarks by Chicago Fed president Michael H. Moskow on the fuure of higher education provide a follow up to this post:

Higher Education at a Crossroad, by Michael H. Moskow, Chicago Fed President: ...Let me begin by offering my perspective on the value of higher education to our economy. At various points in my life I have been a student, a university professor, a college trustee, and an employer who relies on highly educated workers to help run a complex organization. As both an employer and an economist, it is clear to me that the relationship between education, productivity, and economic growth has never been more closely linked. While states and regions once prospered based on an abundance of physical capital and natural resources, today the quality of a region's human capital is paramount. This feature is particularly true for regions such as the Midwest, where our economy continues to restructure from manufacturing to services and high technology industries. These growing industries increasingly require college graduates to successfully compete in a global economy. Even in today's manufacturing firms, higher level skills are required, which mandates that workers obtain an education beyond the high school level.

Despite this recognition, we are at an inflection point. Enrollment in college in the U.S. is at a record level and expected to climb, as students and their parents recognize the very high returns to education ... However, financial pressures on colleges have also mounted. For public institutions, state support has eroded. As state spending pressures continue to rise for elementary and secondary education, Medicaid, and prisons, less is available for higher education. In response, universities today are increasingly forced to rely on their own resources to make budgets balance. But this can restrict access, because schools must often dip into endowments and resort to aggressive tuition hikes to close the gap. It's a Hobson's choice. If the school is concerned with maintaining academic quality, large tuition increases are often the best option, but in doing so access for students may be limited. If on the other hand the university limits tuition increases, it is often forced to economize and offer reduced services, which can jeopardize quality through large classes and the use of part-time faculty. ...

How can universities navigate these challenges and flourish? ... [U]niversities have been unable to maintain the implicit "social compact" ... based on a belief that education was largely a public good and, as such, government support was warranted. This notion has eroded over time. Today, many argue that higher education is a private good whose benefits primarily accrue to the student who is able to ... achieve a more satisfying quality of life and often significantly higher wages. This more market-driven notion suggests that higher education is an investment in an individual's human capital that has limited public spillovers. Therefore, it should be primarily financed by the individual. I believe for universities to flourish, they need to revisit this "social compact" and make a clearer case for the public good content of education. In order to do this, universities will need to be more transparent in their operations so that the public can have a better sense of what the value of the institution is to society. ... Polls indicate that the public ... often does not understand the return to society generated from the use of public funds for university research. In sum, universities need to become better educators of the general public and marketers of their product if they hope to attract greater tax support. ... The historic and increasing importance of higher education to our economic well being makes this a policy area where we must succeed. ...

Friday, November 04, 2005

Credibility, Independence, Stable Inflation, and Economic Growth

Federal Reserve Vice Chair Roger Ferguson speaks at the Cato Institute concerning the connection between central bank credibility and low inflation, and between low inflation and economic growth. He believes credibility and central bank independence are keys to low inflation and hence to robust economic growth. However, as he notes, while there is evidence that credibility and independence lower inflation rates, the empirical evidence on the connection between moderate inflation and economic growth is less clear. Still, he is confident that a relationship exists:

Monetary Credibility, Inflation, and Economic Growth, by Federal Reserve Vice Chairman Roger W. Ferguson, Jr.: By now it must be universally agreed that low and stable inflation is a primary and essential goal for monetary policy, in large part because we believe it ... fosters sustainable economic growth over the longer run.  ... To me, it is axiomatic that monetary credibility, by reducing the level and variability of inflation, lays the foundations for stronger and more-sustained economic growth. In my remarks today, I want to discuss anecdotal and academic evidence for the relationship between monetary policy credibility and economic growth and to do so in two segments: first, the link between monetary policy credibility and inflation performance and, second, the link between inflation performance and longer-run economic growth. ... [C]ommon intuition and numerous academic journal articles ... suggest that .... [w]hen the central bank is viewed to be both committed to and effective at keeping inflation contained, inflation expectations will tend to be anchored. And so long as the central bank pursues sensible policies, those expectations will tend to be self-fulfilling, as they should lead to movements in prices and wages that are consistent with inflation staying low and stable. ... One does not have to look far to see examples of the practical importance of monetary credibility. In the past two years, crude oil prices have about doubled. During the 1970s, similar run-ups set off sharp increases in global inflation. Today, by contrast, core inflation rates both in the United States and abroad, while they have moved up some, remain essentially contained. In large part, they remain so because central banks, including the Federal Reserve, have substantially bolstered their commitment to price stability since the 1970s and markets are now much more confident that monetary authorities will keep inflation from rebounding. ... Aside from such anecdotal evidence, much formal research supports the view that a strong commitment to price stability helps reduce and stabilize inflation. ... Finally, there is considerable literature on the effects of central bank independence on inflation ... [C]entral bank independence frees the monetary authority to pursue price stability more diligently, resulting in lower and less-variable inflation, is supported by many studies. ...

Assuming that monetary credibility does make it easier for central banks to pursue the objective of price stability, what can we say about how stable prices affect the bottom line--economic activity and growth? Empirical research attempting to establish solid links between low inflation and sustainable economic growth has met with mixed success... [R]esearchers seem to agree that extreme inflation rates, say above 40 percent per year, are associated with reduced economic growth. ...  But what can we say about lower inflation rates? Is the pace of economic development slower when inflation is at 15 percent than when it is at 5 percent? Research by IMF staff economists ... has turned up a negative association between inflation and growth. ... To be completely fair regarding the academic literature, however, others have not found such a clear relationship. ... Of course, as a central banker, it makes sense to me that lower and more-stable inflation, by making the returns to saving and investment more predictable and by diminishing the likelihood of shocks to the financial system, should encourage economic growth. ...  I am obviously not alone in this view, it is clear that central banks should strive to achieve low, stable inflation... In conclusion, let us not forget that the declines in inflation over the past two decades and the resulting boost to monetary credibility we currently enjoy were earned with some economic pain... If the academic evidence does not yet unequivocally support this conclusion, perhaps it is because we are only starting to see the return to sacrifices made in the past. ...

Those who would like to see the Fed pause in its campaign of raising the federal funds rate at a measured pace might wonder why the Fed is so concerned about inflation rather than a weak labor market  if there is, as governor Ferguson suggests, only mixed evidence that moderate inflation is costly to the economy.

