Monetary theory ; Monetary policy ; Interest rates

Laurence H. Meyer

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST.L OUIS
JULY/AUGUST 2001      183
Commentary
Laurence H. Meyer
I
t is a pleasure for me to participate in this
conference in honor of Darryl Francis. In the
late 1960s and early 1970s, when Darryl
Francis was president of the Federal Reserve Bank
of St. Louis, I had recently arrived at Washington
University. I had just completed my graduate work
at MIT, primed during those years for combat with
the monetarists at the Federal Reserve Bank of St.
Louis. Needless to say, I engaged in many vigorous
debates, often with Leonall Anderson and Jerry
Jordan, and often at conferences presided over by
Darryl Francis. I can only imagine the degree to
which Darryl Francis enlivened the FOMC meetings
during this period.
It is also a distinct pleasure to comment on
this stimulating and thought-provoking paper by
Charles Goodhart. It is just what many of us hoped
we would be treated to when Charles returned to
full-time academic pursuits after his experience as
a member of the Monetary Policy Committee (MPC)
at the Bank of England—an insightful assessment
of the strategy and process of monetary policy-
making by the MPC.
Charles covers a lot of ground in this paper,
challenging the ability of even a fast-talker like me
to do justice in a short comment. I will focus on
three questions that Charles poses, with most of
my attention on the first two questions, which form
the centerpiece of his paper.
1. Is the MPC’s implicit two-year policy horizon
the optimal one for their inflation targeting
approach?
2. Is the MPC’s practice of conditioning its
forecast on a constant path for the nominal
short-term interest rate appropriate?
3. Under what circumstances should policy
today respond to asymmetric risks in the
outlook?
THE POLICY HORIZON
Charles starts by asking what the relationship
is between the lag in the response of the economy
to monetary policy actions and the policy horizon
in the inflation targeting approach at the MPC. My
immediate response was that this was an interest-
ing question, and I looked forward to the analysis
and answer. Unfortunately, Charles did not follow
up in this direction very effectively. He could, for
example, have varied the length of the lag of the
response of the economy to monetary policy in
some of the models he considered and traced the
effect on the optimal policy horizon.
Instead he reviewed a series of studies, each of
which offered multiple simulations, leaving us
with a smorgasbord of results. This led Charles to
conclude, correctly I believe, that the appropriate-
ness of the two-year policy horizon of the MPC is
unclear because the optimal horizon is so sensitive
to the shocks, the model, and the loss function.
This should not suggest that Charles’s analysis
was a dead-end. The point, it seems to me, is that
one cannot determine a single optimal policy hori-
zon for an inflation targeting approach precisely
because the optimal horizon should be variable,
depending on the source and size of shocks, which
affect the speed of the desired return to the infla-
tion target. I do not read this as the conclusion
that Charles reaches, but it seems it is a conclusion
that follows from his careful analysis and survey
of the literature. 
The fundamental problem with the selection
of an arbitrary policy horizon in an inflation
targeting approach is its inability to deliver on its
raison d’être. The policy horizon in an inflation-
targeting approach is a device for taking into
account the unacceptable output variability that
would follow from an excessively rapid return to
the inflation target following a departure from
the target. Charles approvingly quotes Batini and
Haldane: “[A]ny degree of output stabilization can
be synthetically recreated by judicious choice of
parameters entering an inflation-targeting formula.
There is no need for any explicit output terms to
enter this rule.” 
This may be true on average over some
period, but it is clearly not true episode by episode,
depending on the source and size of the shocks.
The ability of forecast-based rules that exclude the
output gap to achieve any desired level of output
stabilization by adjusting the forecast horizon is
not robust across models, and there are several
cases in which the cost of excluding the output
gap are quite significant.
It seems to me that the interesting question
here is, Why use an imperfect, synthetic device to
Laurence H. Meyer is a member of the Board of Governors of the
Federal Reserve System.184 JULY/AUGUST 2001
REVIEW
allow for output stabilization when you can use the
real thing, that is, take output variability directly
into account? The answer I sometimes hear—
usually from policymakers at inflation-targeting
central banks—is that admitting that a central bank
carries out its monetary policy in part to stabilize
output would undermine the public’s confidence
in its commitment to price stability. But this would
be a strange answer from a central bank that prides
itself on its transparency. 
Let me compare the MPC’s well-articulated
inflation targeting approach to the Fed’s less well-
articulated strategy. First, the Fed’s mandate, given
by the Congress, is to promote full employment
and price stability, an explicit dual mandate, with
a clear directive to worry about output stabilization.
Given that policymakers inevitability face a trade-
off between output and inflation variability and
the public cares about both, this seems to me the
right way to frame a central bank’s objectives. In
addition, I don’t see any reason to saddle the
Federal Open Market Committee (FOMC) with an
arbitrary horizon for returning inflation to the
target—that requirement that would force us to
deviate from the optimal policy response to a
given shock that balances the two objectives. 
THE INTEREST RATE PATH IN AN
INFLATION FORECAST
The next question tackled by Charles was the
appropriateness of the fixed short-term interest
rate path in the MPC’s inflation forecast. I thought
Charles did an admirable job of presenting the
prima facie case against this approach. I was
convinced.
This approach is unnecessary, suboptimal,
and may undermine the credibility of the MPC’s
inflation forecast. It reflects a historical precedent
that no longer applies, as well as institutional inertia
and an over-emphasis on simplicity.
Let’s model the constant nominal interest rate
path in this inflation targeting exercise as a variant
of the Taylor rule. It sets the real interest rate as a
function of the (expected) inflation rate with a
coefficient of –1, assuming there is some variation
in (expected) inflation over the policy horizon. This
leads to an immediate insight. It would be better to
set the coefficient to zero. So a still-simple, but I
believe clearly improved, approach would be to set
a constant real interest rate.
Still better, it seems to me, would be for the
MPC to set the entire path for the real interest rate
as consistent with its forecast and policy objectives.
Charles’s conclusion is that such an approach,
while desirable in principle, simply would not be
practical, given the likely difficulty the committee
would face in reaching a consensus about the full
path of interest rates. But one has to be concerned
if the policy process is set up in such a way that it
potentially distorts the current policy decision as
well as the communication to the market about
prospective policy. 
Let me now shift to the FOMC practice,
because the staff has to take into account the
interdependence between the forecast and policy
process. The FOMC makes forecasts only twice a
year, when a central tendency is reported; the
forecast is, at most, two years out based on mem-
bers’ forecasts of fourth-quarter-to-fourth-quarter
inflation and output growth and the fourth-quarter
level of the unemployment rate. The staff makes
the forecast presented at each FOMC meeting. The
FOMC is a more eclectic group than the MPC—
fewer economists and fewer members who would
be comfortable putting together a forecast. We
have an implicit deal with the staff. We let them
put together the forecast without interference and
we don’t promise to use their forecast to make our
policy decisions. I am not sure it makes sense, in
fact, to require the policy committee to reach a
consensus on the forecast. Policy decisions of the
respective members should reflect their individ-
ual judgment about the outlook as well as their
individual policy preferences. 
The staff, on the other hand, faces a dilemma
similar to that faced by the MPC before the Bank
of England received its operational independence.
How is the staff to make a forecast without some
assumption about the path of the policy rate? How
can the staff specify the path for the policy rate
when this would appear to prejudge the outcome
of the policy decision?
This dilemma is sometimes resolved by the
staff conditioning its forecast on a constant path
of the nominal funds rate, at the initial setting for
the policy rate, so that it represents no change in
policy. This is the simplest way to separate the
forecast from the policy decision, as long as you
don’t mind that the staff’s forecast is not its best
judgment about the outlook over the forecast
horizon. Still, this simple approach has proved a
very effective device for the staff to provide the
FOMC with information about what the outlookFEDERAL RESERVE BANK OF ST.L OUIS
JULY/AUGUST 2001      185
might be in the absence of any change in the policy
rate. This can be a powerful motivator to action.
Sometimes, however, this assumption seems
so out of line with the committee’s long-term
objectives that the staff cannot—and, I believe,
should not—resist a more activist approach. The
first fallback is the constant real rate assumption,
aligned to the prevailing real rate. But, at times, the
staff will go still further and condition the forecast
on a rising or falling real federal funds rate path,
though never with a change assumed as the out-
come at the current meeting.
But the MPC situation is quite different. It pub-
lishes a forecast that extends a couple of years. If
the MPC wants this forecast to be credible, it has
to condition it on a credible path of interest rates.
Charles says that it would be a slur on the MPC to
imply that they fudge the forecast relative to the
path of interest rates so that the forecast should be
credible even if the path of interest rates is not. I
apologize for any offense taken, but I have had my
doubts about the credibility of the MPC’s forecast
because of the restrictions under which it is made. 
Charles then suggests that the decision to con-
dition the forecast on a constant nominal interest
rate has the desirable consequence of encouraging
policymakers to be more preemptive than they
otherwise would have been. What was missing
from this discussion was an explanation of why
the committee would be less preemptive than
would be optimal if it were freed from the restraint
on its forecast procedure. What is it that biases the
MPC to be suboptimally responsive to changing
economic conditions? Actually, this might be an
interesting line of inquiry because I suspect that
there is a bias toward waiting longer than is appro-
priate to change policy. This arises perhaps from
the view that it would be undesirable to move rates
in one direction and then have to reverse course in
short order, as would be more likely to be the case
if policy were the random walk that Charles talked
about. To avoid this outcome, a high hurdle is set
for rate moves, especially at turning points. The
result may well be a bias toward holding rates too
long.
Charles then proceeds to offer an alternative to
the current procedure of a constant policy rate in
the MPC forecast. I was, however, a little confused
about the alternative approach Charles suggested.
After all, he had just concluded that there were
constructive incentives that followed from the
current approach and that the forecast was in fact
fully consistent with the rate path. Why, based on
this assessment, even offer an alternative? At any
rate, Charles recommends that, in addition to the
forecast conditioned on a constant nominal interest
rate, the MPC publish two alternatives. One alterna-
tive would have higher rates and the other would
have lower rates, initially, but in each case rates
would be set later in the forecast to ensure the
same conformity of inflation with the target at
the policy horizon. It seems to me that this option
would leave the MPC with three arbitrary, potenti-
ally suboptimal forecasts instead of one. I view
Charles’s solution, therefore, as multiplying the
problems with the existing approach rather than
resolving them.
I have struggled to come up with some alterna-
tives of my own, abiding by the restriction that
the alternatives maintain the concept of a policy
horizon. First, the MPC could set a constant real
interest rate, as discussed above. Second, the MPC
could set the current policy rate, as it does today,
but then allow the remainder of the rate path to be
set according to a simple feedback rule. It might
be relatively easy, in such a practice, to limit the
perception of commitment to the rules-based path
and therefore preserve a high degree of flexibility
for the MPC with respect to future policy actions.
This might be a better “device” to reconcile the
forecast with the absence of a fully agreed to policy
path. On the other hand, it would likely be difficult
to get agreement on a specific rule, even though
that rule might not carry a clear policy commit-
ment. Third, the MPC could continue to set a
constant nominal path but not insist that inflation
be aligned with the target at the 18- to 24-month
horizon, as appears to be the case today. This would
remove the possible perception that the current
interest rate path is the MPC’s best judgment about
the path consistent with achieving the inflation
target at the policy horizon. On the other hand, it
would give the market a reading on the likely
direction of future policy actions and therefore be
a highly explicit statement of a policy bias related
directly to prospects for future policy.
SKEWS AND MONETARY POLICY
Charles then asks whether and when policy-
makers should explicitly take account of
asymmetric risks in the forecast. That is, should
policy respond to only the mode of the forecast
probability distribution—presumably the point
forecast—or to the mean, when the two are differ-186 JULY/AUGUST 2001
REVIEW
ent on account of an asymmetric probability dis-
tribution of forecast outcomes.
I have often felt there were asymmetric risks
in the outlook. I nevertheless have suspicions when
others tell me that their forecasts have asymmetric
risks! I usually suggest that they to go back and
work on their forecasts until they can return with
a symmetric probability distribution. When they
tell me the risks are to the downside, for example,
I wonder if they just got lazy about changing the
forecast and didn’t line it up on their true mode.
But as I said, the risks to the forecast do on
occasion appear asymmetric, and Charles’s ques-
tion is therefore a most interesting one. Should
policy with symmetric risks be different from policy
with asymmetric risks if the modal forecast is the
same in the two cases?
Charles’s answer is, It depends. This is one of
my favorite answers to interesting questions, so I
thought this was a promising start. But as I always
told my students, you also have to tell me what it
depends on when you choose this answer.
Charles did precisely that. He believes that it
depends on whether the risks are observable or
not. Don’t respond to observable risks, because
you will know when they come into play and you
can wait to respond then. On the other hand, if
they are unobservable, respond immediately,
because you will never be in a better position to
clarify their relevance. Charles also argues that
you should not take into account low-probability,
high-payoff risks such as earthquakes and wars. 
I thought the discussion of asymmetric risks
related to asset prices was particularly interesting.
Otherwise, I was not very satisfied with his cri-
teria for when policymakers should or should not
respond to asymmetric risks. I would have thought
that the issue was not whether the risks are observ-
able but instead whether timely action is needed.
For example, if an upside risk is that the stock
market may start to surge again, there may be no
need to react today to such a possibility. The impact
of an increase in the stock market on the economy
is gradual and policymakers will have time to react.
But I am only scratching the surface of a most
interesting question. I judge Charles’s answers
here to be quite preliminary ones and I hope he
will return to this topic in future work. 
REFERENCES
Batini, Nicoletta and Haldane, Andrew G. “Forward-
Looking Rules for Monetary Policy,” in John B. Taylor,
ed., Monetary Policy Rules. Chicago: University of
Chicago Press, 1999, pp. 157-92.

ForwardLooking Rules for Monetary Policy,”

Monetary transmission lags and the formulation of the policy decision on interest rates (commentary)

http://research.stlouisfed.org/publications/review/01/05/183-186Meyer.qxd.pdf

Monetary transmission lags and the formulation of the policy decision on interest rates (commentary)

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