This is the last of four issues devoted to our updated and expanded Q&A on monetary policy: (1) "How is the Federal Reserve structured?" and "What are the tools of U.S. monetary policy?" (2) "What are the goals of U.S. monetary policy?" (3) "How does monetary policy affect the U.S. economy?" and (4) "How does the Fed decide the appropriate setting for the policy instrument?" The revised text will appear in a pamphlet soon.Monetary policy ; Interest rates ; Federal Open Market Committee ; Federal Reserve System

anonymous

English

Research Papers in Economics

U.S. Monetary Policy:An Introduction
Part 4: How does the Fed decide the appropriate setting 
for the policy instrument?
The Fed’s job of stabilizing output in the short
run and promoting price stability in the long run
involves several steps. First, the Fed tries to esti-
mate how the economy is doing now and how
it’s likely to do in the near term—say, over the
next couple of years or so.Then it compares these
estimates to its goals for the economy and infla-
tion. If there’s a gap between the estimates and
the goals, the Fed then has to decide how force-
fully and how swiftly to act to close that gap. Of
course, the lags in policy complicate this process.
But so do a host of other things.
What things complicate the process of determining
how the economy is doing?
Even the most up-to-date data on key variables
like employment, growth, productivity, and so on,
reflect conditions in the past,not conditions today;
that’s why the process of monetary policymaking
has been compared to driving while looking only
in the rearview mirror.So,to get a reasonable esti-
mate of current and near-term economic conditions,
the Fed first tries to figure out what the most rele-
vant economic developments are; these might be
things like the government’s taxing and spending
policies, economic developments abroad, financial
conditions at home and abroad,and the use of new
technologies that boost productivity.These develop-
ments can then be incorporated into an economic
model to see how the economy is likely to evolve
over time.
Sounds easy—plug the numbers into the model and
get an answer. So what’s the problem?
There are lots of problems. One problem is that
models are only approximations—they can’t cap-
ture the full complexity of the economy.Another
problem is that, so far, no single model adequately
explains the entire economy—at least, you can’t
get economists to agree on a single model; and
no single model outperforms others in predicting
future developments in every situation.Another
problem is that the forecast can be off base because
of unexpected,even unprecedented,developments—
the September 11 attacks are a case in point.So in
practice,the Fed tries to deal with this uncertainty
by using a variety of models and indicators,as well
as informal methods, to construct a picture of the
economy.These informal methods can include anec-
dotes and other information collected from all kinds
of sources, such as the Directors of the Federal
Reserve Banks, the Fed’s various advisory bodies,
and the press.
So now are we in a position to compare the Fed’s
estimates with its goals?
Not so fast.Coming up with operational measures
of the goals is harder than you might think, espe-
cially the goal for the rate of maximum sustainable
output growth.Unfortunately,this is not something
you can go out and measure. So, once again, the
Fed has to turn to some sort of model or indicator
to estimate it.And it’s hard to be certain about any
estimate,in part because it’s hard to be certain that
the model or indicator the estimate is based on is
the right one.There’s one more important complica-
tion in estimating the rate of maximum sustainable
growth—it can shift over time!
What problems does a shift in the rate of maximum
sustainable growth cause? 
The experience of the late 1990s provides a good
example of the policy problems caused by such a
shift. During this period, output and productivity
surged at the same time that rapid innovation was
transforming the information technology industry.
FRBSF ECONOMIC LETTER
Number 2004-04,February 6,2004
This is the last of four issues devoted to our updated and expanded Q&A on monetary policy: (1) “How is
the Federal Reserve structured?” and “What are the tools of U.S. monetary policy?” (2) “What are the goals
of U.S. monetary policy?” (3) “How does monetary policy affect the U.S. economy?” and (4) “How does the
Fed decide the appropriate setting for the policy instrument?”The revised text will appear in a pamphlet soon.FRBSF Economic Letter 2 Number 2004-04, February 6, 2004