Update: I should have distinguished between the trend growth of GDP and stabilizing GDP growth around the trend. As I read the evidence, price stability reduces variation of GDP around the trend rate of growth but does not have much, if any, affect on the trend rate of growth itself.

Thursday, November 03, 2005

Greenspan's Testimony before Congress on the Economic Outlook

Alan Greenspan testifies before congress on the state of the economy. He expresses confidence about economic growth, but is concerned over inflationary pressures in the long-run due to several factors including higher energy prices and increases in labor costs as the growth in the supply of labor abates worldwide. Also, the comments at the end on the budget deficit are notable:

Testimony of Chairman Alan Greenspan Economic outlook Before the Joint Economic Committee, U.S. Congress November 3, 2005: Mr. Chairman, when I last appeared before the Joint Economic Committee in early June, economic activity appeared to be reaccelerating after a slowdown in the spring. The economy had weathered a further run-up in energy prices over the winter, and aggregate demand was again strengthening. ... By early August, the economy appeared to have considerable momentum, despite a further ratcheting up of crude oil prices; pressures on inflation remained elevated. As you know, the economy suffered significant shocks in late summer and early autumn. Crude oil prices moved sharply higher in August, bid up by growth in world demand that continued to outpace the growth of supply. Then Hurricane Katrina hit ... causing widespread disruptions to oil and natural gas production... Because of a lack of ready access to foreign supplies, natural gas prices rose even more sharply. At the end of September, with the recovery from the first storm barely under way, Hurricane Rita hit, ... These events are likely to exert a drag on employment and production in the near term and to add to the upward pressures on the general price level. But the economic fundamentals remain firm, and the U.S. economy appears to retain important forward momentum. ... Except for the hurricane effects, readings on the economy indicate a continued solid expansion of aggregate demand and production. ... The longer-term prospects for the U.S. economy remain favorable. Structural productivity continues to grow at a firm pace, and rebuilding activity following the hurricanes should boost real GDP growth for a while. More uncertainty, however, surrounds the outlook for inflation.

The past decade of low inflation and solid economic growth in the United States ... is attributable to the remarkable confluence of innovations that spawned new computer, telecommunication, and networking technologies, which ... have elevated the growth of productivity, suppressed unit labor costs, and helped to contain inflationary pressures. .... Contributing to the disinflationary pressures ... over the past decade or more has been the integration of in excess of 100 million educated workers from the former Soviet bloc into the world's open trading system. ..., and of even greater significance, ... the freeing from central planning of large segments of China's 750 million workforce. The gradual addition of these workers plus workers from India ... would approximately double the overall supply of labor once all these workers become fully engaged in competitive world markets. ... Over the past decade or more, the gradual assimilation of these new entrants into the world's free-market trading system has restrained the rise of unit labor costs in much of the world and hence has helped to contain inflation. ... The effective augmentation of world supply and the accompanying disinflationary pressures have made it easier for the Federal Reserve and other central banks to achieve price stability in an environment of generally solid economic growth.

But this seminal shift in the world's workforce is producing, in effect, a level adjustment in unit labor costs... the suppression of cost growth and world inflation, at some point, will begin to abate and, with the completion of this level adjustment, gradually end. These global forces pressing inflation and interest rates lower may well persist for some time. Nonetheless, it is the rate at which countries are integrated into the global economic system, not the extent of their integration, that governs the degree to which the rise in world unit labor costs will continue to be subdued. Where the global economy is currently in this dynamic process remains open to question. But going forward, these trends will need to be monitored carefully by the world's central banks.

I want to conclude with a few remarks about the federal budget situation ... even apart from the hurricanes, our budget position is unlikely to improve substantially further until we restore constraints similar to the Budget Enforcement Act of 1990, which were allowed to lapse in 2002. Even so, the restoration of paygo and discretionary caps will not address the far more difficult choices that confront the Congress as the baby-boom generation edges toward retirement. As I have testified on numerous occasions, ... So long as health-care costs continue to grow faster than the economy as a whole, as seems likely, federal spending on health and retirement programs would rise at a rate that risks placing the budget on an unsustainable trajectory. Specifically, large deficits will result in rising interest rates and an ever-growing ratio of debt service to GDP. Unless the situation is reversed, at some point these budget trends will cause serious economic disruptions. We owe it to those who will retire over the next couple of decades to promise only what the government can deliver. ... Crafting a budget strategy that meets the nation's longer-run needs will become ever more difficult and costly the more we delay. The one certainty is that the resolution of the nation's demographic challenge will require hard choices and that the future performance of the economy will depend on those choices. .... The Congress must determine how best to address the competing claims on our limited resources. In doing so, you will need to consider not only the distributional effects of policy changes but also the broader economic effects on labor supply, retirement behavior, and private saving. The benefits of taking sound, timely action could extend many decades into the future.

I threw this together rather quickly - I will try to say more about this later. In other news, U.S. productivity was higher than expected in the third quarter at 4.1%, but unit labor costs, i.e. labor compensation, is dragging. That's good news for inflation fighting, but bad news if it's your take home pay. The remarks above on globalization offer one reason for lagging wages.

[Update:  See Angry Bear and William Polley for more on productivity and labor compensation.]

[Update: Brad DeLong has more on Greenspan's statements on entitlement spending, The Big Picture has more on Greenspan's statement that the yield curve is no longer useful, and a comment from Calmo wonders how "Dr Estrella feels about that remark:  inverted yield curves are obsolete" given this from the NY Fed.]

I intended to say more, but the links above cover the issues fairly well. Unless I think of something different to add, I think I will leave it at that.

