The Bank of Korea International Conference on Monetary Policy in an Environment of Low Inflation, Seoul, Korea, June 16, 2006Monetary policy

William Poole

English

Research Papers in Economics

1
The Role of Anecdotal Information in
Monetary Policy
The Bank of Korea International Conference on Monetary Policy in an Environment of Low Inflation
Seoul, Korea
Conference Session “General Discussion”
June 16, 2006
Today central banks are concerned with two-
sided risk with respect to their inflation objective.
On the one hand, no one wants to see an upward
drift of inflation, either sudden or gradual, and
on the other hand, no central bank wants a sys-
temic deflationary environment. In the United
States it is likely that the inflation rate bottomed
out in 2003, around the time that the FOMC
expressed concern that “...the probability of an
unwelcome substantial fall in inflation, though
minor, exceeds that of a pickup in inflation from
its already low level.”1
Now, approximately three years later, after a
period of strong economic growth in many parts
of the world and demand driven increases in
energy prices, the perceived risk has shifted in
the other direction. The current assessment of
the FOMC is summarized in its statement follow-
ing its meeting in May 2006:
As yet, the run-up in the prices of energy and
other commodities appears to have had only
a modest effect on core inflation, ongoing pro-
ductivity gains have helped to hold the growth
of unit labor costs in check, and inflation
expectations remain contained. Still, possible
increases in resource utilization, in combina-
tion with the elevated prices of energy and
other commodities, have the potential to add
to inflation pressures.2
I
’ll use my discussion time to make a simple
argument—that in a low inflation environ-
ment, further improvements in reducing
the variances of inflation and employment
will require increased attention to informal, or
anecdotal, information. Before developing that
argument, I offer the usual Fed disclaimer that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their com-
ments, especially Robert Rasche, but I retain full
responsibility for errors.
Central bankers around the world are cur-
rently faced with a challenge not experienced in
over 40 years: maintaining low and stable inflation
now that it has been achieved for more than a
passing quarter or two. In the aftermath of the
Great Inflation, the primary objective of monetary
policy was clear and distinctly one-sided: Bring
inflation down to achieve a low and stable long-
term rate of inflation. In the early 1990s, inflation
subsided to levels that are widely regarded as
roughly consistent with price stability, and the
short-run volatility of inflation became substan-
tially smaller. This observation applies to coun-
tries that adopted formal inflation targets and to
countries such as the United States where mone-
tary policy inflation objectives are asserted only
qualitatively.
1 FOMC Press Release, May 6, 2003.
2 FOMC Press Release, May 10, 2006.Meeting the challenge of sustaining a low-
inflation environment may require new
approaches to policy analysis. Policymakers
understand that their actions do not generate
immediate responses in the economy, which is
why they must look out into the future. Perfect
foresight may be a useful construct for theoretical
analyses, but policymakers in practice must make
their decisions with full knowledge of the normal
range of forecast errors. Economic forecasts are
rooted in statistical models estimated from his-
torical data, and the model forecasts are then
modified, often substantially, through the appli-
cation of expert judgment. Experience indicates
that forecasting inflation is hardly precise and
that forecasting models are not robust.
Stock and Watson summarize their experi-
ments with numerous forecasting models for
inflation across seven industrial economies:
These forecasting successes, however, are iso-
lated and sporadic...For example, the seasonal
no-change forecast works well in the United
States in the second period but poorly in the
first, a similar pattern as in Canada (but the
opposite pattern as in the United Kingdom).3
The only set of predictors that usually
improves upon the AR [autoregressive] fore-
casts is the measures of economic activity.
For example, the IP [Industrial Production]
and unemployment gaps both improve on the
AR (or are little worse than the AR) for both
periods for Canada, Germany and the United
States. Even for these predictors, however, the
improvement is neither universal nor always
stable.4
Economists have long understood that control
theory implies that the more successful a central
bank is in achieving and maintaining a low infla-
tion environment, the smaller are the correlations
between the control objective—here, the inflation
rate—and the instruments that a policymaker
has available to affect the economy. Years ago
Solow and Kareken provided a straightforward
illustration of this proposition:
Suppose that by heroic (and perhaps even
cyclical) variation in the money supply and
its rate of change, the Federal Reserve manages
deftly to counter all disturbing impulses and
to stabilize the level of economic activity
absolutely. Then an observer following the
Friedman method would see peaks and troughs
of monetary change accompanied by a steady
level of aggregate activity. He would presum-
ably conclude that monetary policy has no
effects at all, which would be precisely the
opposite of the truth.5
The observation that correlations are chang-
ing or disappearing does not mean that the econ-
omy has fundamentally changed. In particular, it
is likely that the correlation between the growth
of monetary aggregates and the inflation rate (or
even nominal income growth) will be small in
low inflation environments. Yet central bankers
who fail to monitor the growth rates of monetary
aggregates do so at their own peril. History illus-
trates that rapid and accelerating monetary growth,
positive or negative, is a recipe for the demise of
the low inflation regime into inflation or deflation.
Just because a low inflation environment has been
established, central bankers cannot print money
without restraint. Large correlations, then, pro-
vide evidence that the central bank has failed to
exploit relevant information; as policy becomes
more effective, correlations tend toward zero.
In a low inflation environment, the stability
of expectations of long-run inflation is certainly
one, and perhaps the single most important, ele-
ment in the continued success of the low inflation
policy. Of first importance is that such expecta-
MONETARY POLICY AND INFLATION
2
3 J.H. Stock and M.W. Watson, “Forecasting Output and Inflation: The Role of Asset Prices,” Journal of Economic Literature, September, 2003,
41, p. 805.
4 J.H. Stock and M.W. Watson, “Forecasting Output and Inflation: The Role of Asset Prices,” Journal of Economic Literature, September, 2003,
41, p. 808.
5 R. M. Solow and J. Kareken, “Lags in Monetary Policy”, in A. Ando, E.C. Brown, R.M. Solow and J. Kareken, eds., “Lags in Fiscal and
Monetary Policy,” in Commission on Money and Credit, Stabilization Policies, Englewood Cliffs NJ: Prentice-Hall, 1963, p. 16.tions remain “well contained” or “well anchored.”
In rational expectations models of the macro-
economy, monetary policy rules specified with
a nominal interest rate instrument require a con-
stant expected long-term (or equilibrium) expected
rate of inflation to assure the existence of an
equilibrium rate of inflation. The familiar “Taylor
rule” contains a ≠* term, the desired rate of infla-
tion of the monetary authorities. Note that in the
Taylor rule the term is ≠* not ≠*
t.6 In such models,
≠* is the “anchor” on which the long-term
expected inflation rate of private agents is based.
If the inflation objective is time-varying, or is
perceived by private agents as time-varying, then
long-term inflation expectations become unglued
and the inflation rate will not remain low and
stable; indeed depending on how the desired
inflation rate of the policymakers is perceived,
inflation can become a self-fulfilling explosive
process.
Such models provide insight into how to
conduct monetary policy that will successfully
sustain a low and stable inflation environment:
The monetary authorities must clearly commu-
nicate their inflation policy objectives. The com-
munication must be symmetric: Private agents
must understand what rates of inflation are
unacceptably high and what are unacceptably
low to the central bank. Central banks that
announce explicit numeric inflation objectives
go a long way towards satisfying this communi-
cation objective. However, announcements must
be confirmed by deeds. Central banks must
demonstrate that they are prepared to act deci-
sively against sustained deviations from their
announced objective. Further, to preserve the
credibility of the announced inflation objective,
changes in the announced objective must be
undertaken sparingly and infrequently, and cer-
tainly not in directions away from low rates of
inflation. If the central bank loses credibility with
respect to the announced inflation target, then
long-term inflation expectations of private agents
will become disconnected from the target, and
the economy will begin to drag its nominal anchor.
Central bankers may be reluctant to take deci-
sive policy actions as actual inflation approaches
a perceived boundary of price stability because
of their imprecise forecasts of inflation and eco-
nomic activity. Faced with an uncertain view of
the future, the natural tendency of policymakers
is to wait for further information on the state of
the economy. In the absence of decisive policy
actions, central bankers may be able to stabilize
long-term inflation expectations by clarifying
their vision of price stability. The text in the
minutes of the May 2003 FOMC meeting is an
example of such a clarification:
Given the pressure of a considerable amount
of unused resources, any adverse developments
that held down economic expansion would
increase the probability of further disinflation.
Members commented that substantial addi-
tional disinflation would be unwelcome
because of the likely negative effects on eco-
nomic activity and the functioning of financial
institutions and markets, and the increased
difficulty of conducting an effective monetary
policy, at least potentially in the event the
economy was subjected to adverse shocks.7
Note that these minutes provide symmetry to
the concerns of FOMC participants about inflation:
they reveal that the implicit inflation objective
of the Committee evaluated downside as well as
upside risk.
A difficult question facing central bankers is