In the early stages,there was no way for the Fed—
or anybody else—to tell why output was growing
so fast. In other words, the Fed had to determine
how much of the surge in output was due to unusu-
ally rapid technical progress and whether this implied
an increase in the economy’s trend growth rate.
This was a crucial issue because policy would re-
spond differently depending on exactly why the
economy was growing faster. If it was largely due
to the spread of new technologies that enhanced
worker and capital productivity, implying that the
trend growth rate was higher, then the economy
could expand faster without creating inflationary
pressures.In that case,monetary policy could stand
pat. But if it was just the economy experiencing a
more normal business cycle expansion, then infla-
tion could heat up. In that case, monetary policy
would need to tighten up.
The Fed’s job was complicated by the fact that
statistical models did not find sufficient evidence
to suggest a change in the trend growth rate. But
the Fed looked at a variety of indicators, such as
the profit data from firms, as well as at informal
evidence, such as anecdotes, to conclude that the
majority of the evidence was consistent with an
increase in the trend growth rate. On that basis,
the Fed refrained from tightening policy as much
as it would have otherwise.
Does the trend growth rate ever fall? 
Yes, it does.A good example, with a pretty bad
outcome, was what happened in the early 1970s,
a period marked by a significant slowdown in the
trend growth rate.A number of economists have
argued that the difficulty in determining that such
a slowdown had actually taken place caused the Fed
to adopt an easier monetary policy than it might
otherwise have, which in turn contributed to the
substantial acceleration in inflation observed later
in the decade.
What happens when the estimates for growth and
inflation are different from the Fed’s goals? 
Let’s take the case where the forecast is that growth
will be below the goal.That would suggest a need to
ease policy.But that’s not all.The Fed also must decide
two other things: (1) how strongly to respond to
this deviation from the goal and (2) how quickly
to try to eliminate the gap. Once again, it can use
its models to try to determine the effects of vari-
ous policy actions.And, once again, the Fed must
deal with the problems associated with uncertainty
as well as with the measurement problems we have
already discussed.
Uncertainty seems to be a problem at every stage.
How does the Fed deal with it?
Uncertainty does,indeed,pervade every part of the
monetary policymaking process.There is as yet no
set of policies and procedures that policymakers
can use to deal with all the situations that may arise.
Instead,policymakers must decide how to proceed
by going case by case.
For instance, when policymakers are more uncer-
tain about their reading of the current state of the
economy, they may react more gradually to eco-
nomic developments than they would otherwise.
And because it’s hard to come up with unambigu-
ous benchmarks for the economy’s performance,
the Fed may look at more than one kind of bench-
mark. For instance,because it’s hard to get a precise
estimate of the trend growth rate of output, the
Fed may look at the labor market to try to figure
out where the unemployment rate is relative to
some kind of benchmark or “natural rate,” that is,
the rate that would be consistent with price stability.
Alternatively, it might try to determine whether
the stance of policy is appropriate by comparing
the real funds rate to an estimate of the “equilib-
rium interest rate,” which can be defined as the
real rate that would be consistent with maximum
sustainable output in the long run.
These issues are far from settled. Indeed the Fed
spends a great deal of time and effort in research-
ing various ways to deal with different kinds of
uncertainty and in trying to figure out what kind
of model or indicator is likely to perform best in
a given situation. Since these issues aren’t likely to
be resolved anytime soon,the Fed is likely to con-
tinue to look at everything.
Suggested reading
For further discussion of the topics in this article, see
the following issues of the FRBSF Economic Letter.
93-01 “An Alternative Strategy for Monetary Policy,”
by Brian Motley and John Judd.http://www.frbsf.org/
publications/economics/letter/1993/el93-01.pdf
93-38 “Real Interest Rates,” by Bharat Trehan. http://
www.frbsf.org/publications/economics/letter/1993/
el93-38.pdf93-42 “Monetary Policy and Long-Term Real Interest 