The Declining Role of Money in Monetary Policy

For no particular reason other than posting something on it not too long ago, and then again more recently, I've been revisiting the issue of using monetary aggregates as targets for monetary policy. First recall, in very general terms, one reason why there is an issue. The Fed has one policy tool. With a single tool it is not possible to control two variables, a monetary aggregate and an interest rate simultaneously. So the Fed must choose one or the other (or some combination strategy where both are kept within some tolerable range, but I'll set that aside for this discussion to keep it simple). In recent years, the Fed has chosen to target the overnight borrowing rate between banks, the federal funds rate, but there was a time when the Fed relied much more on monetary aggregates, first M1, then M2. In this speech, Alan Greenspan explains why the Fed has deemphasized monetary aggregates. The first event that undermined aggregates was the introduction of NOW accounts. The appearance of NOW accounts made M1 assets much more interest sensitive and hence much more volatile, and that volatility made the relationship between M1 and other variables of interest such as output and inflation more difficult to discern:

Rules vs. discretionary monetary policy, by Chairman Alan Greenspan, Stanford University, 1997: ...Although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. Focusing on M1 ... was extraordinarily useful in the early Volcker years. But after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the Federal Open Market Committee became too interest sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation. ... As a consequence, by late 1982, M1 was de-emphasized... However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance.

By turning to M2, the Fed stabilized the target monetary aggregate since much of the asset movement was between M1 and M2. But as he notes, this did not last long as financial innovation brought about highly liquid assets outside of the definition of M2 which began to attract financial investment:

As an indicator, M2 served us well for a number of years. But by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors... The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Federal Reserve was forced to begin disregarding the signals M2 was sending... Data since mid-1994 do seem to show the reemergence of a relationship of M2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s. ...however, the period of predictable velocity is too brief to justify restoring M2 to its role of earlier years... The absence of a monetary aggregate anchor ... has not left policy completely adrift. From a longer-term perspective we have been guided by a firm commitment to ... the ultimate goal of achieving price stability. ...

The period he talks about, 1990-1994, is evident in this graph from a recent post repeated for convenience:

What explains the behavior in the early 1990s? Here's one explanation from the Cleveland Fed (this is long already, so maybe I can get to the recent MZM results, e.g. here, some other time):

Results of a Study of the Stability of Cointegrating Relations Comprised of Broad Monetary Aggregates, by John B. Carlson, Dennis L. Hoffmanb, Benjamin D. Keenc, Robert H. Rasche, Federal Reserve Bank of Cleveland (1999): Abstract We find strong evidence of a stable “money demand” relationship for ... M2M through the 1990s. Though the M2 relation breaks down somewhere around 1990, evidence has been accumulating that the disturbance is well characterized as a permanent upward shift in M2 velocity, which began around 1990 and was largely over by 1994. Taken together, our results support the hypothesis that households permanently reallocated a portion of their wealth from time deposits to mutual funds...

But this is certainly not the only explanation. E.g., from the Dallas Fed:

What was Behind the M2 Breakdown?, Dallas Fed, 1999: A deterioration in the link between the M2 monetary aggregate and GDP, along with large errors in predicting M2 growth, led the Board of Governors to downgrade the M2 aggregate as a reliable indicator of monetary policy in 1993. In this paper, we argue that the financial condition of depository institutions was a major factor behind the unusual pattern of M2 growth in the early 1990s...

The unusual M2 growth pattern can be seen here in the graph from the post linked above. By targeting an interest rate rather than a monetary aggregate, the Fed has avoided the problems associated with targeting unstable aggregates, and interest rate targeting is also supported by the theoretical literature. Because of this, the focus on monetary aggregates has waned in recent years.

Thursday, October 27, 2005

Greenspan on the Role of the Council of Economic Advisers

Federal Reserve Chair Alan Greenspan discusses the contributions of the Council of Economic Advisers and other agencies created by the Employment Act of 1946 in a speech given today in St. Louis. This is somewhat timely given the vacancy at the CEA created by Bernanke's departure, if confirmed, to become Fed chair:

Receipt of the Truman Medal for Economic Policy, Remarks by Chairman Alan Greenspan, October 26, 2005: ...[P]art of Truman's importance derives from the fact that several key new governmental structures were established during his Administration. Among these were the Council of Economic Advisers (CEA) and the Joint Economic Committee of the Congress (JEC). These organizations were established by the Employment Act of 1946... Two ingredients seem to have been essential precursors of the Employment Act. The first was a deep concern that the problem of peacetime unemployment had not been solved. ...many feared that the economy would slip back into depression. The second element was the economic thinking of John Maynard Keynes. ... President Truman's memoirs make clear that both of these strands ... influenced his request to the Congress for full employment legislation in the fall of 1945. ... Early drafts of the Employment Act enshrined ... new processes and institutions, ... the CEA, the annual Economic Report of the President, and the JEC... The CEA consists of a chairman and two other members, ...Over the years, the CEA has provided objective and professional economic advice at the highest levels in the White House. ... A hallmark of the ethos of the CEA is the pride that its staff members take in providing objective analysis. ... Because the CEA has retained its small size over the years, it can be quick and nimble in ways that are difficult for some larger agencies. Moreover, because the CEA is viewed as a neutral agency without ties to any particular constituency, the CEA often has played an important role on interagency committees and working groups... Along those lines, perhaps the most important role of the CEA has been to scuttle many of the more adventuresome ideas that inevitably bubble up through the machinery of government. ... This role of the CEA is wholly unheralded--after all, who hears about the idea that never came to fruition--but it serves as an important check in the policymaking process. ... Of course, as chairman of the Council during President Ford's Administration, I was close to some of these debates and decisions. ...I began work at the CEA in September 1974. ... I found my time there quite rewarding, ... I will only highlight three themes that recurred during my tenure. First, economic modeling is as much art as science. ... Economic models provide a set of useful tools to frame future outcomes; but ... models can go off track in myriad ways. Objective and thorough analysis, as is the norm at the CEA, is the most effective counterweight to this challenge. Second, high-quality and timely data are crucial inputs to the process of making economic policy. ... Finally, as hard as this can be to achieve, economic policy should take the long view. Although pressures to use the government's tools of economic management to achieve one or another short-term aim are always present, the tools of government are, in fact, most appropriately used to create an environment in which private economic activity can flourish over the longer run...

What's left unstated, and the hard part of the statement at the end, is deciding what the "longer run" is, particularly in light of the long lags before monetary policy takes full effect. Obviously, the Fed cannot manage aggregate output hourly, daily, or even weekly. But what about monthly output? Quarterly? Annual? When there is a recession, a short-run event around the long-run trend the Fed, even Greenspan's Fed responds by lowering rates. Deciding whether an event is a short-term cyclical fluctuation of little concern to the Fed, or a medium term fluctuation that requires action is part of the art of policymaking Greenspan discusses. This task is made harder by having imperfect models of the economy and this explains his craving for more high-quality and timely data. Greenspan proved to be quite skilled at untangling more persistent fluctuations from more transitory ones and this is one reason for his success as Chair of the Fed.

Wednesday, October 26, 2005

Should FOMC Meetings be Televised?

With the talk about increasing the transparency of the Fed even further under Bernanke, should FOMC meetings be televised? Will Bernanke go that far? What is the downside of doing so? Ben Bernanke answers this question in a speech given at the American Economic Review Association Meetings in San Diego in 2004:

Other possibilities for improved transparency may exist. Importantly, as we think about these, we should not simply take the view that more information is always better. Indeed, irrelevant or badly communicated information may create more noise than signal; and some types of information provision--an extreme example would be televising FOMC meetings--risk compromising the integrity and quality of the policymaking process itself. Rather, the key question should be whether the additional information will improve the public's understanding of the Fed's objectives, economic assessments, and analytical framework, thus allowing them to make better inferences about how monetary policy is likely to respond to future developments in the economy.

So he is not in favor of televising meetings, a sentiment repeated here in an interview with the Minneapolis Fed. I'm not as sure as he is that the public would be misled by listening in on the process. However, William Poole, president of the St. Louis Fed, agrees with Bernanke. He is also worried about misleading the public, but that is not his main worry since he believes only those who would understand the proceeding would be interested in tuning in. He has concerns about confidentiality issues, and he is also worried about how behavior changes when the cameras are watching, for instance the difficulty in talking about policy that might increase unemployment. I am not so sure. Hypotheticals can be clearly elucidated, and if the merits of a particlar policy proposal cannot be articulated publicly in an understandable manner, perhaps it needs to be thought through again. Wouldn't forcing people to tighten up their arguments due to increased public scrutiny be helpful?:

Consider the possibility of televising FOMC meetings, so all can observe the proceedings. One issue is the mismatch between the technical level of the meeting and the knowledge of the audience. ... Monetary policy needs to be conducted at the highest possible technical level; a general audience is more likely to be confused than enlightened by watching an FOMC meeting live. Most viewers would get little out of watching a discussion of technical econometric issues ... and might well misinterpret such discussion. Perhaps we shouldn't worry too much about this issue, as the audience for an FOMC meeting would probably be pretty small after a few such episodes. I do not think we would compete very successfully with daytime television! Of course, a televised FOMC meeting ... could not include discussion of information obtained under pledge of confidentiality. Information from individual firms does play a useful role in policymaking, and the Fed could not obtain such information without maintaining its confidentiality. Moreover, there is ample evidence that people in televised meetings behave differently ... Some participants might have a tendency to grandstand for the audience, and to avoid discussing difficult or controversial issues. ... It is particularly difficult to analyze unpleasant possibilities in public, such as that a particular policy action might have the effect of increasing the risk of recession. ... During the time I’ve been in St. Louis, my impression is that FOMC deliberations are extremely open and that issues are thoroughly explored. I do not think that disclosing the transcript with a five-year lag inhibits my discussion, and believe that to be the case for most other members as well. I also believe that the transcript provides a valuable record for scholars and I strongly support the current system of releasing lightly edited transcripts. ... The current system of releasing the FOMC transcript with a five-year lag works well.

I am sold on the confidentiality argument, but remain skeptical that the public cannot digest the information properly or that the behavioral changes televising the proceedings would have on participants are unambiguously negative. Following the lead on the transcripts, a "lightly edited" video of the meetings released as soon as possible after FOMC meetings could address confidentiality issues, so that objection seems manageable as well. But I suspect I will be the cheese that stands alone on this one and that most will feel the negatives of televising the proceedings outweigh the positives.

Tuesday, October 25, 2005

Will the Bernanke Fed Retain Its Inflation Fighting Credentials?

I have heard and read worries that the Fed under Ben Bernanke will not be as committed to fighting inflation as the Fed under Greenspan, a worry I do not share. These quotes from a speech Bernanke gave in 2003 while he was a Fed governor called "A Perspective on Inflation Targeting" give information about Bernanke's views on how committed the Fed should be to fighting inflation (the whole speech is worth reading if you want to learn more about inflation targeting, and it gives links to related remarks by Bernanke and others on this topic). He uses the oil price shocks of the 1970s as an example and says that the inflation problems of that time were primarily the result of poor monetary policy not high oil prices, a statement of interest given the recent increase in energy prices:

However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control.

Although constrained discretion acknowledges the crucial role that monetary policy plays in stabilizing the real economy, this policy framework does place heavy weight on the proposition that maintenance of low and stable inflation is a key element--perhaps I should say the key element--of successful monetary policy.

I gave the Great Inflation of the 1970s in the United States as an example of what can happen when inflation expectations are not well anchored. ... Even today conventional wisdom ascribes this unexpected outcome to the oil price shocks of the 1970s. Though increases in oil prices were certainly adverse factors, poor monetary policies in the second half of the 1960s and in the 1970s both facilitated the rise in oil prices themselves and substantially exacerbated their effects on the economy. Monetary policy contributed to the oil price increases in the first place by creating an inflationary environment in which excess nominal demand existed for a wide range of goods and services. ... Without these general inflationary pressures, it is unlikely that the oil producers would have been able to make the large increases in oil prices "stick" for any length of time.

...The upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per se. An equally important source of the recession was several years of overexpansionary monetary policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the economic impact of the oil producers' actions was significantly larger than it had to be. Instability in both prices and the real economy continued for the rest of the decade, until the Fed under Chairman Paul Volcker re-established the Fed's credibility with the painful disinflationary episode of 1980-82. This latter episode and its enormous costs should also be chalked up to the failure to keep inflation and inflation expectations low and stable.

Of course, as has often been pointed out, actions speak louder than words; and declarations by the central bank will have modest and diminishing value if they are not clear, coherent, and--most important--credible, in the sense of being consistently backed up by action...