how to judge when inflation expectations remain
anchored. One way to approach this question is
to ask what critical data might be expected to
show different characteristics when inflation
expectations are “well anchored” compared with
when they are coming unglued. Most such data
The Role of Anecdotal Information in Monetary Policy
3
6 There is an ongoing debate in the monetary policy literature over “instrument rules” versus “targeting rules.” See for example, B.T. McCallum
and E. Nelson, “Targeting versus Instrument Rules for Monetary Policy,” Federal Reserve Bank of St. Louis Review, September/October 2005,
87(5), pp. 597-612 and L.E.O. Svensson, “Targeting versus Instrument Rules for Monetary Policy: What Is Wrong with McCallum and Nelson?”
Federal Reserve Bank of St. Louis Review, September/October 2005, 87(5), pp. 613-26. In both approaches it is important that the policy
rules specify ≠*, not ≠*
t.
7 Minutes, FOMC Meeting, May 6, 2003.will require direct or indirect measures of inflation
expectations. Survey data on inflation expecta-
tions provide some evidence, but typically have
limitations such as small sample size, nonscien-
tific sample design, and a restricted population
from which survey respondents are drawn. The
introduction, over the past decade in a number of
countries, of inflation-indexed long-term govern-
ment debt instruments and the emergence of liq-
uid secondary markets in such securities offers
additional information.
In an economy with well-anchored inflation
expectations, it can be expected that those expec-
tations would not be highly responsive to changes
in the observed rate of inflation. A limitation of
survey data in this respect is that historically they
have been characterized by strong persistence.
For example, in the 34 quarterly Surveys of
Professional Forecasters conducted by the Federal
Reserve Bank of Philadelphia since the second
quarter of 1998, the average 10-year-ahead fore-
cast of CPI inflation has differed from 2.5 percent
on only five occasions. On those five occasions,
the range of the average forecast was from 2.3
percent to 2.6 percent.
In contrast, with highly liquid markets for
both nominal and indexed government debt of
comparable maturity, it is possible to observe both
real interest rates and inflation compensation. If
inflation expectations are well-anchored, the
correlation between changes in yields on nominal
securities and indexed securities should be quite
high. At the opposite end of the spectrum, if
inflation expectations become unanchored, then
the correlation between changes in these yields
should be much lower. In the extreme of highly
unstable inflation expectations, changes in nomi-
nal yields will be dominated by changes in infla-
tion expectations and the correlation of changes
in nominal and real yields will approach zero.
In the absence of precise statistical forecast-
ing models, another potentially useful source of
information to assess the stability of inflation
expectations and the likely course of the real
economy is real-time anecdotal information. The
drawback of anecdotal information is that there
is no scientific basis for the sample. Yet the accu-
mulation of forward-looking anecdotal informa-
tion at critical times can be informative. An
example can be drawn from the recently released
transcripts of the FOMC meetings of October,
November, and December, 2000. At that time,
the best inference from statistical forecasting
models was that economic growth in the U.S.
would gradually slow from the very high rate of
the first half of the year to rates that were regarded
as more sustainable. Yet, also at that time, more
and more FOMC participants were reporting sto-
ries indicating sharply slowing conditions from
an ever increasing number of respondents. We
now measure real growth in the second half of
2000 as less than 1 percent (annual rate), with
negative growth in the third quarter. In this
instance, the anecdotes gave a better early warn-
ing signal of the turn in activity than did the
forecasting models.
A similar situation may prevail today. Statis-
tical studies to detect pass-through from recent
energy price increases have failed to show signifi-
cant effects in U.S. price data, but stories about
widespread pass-through are becoming increas-
ingly common. We may—and I emphasize “may”
because my purpose is to make a general point
and not to conduct a full analysis of the current
situation—face more inflation pressure than cur-
rently shows up in formal data. The general point
is that the more successful are policymakers in
exploiting regularities in formal data, the more
they will have to rely on anecdotal information
to make further progress in stabilizing inflation.
Refining collection and analysis of anecdotal
information promises earlier policy responses to
changing economic conditions. The Federal
Reserve already devotes substantial resources to
making judgmental adjustments to its formal
forecasting model, but my hunch is that there
will be significant improvements in policy analy-
sis from strengthening our sources of anecdotal
information.
MONETARY POLICY AND INFLATION
4

The role of anecdotal information in monetary policy

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The role of anecdotal information in monetary policy

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