What happens when an academic researcher becomes a policymaker? Recently, President Anthony Santomero shared some thoughts on this topic with members for the Downtown Economists Club in New York City. In particular, he talked about several conundrums he's encountered since moving from the academy to the central bank. We've reprinted his speech "The Complexities of Monetary Policy" in this issue of the Business Review so that we can share President Santomero's insights with our readers as well.Monetary policy

Anthony M. Santomero

English

Research Papers in Economics

  Business Review  Q2 2001   3 www.phil.frb.org
Anthony M. Santomero, President,
Federal Reserve Bank of Philadelphia
BY ANTHONY M. SANTOMERO
A
The Complexities of Monetary Policy
The following is a speech President Santomero delivered to the Downtown Economists Club, New York City, on  March 26, 2001.
s a former academic researcher who is now
president of the Federal Reserve Bank of
Philadelphia, I’ve encountered several
places where macroeconomic theory intersects with
real world economics.
capacity for growth in light of the
remarkable gains in productivity in the
latter half of the 1990s. The strength of
the economy over that period, accompa-
nied by a remarkably low inflation rate,
was due, in no small measure, to more
rapid productivity growth, which
stemmed largely from technology
investments made during the decade.
With the technology sector undergoing
substantial change and reevaluation, it
might be interesting to examine this
relationship as the first area of focus.
Let me begin with what we
know: productivity growth has
improved because of technology.  But
this statement is not as useful as it
might be, because one does not know
exactly what this foretells about the
future pace of productivity growth.
Put another way, we don’t
have the equation that describes how
technology affects productivity. Nor do
we have the equation that describes
how technology evolves.  In the end,
we do not even have a satisfying
As a long-time research economist, I
derive great enjoyment from spending
time with fellow economists. Some call
us practitioners of the “dismal science,”
but all of us in this room know better.
After all, this is a meeting of the
Downtown Economists Club. “Club”
certainly has a festive, friendly ring to it,
so I’m confident our time together will
be anything but dismal.
As you know, I came to the
Federal Reserve Bank of Philadelphia
after spending many years on the
faculty of the Wharton School.  So I
thought I would spend my time with
you today talking about the interplay
between my long experience as an
academic researcher and my new
responsibilities as a central banker.
Since I joined the Fed last
summer, I’ve encountered several
conundrums.  I suppose you could also
call them “points of tension” — places
where macroeconomic theory inter-
sects with real world economics.
Whatever terminology one
uses, these conundrums illustrate the
challenges that one confronts in
analyzing economic conditions,
forecasting their likely future course,
and using information that is often
imperfect to map out appropriate
monetary policy.
As it happens, my tenure at
the Fed has partly coincided with
events that illustrate some of the
fundamental issues that I would like to
talk about today. Not long ago there
was concern about an overheating
economy. Then, in little more than the
blink of an eye, there was concern
about a possible recession. How
quickly things change and how
suddenly pressure for policy response
shifts direction!  I once viewed this
from the relatively safe haven of the
academy. I now view it from the
trenches as a policymaker. It’s been an
interesting time.
Today I’ll talk about four
conundrums I’ve come upon in
making monetary policy decisions.
Let’s take them one at a time.
ON THE SUPPLY SIDE
The first we might call the
“supply side” conundrum. The key
challenge here lies in resolving the
fundamental issue of how rapidly the
economy can grow on a sustained
basis. There has been much discussion
about the U.S. economy’s long-run4   Q2 2001 Business Review www.phil.frb.org
measure of the variable we call
technology.  So when we ask ourselves
how fast the economy can grow going
forward, we must acknowledge that
there is a substantial degree of uncer-
tainty about the answer because of our
limited knowledge of the processes
underlying future productivity enhance-
ment.
As an economist I can accept
this.  But as a policymaker, I have to
take the next step — the one that
makes me uncomfortable as an
economist.  That is, in spite of our
uncertainties, indeed our ignorance, I
have to make some assessment of the
rate at which the application of
technological innovations raises