And here are his misconceptions about inflation targeting from the same speech (the Bernanke and Mishkin 1997 paper he mentions is here):

Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. As Rick Mishkin and I emphasized in ...Bernanke and Mishkin, 1997..., inflation targeting is a policy framework, not a rule. ... Inflation targeting provides one particular coherent framework for thinking about monetary policy choices which, importantly, lets the public in on the conversation. ... monetary policy under inflation targeting requires as much insight and judgment as under any policy framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to give careful, fact-based, and analytical explanations of their actions to the public.

Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. Several authors have made the distinction between ... "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. ... For quite a few years now, however, strict inflation targeting has been without significant practical relevance. In particular, I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective. To use the wonderful phrase coined by Mervyn King, the Governor-designate of the inflation-targeting Bank of England, there are no "inflation nutters" heading major central banks. Moreover, virtually all (I am tempted to say "all") recent research on inflation targeting takes for granted that stabilization of output and employment is an important policy objective of the central bank...

A second, more serious, issue is the relative weight, or ranking, of inflation and ... the output gap... among the central bank's objectives. ... As an extensive academic literature shows, ... the general approach of inflation targeting is fully consistent with any set of relative social weights on inflation and unemployment; the approach can be applied equally well by "inflation hawks," "growth hawks," and anyone in between. What I find particularly appealing..., which is the heart of the inflation-targeting approach, is the possibility of using it to get better results in terms of both inflation and employment. Personally, ... I would not be interested in the inflation-targeting approach if I didn't think it was the best available technology for achieving both sets of policy objectives.

Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. ...The most important single reason for the founding of the Federal Reserve was the desire of the Congress to increase the stability of American financial markets, and the Fed continues to regard ensuring financial stability as a critical responsibility... I have always taken it to be a bedrock principle that when the stability or very functioning of financial markets is threatened, ... the Federal Reserve would take a leadership role in protecting the integrity of the system...

And this may be of interest:

Given the Fed's strong performance in recent years, would there be any gains in moving further down the road toward inflation targeting? ... I believe that U.S. monetary policy would be better in the long run if the Fed chose to make its policy framework somewhat more explicit. ... To move substantially further in the direction of inflation targeting, ... the Fed would have to take two principal steps: first, to quantify (numerically, and in terms of a specific price index) what the Federal Open Market Committee means by "price stability", and second, to publish regular medium-term projections or forecasts of the economic outlook...

Friday, October 21, 2005

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.

Continue reading "Richmond Fed President Lacker: Interest Rate Policy After Greenspan" »

Thursday, October 20, 2005

New York Fed President Geithner on Global Imbalances

Continuing with the series of posts on globalization (based on Krugman, Samuelson, and Fisher), here's New York Fed president Timothy Geithner. He:

  1. sees substantial risks due to global imbalances, risks that are not fully understood.
  2. is insistent that fiscal authorities need to regain control of the budget and says "Improving our fiscal position is the most effective means we have available to reduce our vulnerability during this prolonged period of adjustment."
  3. in equally insistent that fixed exchange rate regimes must allow more flexibility.
  4. worries that increases in demand growth in the foreign sector needed to offset a decline in U.S. consumption and increase in U.S. saving will have to overcome difficult political hurdles.
  5. says smooth adjustment requires, in addition to improved fiscal management, a strong and flexible financial system and open and free trade.
  6. says that avoiding protectionism calls for "improving educational opportunity and achievement in this country, and perhaps also in improving the design of the temporary assistance we provide individuals who bear the brunt of the adjustment costs than come with greater global economic integration."

Here's the speech:

U.S. and the Global Economy, by Timothy F. Geithner, President, New York Fed: I want to focus my remarks today on the imbalances in the world economy and their implications .... These imbalances... present challenges—and risks ... The sources of these imbalances are varied and complex. ... not anticipated and not fully understood. ... The magnitude and persistence of these imbalances seems to be the result of the interaction of two forces. The first involves a decline in U.S. savings relative to domestic investment, matched by an increase in savings relative to investment in parts of the rest of the world, principally in emerging Asia and the major oil exporters. ... The second feature ... has been an increase in the willingness of the rest of the world to invest its savings in the United States. ... This phenomenon is due in part to the perceived attractiveness of relative returns in the United States arising from the acceleration of productivity growth here, and in part due to the dynamics associated with exchange rate regimes linked in one way or another to the dollar. Together these forces have produced larger imbalances ... that have been sustained longer and financed more easily than conventional wisdom would have thought possible a decade or even five years ago. ...

This ... should concern us because it is not simply the result of the savings and investment decisions of the private sector. The fact that we are using a substantial part of the savings we are borrowing from the rest of the world to finance an unsustainable level of public borrowing leaves us more vulnerable than if those savings were being used for productive private investment. ... It should concern us because of how the imbalance has been financed. A substantial portion of the capital inflows ... has come from foreign central banks—which have been accumulating dollar reserves to preserve exchange rate arrangements that are unlikely to be sustainable and are already in the process of change... And ... these imbalances matter because at some point they will have to reverse. Market forces will at some point induce an adjustment. And that inevitable process of adjustment will bring with it the risk of ... slower growth in the United States and in the rest of the world. The magnitude of this risk is difficult to measure with any confidence. Past episodes of external adjustment offer some reassurance, but the present circumstances seem sufficiently different from historical precedent that history may not be a particularly useful guide. ... The risks associated with this adjustment process may be magnified ...[because the] average household in the United States today has a higher level of debt to income and is somewhat more exposed to interest rate risk than in the past. ... The adjustment process is also complicated by the fact that the rest of the world does not appear likely ... to be in a position to provide a sufficiently strong offsetting source of demand growth to compensate for the necessary slowing in U.S. domestic demand. ...

What can we do to mitigate these risks? For the United States, these challenges put a premium on putting in place a more credible fiscal policy framework, maintaining as strong and resilient a financial sector as possible, and preserving an open and flexible economy. ... Improving our fiscal position is the most effective means we have available to reduce our vulnerability during this prolonged period of adjustment. ... And even though substantial fiscal consolidation would not by itself bring the external imbalance down to a more sustainable level, it would improve the prospect for a smoother adjustment... The increase in the flexibility and resilience of the U.S. economy over the past two decades has a lot to do with the increased openness of the U.S. economy. ... We jeopardize future income gains if we are unable to sustain support ... a relatively open trade policy. How effective we are in meeting this political challenge is likely to depend significantly on how effective we are in improving educational opportunity and achievement in this country, and perhaps also in improving the design of the temporary assistance we provide individuals who bear the brunt of the adjustment costs than come with greater global economic integration. ... For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings ... would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. ...

I've stated my views already, they are close to those of Geithner, so I won't repeat them again. Besides, from previous comments, I have the sense that many of you are tired of being told about the virtues of free trade and the efficiency gains of structural adjustment and would prefer that economists listen a little more and lecture a little less.

Dallas Fed President Fisher: Cost-Pull Disinflation from Globalization

This continues the discussion on gobalization in the posts based on columns by Krugman and Samuelson. Two members of the Federal Reserve's FOMC discussed globalization today, Dallas Fed president Richard Fisher and New York Fed president Timothy Geithner. Let's begin with Richard Fisher whose ability to spice up a Fed speech is quickly turning him into one of my favorites (background on Fisher from a Houston Chronicle story), and I'll follow up with Geithner in the next post.  Fisher discusses how globalization will force governments towards less regulation, lower taxes, and more spending on investment rather than consumption goods, and its ability to produce cost-pull disinflation:

Globalization and Texas, by Richard W. Fisher, President, Dallas Fed: ...Speeches delivered by Federal Reserve Governors and Bank presidents are subject to interpretation in a manner akin to the ancient art of prophecy, which often divined the future by slicing open an animal and studying its entrails. It is interesting to be the “slice-ee” ... Philip Coggan ... [w]riting in the Financial Times last week, ... noted that when the great French statesman Talleyrand died, his archrival, Prince Metternich of Austria, was heard to muse, “I wonder what he meant by that?”...

[F]or the magic of free enterprise to work, fiscal authorities and central bankers must provide a healthy economic environment for the private-sector managers... in a challenging new global environment. [G]lobalization ... may well be the key development of our era; yet, we do not understand it very well. ... Globalization has intensified worldwide competition for investment capital. The consequences have included pushing governments to simplify or lower tax burdens to attract these funds... for legislatures and parliaments to maintain the rule of law, minimize obstacles to flexibility and maximize the ability to compete... The forces of international competition may be heralding a period when decisionmakers responsible for fiscal policy are forced to focus on investment rather than public-sector consumption. In ... today’s newly competitive world, governments’ purpose ... is to build an economic infrastructure that fosters private-sector production and growth, rather than transferring spending from one part of society to another. In an increasingly global economy, ... a dollar’s worth of government spending on consumption or entitlements has a higher opportunity cost today than it did yesterday. This will likely lead to a reconfiguring of government decisionmaking that in the past has short-changed infrastructure, research, education and other more productive public investments. ...

On the inflation-fighting front, globalization has been a positive factor. ... By lowering trade barriers ... we have benefited on the inflation front  ... [as] competition from abroad acts as a check on price increases by our own producers. ... To be sure, the growth of Russia, India, China and other new economic entrants has created upside price pressures, too. ... [P]roducers have felt some upward pressure on non-energy commodity prices driven by new sources of global demand. Steel is a case in point—as are copper and so many other commodities. Even so, I feel that the net effect of new entrants like China into our markets ...  has been a plus in exerting downward pressure on core inflation. I refer to this phenomenon internally at the Dallas Fed as “cost–pull disinflation.” As long as we keep our markets open and hold protectionists at bay, I expect this will continue...

Wednesday, October 19, 2005

Speeches by Fed Governor Kohn and Cleveland Fed President Pianalto (Update 2: Fisher and GeithnerToo)

I hope to do more on these later, but I thought I'd let you know about two more speeches from Federal Reserve officials adding to the chorus  of voices (e.g. here and here yesterday, here the day before) calling for a continuation of measured increases in the target value of the federal funds rate:

The Economic Outlook, by Fed Governor Donald L. Kohn ...In sum, I see risks on both sides of my expectations that the growth of economic activity will slow modestly on balance over the next year or so, leaving the economy producing at about its sustainable potential. But unless activity slows unexpectedly, and after the rise in retail energy prices, the risks may be skewed a little toward the upside on inflation. ... Obviously, we are considerably closer to where policy needs to be than we were sixteen months ago, but we are not yet at a point where we can stop and watch the economy evolve for a while. ... How far we go will depend on the evolution of economic activity and prices...

Economic Conditions and Monetary Policy, by Sandra Pianalto, President, Cleveland Fed ...Katrina and Rita did not change the broad contours of my forecast for continued economic growth and lower inflation into 2006. So, to me, the plan of continuing to remove the remaining amount of policy accommodation still looks like a sound one. We have already removed a substantial amount of that accommodation, and it is fair to ask how much further we might have to go. ... The answer ... depends on how economic conditions unfold.... Monetary policymaking requires managing risks. That means having a plan that is flexible enough to take into account sudden surprises and changing conditions. While I may be uncertain about which path the economy will take, ... Removing the remaining monetary policy accommodation puts us in the strongest possible position to react as evolving economic conditions require...

The message from the speeches is transparent - unless incoming data alter the picture substantially, rates will continue to rise.

Update: One more from Dallas Fed president Richard Fisher. He also discusses gobalization.  Given the recent discussion here on this topic (here and here), I hope to summarize his remarks later.

Globalization and Texas, by Richard Fisher, President, Dallas Fed: My recent soundings ... have caused my brow to furrow, reflecting concerns about the drag on growth by Hurricanes Katrina and Rita and the increases in energy prices. Several questions arise. How permanent are these influences? ... Will energy and associated costs work their way into core inflation? ... I must give an honest answer. ... I really don’t know... we must listen carefully to the anecdotal evidence... Price stability is a necessary condition for achieving maximum sustainable economic growth. Central bankers have always... recoiled from inflation. ... Here the Fed watchers who read entrails might take note: I am fully confident that the Fed will continue to do its part by containing inflationary expectations and pressures. ... You will note that the operative phrase ... was “inflation expectations.” A key to containing them is the conduct of the FOMC. For my part, as a member of the FOMC, I will not waver from advocating policy that discourages expectations of higher core inflation...

Update: There was yet another speech today, this one by Timothy Geithner, President of the New York Fed.  However, this talk did not address the future course of monetary policy.  Instead, the focus is on global imbalances and how they will be resolved. This would also be good to present more fully later:

U.S. and the Global Economy, by Timothy F. Geithner, President, New York Fed: For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings and the necessary slowing in U.S. domestic demand growth relative to growth of U.S. output would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others... the U.S. economy is in many ways in a relatively favorable position to manage through the risks in the adjustment process ahead. ... But we face a number of difficult long-term challenges as a nation—in our fiscal position, in how well we equip our citizens to prosper in a more competitive world and in our ability to sustain political support for the policies, including our relatively open trade policy, that have been an important source of the improvement in U.S. prosperity...

Federal Reserve Vice Chairman Roger W. Ferguson on the Economic Outlook for the U.S.

Having said in this post that San Francisco Fed president Janet Yellen had spoken more directly in her speech than others have since the last FOMC meeting regarding the future course of monetary policy, this speech from Vice Chairman Roger Ferguson is at least as direct and comes to much the same conclusion. His bottom line, "For now, I believe that our policy of removing monetary accommodation at a "measured" pace is most likely to promote our broader objectives of price stability and maximum sustainable economic growth," though he is clear to say that the rate changes in the future will be highly dependent upon incoming data and that the main risk in the future are the same as those identified by Yellen, high energy prices and a slowdown in housing, and he also points to the risk of slower business investment:

Economic Outlook for the United States, Federal Reserve Vice Chairman Roger W. Ferguson: I appreciate the opportunity to speak to you today about the outlook for the U. S. economy. ... To jump right to the bottom line, I believe that the outlook for the economy remains solid despite the devastating blows delivered to the Gulf Coast by Hurricanes Katrina and Rita. ... Before the hurricanes, ... the outlook was relatively benign: continued moderate economic growth accompanied by little change in the underlying pace of core inflation. There were, of course, risks in this forecast. The cumulative impact of the rise in energy prices on inflation and activity ... was clearly one concern. So too was the ongoing rise in home prices and the possibility that this phenomenon is unsustainable. ... I do not think that a significant and widespread drop in home prices is the most likely outcome, but the situation will require careful monitoring in the months ahead. A further risk is the apparent deceleration in business spending on new equipment and software (E&S). ... Are businesses becoming more reluctant to invest?...

I'd now like to turn to the economic effects of Hurricanes Katrina and Rita. ... At this point, it seems likely that the hurricanes had, at most, a small effect on the supply side of the economy. ... The hurricanes have, however, adversely affected the outlook for inflation. ... Consumer energy prices are projected to rise substantially in the second half of this year, and some spillover into the prices of non-energy goods and services looks likely as well. ... In general, economists believe persistent changes in relative prices have a larger effect on economic activity than do temporary changes. ... A large, long-lasting increase in the relative price of energy will affect inflation for a time. ... The behavior of inflation expectations is the key ... If expectations for long-run inflation become unanchored ... the possibility of a wage-price spiral increases...

The reaction of the business sector to permanently higher energy prices is more complicated. ... ... firms tend, where possible, to substitute capital and labor for energy consumption. In the 1970s and 1980s, such substitution greatly reduced the amount of energy consumed ... I'd expect to see a similar response to the latest price run-up in the years ahead. ... Studies have shown that adjustments by households and businesses in response to higher energy prices reduce the long-run level of potential output in the economy. This reduction mainly reflects the tendency of production to become more labor intensive ... In essence, labor productivity grows more slowly after an energy price shock and that effect lowers the trajectory for potential output... What does all of this mean for the conduct of monetary policy? In my view, it reinforces the need for policy to continue to be dependent on the incoming data on output and prices and on our forecasts for how those variables will evolve over time. ... it is also important to recognize that the measurement of economic activity in the immediate aftermath of the hurricanes may give an incomplete picture. Since it began withdrawing monetary accommodation in June 2004, the FOMC has repeatedly stated that its future policy actions will be governed by the expected performance of the economy. ... For now, I believe that our policy of removing monetary accommodation at a "measured" pace is most likely to promote our broader objectives of price stability and maximum sustainable economic growth.

Tuesday, October 18, 2005

San Francisco Fed President Yellen with an Update on the U.S. Economy

Of all the speeches since the last FOMC meeting, this speech from Janet Yellen has the most detail regarding her views on the state of the economy and the future course of monetary policy. The bottom line is that unless incoming data change the picture of the economy, rates will continue to increase. Those who are interested solely in her view of where rates are headed in the future may want to jump to the last paragraph or two:

Update on the U.S. Economy, Janet Yellen: ...I'll start by addressing some major developments in the U.S. economy relating to employment and output growth. I'll review the recent past and indicate my sense of the economy's likely path going forward, focusing particularly on risks I see relating to energy and the housing sector. Next I'll turn to the inflation picture. Finally, I'll conclude with some thoughts on the course of monetary policy in the U.S.

The part of the speech that follows this introduction repeats remarks she has made before on using fiscal policy rather than monetary policy to address the consequences of the hurricane, so I will not repeat them. The problem is that the lags in monetary policy are too long to be of much help and monetary policy cannot be directed at a particular region.  I will also add that while monetary policy can increase or decrease aggregate demand, it cannot produce oil or refineries, it cannot replace lost supply. Returning to the speech, Yellen next discusses her view of the strength of the economy and two risks to output growth in the future, higher energy costs and a fall in housing prices:

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Alan Greenspan on Energy

Alan Greenspan discusses oil and energy in this speech given in Japan. The speech covers the days of John D. Rockefeller and Standard oil to the present day, and speculates into the future. He believes the recent rise in oil prices will slow the economy, but with the flexibility and adaptability that market systems provide, and the changes the economy has undergone in response to high oil prices in the past, the rise in oil prices should prove far less costly in terms of both output losses and higher inflation than in the 1970s. As always, he expresses his great faith in free markets as the best solution to economic problems:

Energy, by Alan Greenspan: Even before the devastating hurricanes of August and September 2005, world oil markets had been subject to a degree of strain not experienced for a generation. Increased demand and lagging additions to productive capacity had eliminated a significant amount of the slack in world oil markets ... Although the global economic expansion appears to have been on a reasonably firm path through the summer months, the recent surge in energy prices will undoubtedly be a drag from now on. In the United States, Japan, and elsewhere, the effect on growth would have been greater had oil not declined in importance as an input to world economic activity since the 1970s. How did we arrive at a state ... so fragile that weather, not to mention individual acts of sabotage or local insurrection, could have a significant impact on economic growth? ... The history of the world petroleum industry is one of a rapidly growing industry seeking the stable prices that have been seen by producers as essential to the expansion of the market. In the early twentieth century, pricing power was firmly in the hands of Americans, predominately John D. Rockefeller and Standard Oil. ...  Rockefeller had endeavored with some success to stabilize those prices by gaining control ... of nine-tenths of U.S. refining capacity. But even after the breakup of the Standard Oil monopoly in 1911, pricing power remained with the United States ... Indeed, as late as 1952, crude oil production in the United States ... still accounted for more than half of the world total. ... Of course, concentrated control in the hands of a few producers over any resource can pose potential problems. ...[T]hat historical role ended in 1971, when excess crude oil capacity in the United States was finally absorbed by rising world demand. At that point, the marginal pricing of oil ... abruptly shifted to a few large Middle East producers ... To capitalize on their newly acquired pricing power, many ... in the Middle East, nationalized their oil companies. But the full magnitude of the pricing power of the nationalized oil companies became evident only in the aftermath of the oil embargo of 1973. ...[and the] ...  further surge in oil prices that accompanied the Iranian Revolution in 1979... The higher prices of the 1970s abruptly ended the extraordinary growth of U.S. and world consumption of oil and the increased intensity of its use ... In the United States, between 1945 and 1973, consumption of petroleum products rose at a startling average annual rate of 4-1/2 percent, well in excess of growth of our real GDP. However, between 1973 and 2004, oil consumption grew ... at only 1/2 percent per year... Much of the decline in the ratio of oil use to real GDP in the United States has resulted from growth in the proportion of GDP composed of services, high-tech goods, and other presumably less oil-intensive industries. Additionally, part of the decline in this ratio is due to improved energy conservation ... These trends have been ongoing but have likely intensified of late with the sharp, recent increases in oil prices... [T]he story since 1973 has been as much about the power of markets as it has been about power over markets. ... The failure of oil prices to rise as projected in the late 1970s is a testament to the power of markets and the technologies they foster. Today, the average price of crude oil ... is still in real terms below the price peak of February 1981. Moreover, since oil use ... is only two-thirds as important an input into world GDP as it was three decades ago, the effect of the current surge in oil prices, though noticeable, is likely to prove significantly less consequential to economic growth and inflation than the surge in the 1970s...

[T]he opportunities for profitable exploration and development in the industrial economies are dwindling, and the international oil companies are currently largely prohibited, restricted, or face considerable political risk in investing in OPEC and other developing countries. In such a highly profitable market..., one would have expected a far greater surge of oil investments. ... But because of the geographic concentration of proved reserves, much of the investment in crude oil productive capacity required to meet demand, without prices rising unduly, will need to be undertaken by national oil companies in OPEC and other developing economies. Although investment is rising, ... many governments perceive that the benefits of investing in additional capacity to meet rising world oil demand are limited. ... Unless those policies, political institutions, and attitudes change, it is difficult to envision adequate reinvestment into the oil facilities of these economies. Besides feared shortfalls in crude oil capacity, the status of world refining capacity has become worrisome as well. ... A continuation of this trend would soon make lack of refining capacity the binding constraint on growth in oil use. This may already be happening in certain grades... [T]he expansion and the modernization of world refineries are lagging. For example, no new refinery has been built in the United States since 1976. ... Much will depend on the response of demand to price over the longer run. If history is any guide, should higher prices persist, energy use over time will continue to decline relative to GDP. ... With real energy prices again on the rise, more-rapid decreases in the intensity of energy use in the years ahead seem virtually inevitable. Long-term demand elasticities over the past three decades have proved noticeably higher than those evident in the short term...

Altering the magnitude and manner of energy consumption will significantly affect the path of the global economy over the long term. ... We cannot judge with certainty how technological possibilities will play out in the future, but we can say with some assurance that developments in energy markets will remain central in determining the longer-run health of our nations' economies. The experience of the past fifty years ... affirms that market forces play a key role in conserving scarce energy resources, directing those resources to their most highly valued uses. However, the availability of adequate productive capacity will also be driven by nonmarket influences and by other policy considerations. To be sure, energy issues present policymakers with difficult tradeoffs to consider. The concentration of oil reserves in politically volatile areas of the world is an ongoing concern. But hopes ... that ... does not distort or stifle the meaningful functioning of our markets. Barring political impediments to the operation of markets, the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they stimulate the research and development that will unlock new approaches to energy production and use that we can now only barely envision. Improving technology and ongoing shifts in the structure of economic activity are reducing the energy intensity of industrial countries ... If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out. Indeed, oil displaced coal despite still vast untapped reserves of coal, and coal displaced wood ... New technologies to more fully exploit existing conventional oil reserves will emerge in the years ahead. ... We will begin the transition to the next major sources of energy, perhaps before midcentury, as production from conventional oil reservoirs ... is projected to peak. In fact, the development and application of new sources of energy, especially nonconventional sources of oil, is already in train. Nonetheless, the transition will take time. We, and the rest of the world, doubtless will have to live with the geopolitical and other uncertainties of the oil markets for some time to come.

Monday, October 17, 2005

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.

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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...

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Wednesday, October 12, 2005

Fed Governor Olson on the Fiscal Outlook for the U.S. Economy

Continuing the roundup of recent remarks by Fed officials here, here, and here, Fed Governor Olson discusses his concern about the fiscal outlook for the U.S. economy, and the outlook for monetary policy and the economy.

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Fed Governor Bies on Regulatory Responses to Credit Risk and Discrimination in Mortgage Markets

Continuing the remarks by Fed officials from Greenspan and Kohn, Federal Reserve Governor Susan Bies also discusses monetary policy, particularly regulation.

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Fed Governor Kohn on How Globalization Affects Inflation and Monetary Policy

In addition to Greenspan's remarks today noted here, Fed governor Donald Kohn, discusses globalization, inflation, and monetary policy in a speech given yesterday.

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Greenspan on the Virtues of Free Markets and Information Technology

There are several speeches today by monetary officials.  Let's start at the top with remarks by Alan Greenspan.

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