Rates,” by Timothy Cogley. http://www.frbsf.org/
publications/economics/letter/1993/el93-42.pdf
97-29 “A New Paradigm?” by Bharat Trehan. http://
www.frbsf.org/econrsrch/wklyltr/el97-29.html
97-35 “NAIRU: Is It Useful for Monetary Policy?”
by John Judd.http://www.frbsf.org/econrsrch/wklyltr/
el97-35.html
98-28 “The Natural Rate,NAIRU,and Monetary Policy,”
by Carl Walsh. http://www.frbsf.org/econrsrch/
wklyltr/wklyltr98/el98-28.html
98-38 “Describing Fed Behavior,” by John Judd and 
Glenn Rudebusch.http://www.frbsf.org/econrsrch/
wklyltr/wklyltr98/el98-38.html
99-21 Supply Shocks and the Conduct of Monetary 
Policy,” by Bharat Trehan. http://www.frbsf.org/
econrsrch/wklyltr/wklyltr99/el99-21.html
99-33 “Risks in the Economic Outlook” by Robert T.
Parry. http://www.frbsf.org/econrsrch/wklyltr/
wklyltr99/el99-33.html
2000-21 “Exploring the Causes of the Great Inflation,”
by Kevin Lansing.http://www.frbsf.org/econrsrch/
wklyltr/2000/el2000-21.html
2000-31 “Monetary Policy in a New Environment:
The U.S.Experience”by Robert T.Parry.http://www.
frbsf.org/econrsrch/wklyltr/2000/el2000-31.html
2001-05 “How Sluggish Is the Fed?”by Glenn Rudebusch.
http://www.frbsf.org/publications/economics/letter/
2001/el2001-05.html
2001-13 “The Science (and Art) of Monetary Policy”
by Carl Walsh. http://www.frbsf.org/publications/
economics/letter/2001/el2001-13.html
2003-14 “Minding the Speed Limit” by Carl Walsh.
http://www.frbsf.org/publications/economics/letter/
2003/el2003-14.html
2003-32 “The Natural Rate of Interest”by John Williams.
http://www.frbsf.org/publications/economics/letter/
2003/el2003-32.html
2003-34 “Should the Fed React to the Stock Market?”
by Kevin Lansing.http://www.frbsf.org/publications/
economics/letter/2003/el2003-34.html
FRBSF Economic Letter 3 Number 2004-04, February 6, 2004PRESORTED 
STANDARD MAIL
U.S. POSTAGE
PAID
PERMIT NO. 752
San Francisco, Calif.
Printed on recycled paper
with soybean inks
Index to Recent Issues of FRBSF Economic Letter
DATE NUMBER TITLE AUTHOR
8/1 03-22 Disclosure as a Supervisory Tool: Pillar 3 of Basel II Lopez
8/15 03-23 Understanding State Budget Troubles Daly
8/22 03-24 Improving the Way We Measure Consumer Prices Wu
8/29 03-25 The Present and Future of Pension Insurance Kwan
9/12 03-26 Are We Running out of New Ideas? A Look at Patents and R&D Wilson
9/19 03-27 The Fiscal Problem of the 21st Century Jones
9/26 03-28 Earnings Inequality and Earnings Mobility in the U.S. Daly/Valletta
10/3 03-29 Mortgage Refinancing Krainer/Marquis
10/10 03-30 Is Our IT Manufacturing Edge Drifting Overseas? Valletta
10/24 03-31 Good News on Twelfth District Banking Market Concentration Laderman
10/31 03-32 The Natural Rate of Interest Williams
11/7 03-33 The Bay Area Economy: Down but Not Out Daly/Doms
11/14 03-34 Should the Fed React to the Stock Market? Lansing
11/28 03-35 Monitoring Debt Market Information for Bank Supervisory Purposes Krainer/Lopez
12/12 03-36 Japanese Foreign Exchange Intervention Spiegel
12/19 03-37 The Current Strength of the U.S.Banking Sector Krainer/Lopez
12/26 03-38 Is There a Digital Divide? Valletta/MacDonald
1/16 04-01 U.S. Monetary Policy: An Introduction, Part 1 Economic Research
1/23 04-02 U.S. Monetary Policy: An Introduction, Part 2 Economic Research
1/30 04-03 U.S. Monetary Policy: An Introduction, Part 3 Economic Research
Opinions expressed in the Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank
of San Francisco or of the Board of Governors of the Federal Reserve System.This publication is edited by Judith Goff, with
the assistance of Anita Todd.Permission to reprint portions of articles or whole articles must be obtained in writing.Permission
to photocopy is unrestricted. Please send editorial comments and requests for subscriptions, back copies, address changes, and
reprint permission to:Public Information Department,Federal Reserve Bank of San Francisco,P.O.Box 7702,San Francisco,CA
94120, phone (415) 974-2163, fax (415) 974-3341, e-mail sf.pubs@sf.frb.org. The Economic Letter and other publications
and information are available on our website, http://www.frbsf.org.
ECONOMIC RESEARCH
FEDERAL RESERVE BANK
OF SAN FRANCISCO
P.O. Box 7702
San Francisco, CA 94120
Address Service Requested

U.S. monetary policy: an introduction - Part 4: How does the Fed decide the appropriate setting for the policy instrument?

http://www.frbsf.org/publications/economics/letter/2004/el2004-04.html

U.S. monetary policy: an introduction - Part 4: How does the Fed decide the appropriate setting for the policy instrument?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics