National Association of Business Economics Annual Meeting, Boston, Sept. 11, 2006Monetary policy

William Poole

English

Research Papers in Economics

1
The Monetary Policy Model
National Association of Business Economics (NABE) Annual Meeting
Boston, Massachusetts
September 11, 2006
Our most fundamental challenges are basically
the same ones Smith noted. Uncertainty over the
value of money is one; another is the incentive
of sovereign states to debase the value of money.
My aim in this lecture is to provide a skeletal
picture of how I view the Federal Reserve’s task.
Before proceeding, I want to emphasize 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, but I retain full responsibility for errors.
RATIONAL EXPECTATIONS
MACROECONOMIC EQUILIBRIUM
Most macroeconomists today adhere to a
model based on the idea of a rational expectations
equilibrium. All aspects of government policy
enter the rational expectations model—the
“RE model” for short—but I’ll confine my remarks
to monetary policy. Policymakers are assumed to
have a set of goals and a conception of how the
economy works. The private sector understands,
to the extent possible, policymakers’ views. An
equilibrium is characterized by a situation in
which the private sector has a clear understanding
of policy goals and the policymakers’ model of
the economy, and the policy model of the econ-
omy is as accurate as possible. If the policymakers
and private market participants do not have views
that converge, no stable equilibrium is possible
because expectations as to the behavior of others
will be constantly changing.
In this setting, market behavior depends cen-
trally on expectations concerning monetary policy
I
am sure that all of us find it sobering to
meet on the fifth anniversary of the tragic
events of September 11, 2001. Many of
you were present at the NABE annual
meeting at the World Trade Center that day and
were fortunate to escape before the great towers
came down.
It is a distinct honor to be here today to accept
the Adam Smith Award. I’ll be talking about the
subject I know best—monetary policy. I would
have used the title,“My Monetary Policy Model”
except for the fact that the model I use is not mine.
Our current understanding of monetary eco-
nomics has been built on contributions over many
hundreds of years. In preparing this lecture, I
reminded myself of just how clearly Adam Smith
understood monetary issues by going back to
reread sections of the Wealth of Nations. Smith
begins the book with three short chapters on the
division of labor. Chapter 4 is entitled, “Of the
Origin and Use of Money.” Smith explains that
division of labor requires exchange, and exchange
requires money. He discusses the difficulty of
conducting exchange efficiently because metallic
money needs to be weighed and assayed. Smith
discusses the practice of princes and sovereign
states in debasing the currency. He notes that
“[s]uch operations, therefore, have always proved
favourable to the debtor and ruinous to the cred-
itor, and have sometimes produced a greater and
more universal revolution in the fortunes of pri-
vate persons, than could have been occasioned
by a very great public calamity.”
Monetary policymakers are acutely aware of
the potential for monetary policy to create “a
very great public calamity” and they feel deeply
their responsibility not to permit such an outcome.and the effects of monetary policy on the economy,
including effects on inflation, employment, and
financial stability. A stable equilibrium requires
that markets behave as policymakers expect and
that policymakers behave as markets expect.
It is easiest to describe the rational expecta-
tions equilibrium in a context of certainty. But,
of course, all the really interesting questions arise
in a context of uncertainty. One form of uncer-
tainty concerns future states of the world. In
principle, we can think about a model in which
market responses and policy responses to new
information reflect maximizing behavior. In the
private sector, in response to new information,
households change consumption plans to maxi-
mize utility and firms make operating and invest-
ment decisions to maximize profits. Similarly,
policymakers revise the stance of monetary policy
in an attempt to pursue policy goals as efficiently
as possible. The continuous flow of new informa-
tion includes everything that happens—weather
disturbances, technological developments, routine
economic data reports and the like. Thus, we
can think of the economy as evolving efficiently
in response to stochastic disturbances of all sorts.
Of course, in practice, there is also uncertainty
about market and policy responses to new infor-
mation, and there are improvements over time in
knowledge about how the economy works. Never-
theless, the RE model provides the core insights
that shape my views as to how to make routine
policy decisions and how to design a longer-run
program to improve policy.
MONETARY POLICY
IMPERATIVES IN THE MODEL