potential output going forward.
Making that “supply side” assessment
is essential to laying out the path of
long-term, sustainable economic
growth that monetary policy aims to
match from the demand side.
Well, what is my estimate?  I
expect annual productivity growth to
average 2 to 3 percent for the foresee-
able future. Why? Because I believe
that “new economy” technologies have
yet to fully infuse the “old economy”
with the productivity gains they offer.
When I talk with business people
around our District, they tend to
agree.  It seems that advances in
information technology and informa-
tion management are still in the
process of revolutionizing the way
businesses design, produce, and deliver
their products and services.  This
process takes time and often lags the
purchase of technology, but the
benefits accruing to real sector
productivity are real and sustained.
So if information technology
continues to revolutionize industry,
then the economy can sustain real
GDP growth of 3 to 4 percent without
accelerating inflationary pressures for
the foreseeable future. But let me
stress that this figure is a long-run
average. One must allow for some
margin of error around this number and
expect it to exhibit some cyclical
variability. Only simple equations are
straight lines; real economies tend to
move less linearly.
As an economist I am comfort-
able with this complexity because theory
tells me that the marketplace will weigh
them all and consistently drive the real
rate of interest to its proper equilibrium,
ON THE DEMAND SIDE
The second of my conun-
drums is what might be called the
“demand side” conundrum. As
economists, we know there is some
interest rate that induces investors to
invest just the right amount, and
savers to save just the right amount, to
bring the economy to its potential
output.  The key questions here are:
What is that interest rate? And how
does it evolve over time?  One needs
to answer these questions in order to
assess whether monetary policy is
properly positioned to foster the
economy’s achieving its full growth
potential.
As an economist I am
comfortable with the idea that a
myriad of factors affect both saving
and investment decisions.
Some are identifiable and
measurable – like income on the
saving side, or depreciation rates on
the investment side. Others are
identifiable, if not so easily measured –
like expected returns to savings or
wealth targets on the saving side, and
technological breakthroughs, capacity
utilization, or acceptable hurdle rates
on the investment side.
I also know that some of
these factors are subject to high-
frequency fluctuations – like changes
in wealth due to stock price variation
– and some are subject to low fre-
quency trends – like changing demo-
graphics.
I believe that “new economy” technologies
have yet to fully infuse the “old economy” with
the productivity gains they offer.
whatever it may be – even as that
equilibrium shifts over time.
As a monetary policymaker, I
cannot be quite so comfortable.  That
is because, whether we like it or not,
monetary policy today is an interest
rate policy.  And so gauging the stance
of monetary policy – determining
whether the Fed is being stimulative,
contractionary, or neutral – is essen-
tially an exercise in assessing where we
have set the real rate relative to that
long-run equilibrium path.
Let me give you a very
practical example of how this problem
plays out.  If trend productivity growth
is higher now than it was 10 years ago,
then, everything else constant,
businesses now have a stronger
demand for funds to invest in new
projects and consumers save less
because they expect their incomes to
rise faster. So the equilibrium real rate
of interest should now be higher. How
much higher? And, of course, since
everything else is never constant, how
much higher on net?
My own point of view is that
the average equilibrium real rate
probably is higher now than it was 10
years ago. But again, I would allow for
a wide margin of error around any
estimate. Short-term and cyclical
variations alter the appropriate
momentary natural rate of interest,
making it of considerably less use in
determining the stance of monetary
policy.  Actually, gauging monetary  Business Review  Q2 2001   5 www.phil.frb.org
policy at any point in time presents other
problems as well.  This brings me to my
next conundrum.
ABOUT THE DYNAMICS
OF POLICY
My third conundrum I would
label the “policy dynamics” conun-
drum. This one is certainly nothing
new. Milton Friedman summarized the
problem years ago, coining one of the
most famous phrases in modern
economics, when he said that the
impact of monetary policy is subject to
“long and variable lags.” Consequently,
at any point in time, monetary
policymakers cannot tell whether what
they see going on in the economy is
the reflection of changing market
conditions or, alternatively, the lagged
effect of their own past actions.  And
so an activist monetary policy intended
to fine-tune the economy’s perfor-
mance could, in fact, destabilize it.
Friedman argued that the best
approach for monetary policymakers to
take would be to fix the growth rate of
the money supply at some constant
amount. Following this rule would
allow the economy to achieve its peak
efficiency, recognizing that this would
inevitably include some cyclical ups
and downs.
As an economist, I respect
Friedman’s analysis. But as a policy-
maker, I am left with the dilemma of
how one would put his prescription
into practice. Today there is no
monetary aggregate reliably linked to
spending growth, and so monetary
policy is, as I said a moment ago, an
interest rate policy. Obviously, fixing
an interest rate is not the same thing
as fixing the money growth rate.
Indeed, holding short-term interest
rates constant – not allowing them to
move as market conditions change – is
a sure-fire prescription for destabilizing
the economy.
So how does one balance the
need to move short-term interest rates in
response to shifting economic conditions
with the need to provide the market-
place with a stable and reliable mon-
etary policy?  I think there are two
answers.  One answer is to move beyond
a commitment to stable money growth
and make a credible commitment to low
and stable inflation.
I believe that over the past 10
years, the Fed has successfully made
that transition.  Whatever the
subtleties of particular monetary policy
actions, it is clear that the Fed’s
ultimate goal is to help create the
financial conditions that foster
maximum sustainable economic
growth. In the long run, the most
important contribution the Fed can
make toward this goal is to maintain a
low inflation environment. To a
considerable extent, the public’s
expectations about long-run inflation
are measures of its confidence in the
Fed’s commitment to that mission.
As many of you know, our
own Reserve Bank conducts a quar-
terly survey of professional economic
forecasters. Results of that survey show
that long-run inflation expectations
remain low and stable and have been
for the last several years.  I consider
that an important signal that the Fed
has established its commitment.
The second way to solve the
policy puzzle of preserving flexibility in
setting interest rates while also
providing stability in monetary policy is
more tactical. Fed policymakers must
stand apart from the incessant demand
for instant reaction and the expecta-
tion of instant results.  There is a
tendency among observers to focus on
the Fed’s next interest rate move, with
the implication that the Fed can and
should fine-tune the economy’s
performance. But the fact is that it
takes time for a policy action’s impact
to play out, and we are frequently
waiting for past actions to reach
fruition and achieve their desired
effect on the economy.
ABOUT CONFIDENCE
But before we get too
comfortable with the wisdom of a
“wait and see” approach, let me
describe the fourth and final conun-
drum I want to discuss with you today.
This is one that I personally have
found particularly perplexing since
joining the Fed. It is also one that has
gotten a lot of “ink” recently.  I’ll call it
“the confidence conundrum,” because
it centers on how confidence plays a
role in macroeconomic dynamics.
The issue is this: when waves
of confidence – or doubt – wash over
the economy, how should monetary
policymakers respond to them?  This is
a conundrum because there is ample
evidence that expectations about the
future are rational in the long run, and
the marketplace validates them on
average. But in the short run, the
marketplace is beset by waves of
confidence that move expectations
and thus may significantly affect
spending in ways that may or may not
be either sustainable or desirable.
What to do in the face of
variations in consumer or business
confidence is not an easy issue to
resolve.  Macroeconomists usually
assume that the economy behaves as if
consumers and businesses form their
expectations rationally, and they
forecast the future based on observa-
tions of stable historical economic and
financial patterns.  This is a conve-
nient assumption because it obviates
the need to model people’s decision-
making explicitly, and it keeps changes
in expectations from playing an
independent role in the performance
of the economy.  But we know that
reality is not that simple.
While measures of consumer
confidence usually track historical
movements in economic variables –
income, wealth, indebtedness,
unemployment, and the like – there are
occasions when confidence moves
beyond what the incoming economic6   Q2 2001 Business Review www.phil.frb.org
data might warrant.  These exogenous
shifts in confidence may not be rational.
Consumers and investors are capable of
over- and underreaction. After all, we
are only human.
Nonetheless, these shifts in
confidence can cause changes in
expectations that affect spending
decisions and so can become self-
fulfilling, or at least self-sustaining,
processes for a considerable period of
time. Consequently, the role played by
expectations can be at once more
significant and more complicated than
our standard macroeconomic models
allow.
We should not lose sight of
how important expectations are to
people’s decision-making and how far-
reaching the impact of changes in
expectations can be.  Expectations can
change quickly and can dramatically
alter aggregate demand.
As a former finance professor,
I am intimately familiar with the
investment decision process. It is, to a
large extent, a process of expectations.
Businesses routinely try to project the
future gains to be derived from
investments made today. This is
fundamental to capital budgeting, a
subject that I taught too many MBA
students over the course of too many
years!
Likewise when individuals
make consumption and savings
decisions, expectations play an
important role. The appropriate
amount to save for retirement, for
example, depends in large part on
expectations of future rates of return.
In short, when it comes to
making economic decisions, expecta-
tions matter.  And I would add that
shifts in that intangible we call
confidence affects those expectations.
I believe that we are in the midst of
dealing with one of these shifts in
confidence right now.  The key issue
that we must address is the extent to
which it will have a significant impact
on the aggregate economy going
forward.
So how should monetary
policy respond?  I do not think the Fed
should routinely take policy actions for
the sole purpose of boosting expecta-
tions or merely to affect confidence.
This would ultimately be a dangerous
and destabilizing game. However, I
believe that if a decline in confidence
is viewed as having a substantial
dampening effect on overall real sector
this experience is that sometimes
monetary policy decisions have to be
based on something more than well-
constructed theory and overwhelming
evidence from the data.  Sometimes
they must be based on our sense of the
situation. Such situations do not arise
very often, but when they do, it is
important, given the lags in the impact
of monetary policy, that the Fed move
expeditiously.
Well, I have shared with you
some of the musings of a professor
turned policymaker. At the end of the
day, where do all of these conundrums
leave me?
By their nature, conundrums
are not easily resolved, and so I will
continue to consider them in the
months and years ahead. Even at this
stage, however, I think they suggest a
useful approach to monetary
policymaking.  To deal prudently with
the uncertainties on both the supply
side and the demand side of the
economy, as well as the dynamics of
monetary policy, monetary policy
ought to move in careful increments
and at a measured pace.
Overlaying this is the fact
that expectations matter and we must
deal with the real impact of sharp
shifts in public confidence in a more
expeditious manner. Doing so requires
a sensitivity to nuance and timing that
I expect policymakers will always find
challenging.
For me personally, the
transition from academic life to the
world of central banking is proving to
be an invigorating challenge. In my
new role I’ve learned that I can be the
proverbial two-handed economist only
up to a point. In the end, decision-
making requires a one-handed
economist who must take action, even
if issues remain open and questions
remain unanswered.
We should not lose
sight of how impor-
tant expectations are
to people’s decision-
making and how far-
reaching the impact
of changes in expec-
tations can be.
demand growth, then monetary policy
can and should respond – with the aim
of restoring overall demand growth to a
pace consistent with potential supply
growth.
I believe the Fed’s recent
policy actions are consistent with this
approach. It responded to a variety of
indications that aggregate demand
growth has been weakening, including
a deterioration in confidence that was
more severe than the underlying data
seemed to indicate.  And the Fed
remains vigilant by continually
monitoring the behavior of the real
economy.
The lesson I take away from

The complexities of monetary policy.

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The complexities of monetary policy.

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