We can think of the actual, observed equilib-
rium as a full rational expectations equilibrium
under current policy. There may well be an alter-
native policy that would induce a new rational
expectations equilibrium that would have more
desirable properties than the current equilibrium.
Thinkingofthemodelthiswayprovidesanagenda
for long-run improvement in monetary policy.
Clarity of Goals
For the private sector to form accurate expec-
tations about future monetary policy and outcomes
of key economic variables, policymakers need to
state their goals clearly. The literature on infla-
tion targeting emphasizes this point, and I have
long believed that the FOMC could improve the
clarity with which it conveys its objectives to
the general public. In the past, I have stated my
own personal inflation objective as “zero infla-
tion, properly measured” but have also said that
FOMC agreement on an inflation objective, which
some might express as a “comfort zone of 1 to 2
percent inflation,” is more important than which
precise specification is selected. There are prac-
tical difficulties that can and should be addressed,
such as what price index to use, over what period
to measure price changes, and what degree of
tolerance to adopt if inflation runs outside the
range. I do not believe that uncertainty about the
Fed’s inflation objective is a large issue at present
but do believe that there is an opportunity to
improve clarity.
Maintaining Credibility
To maintain credibility, the monetary author-
ities must deliver what they said they would
deliver. Credibility is essential to the stability of
longer-term inflation expectations. Central banks
around the world emphasize the importance of
achieving low and stable inflation. In the United
States, the Federal Reserve lost considerable
credibility in the 1970s because the inflation rate
rose to unacceptable levels. With impaired cred-
ibility, the FOMC under Paul Volcker had to pur-
sue a sustained anti-inflationary policy even in
the face of the most severe recession since the
Great Depression. The cost of restoring credibility
makes clear the reason for not losing it.
Credibility is not, however, one-dimensional.
Sustained low inflation is desired for its own
sake but even more for the contribution it makes
to high employment and economic growth. Thus,
while inflation damages credibility, so also can
high unemployment. There is a fine balance here.
We know that monetary policy cannot affect
MONETARY POLICY AND INFLATION
2employment in the long run, but we also know
that monetary policy mistakes can create unem-
ployment over an uncomfortably long short run.
When unemployment rises, policymakers need
to be able to explain in credible fashion why the
problem is not a consequence of a monetary policy
mistake, for that perception is always present
among some observers in such circumstances.
There is, after all, some historical justification for
such a perception given that almost all economists
agree that monetary policy mistakes contributed
to the severity of the Great Depression. Given the
importance of high employment, a period of sus-
tained excessive unemployment may create
doubts about future policy, and this uncertainty
is a manifestation of impaired credibility.
The Federal Reserve’s credibility is also
affected by other matters. Sound performance in
dealing with financial crises and regulatory
responsibilities enhances credibility. Reputational
risk applies to the institution as a whole. Poor
performance of responsibilities outside the mon-
etary policy realm can affect the public’s confi-
dence in the central bank’s leadership.
Monetary policy success depends on high
credibility, but it is important to recognize that
credibility adheres to the entire institution that
conducts monetary policy and not just to the
department within the institution responsible
for monetary policy.
SOME IMPLICATIONS OF THE
MODEL
The model I’ve sketched provides a way of
thinking about current policy decisions. At least,
the model provides a way for you to think about
my thinking about current policy decisions. The
model also provides a framework for analyzing
potential policy improvements over time.
The model clearly calls for improved clarity of
central bank goals, a topic I’ve already discussed.
Clearly, also, the model supports continuing
macroeconomics research to improve understand-
ing of how the economy works. Because a full
rational expectations equilibrium requires com-
plete knowledge on the part of the private sector
of central bank thinking and analysis, Federal
Reserve research findings should be distributed
widely. More generally, the model points to the
importance of reducing asymmetries of knowl-
edge through central bank transparency.
A finding of the optimal control literature is
that when a policy authority uses all available
information as efficiently as possible in pursuing
its goals, simple correlations between observable
variables and goal variables may go to zero.
Although the exact result will be model depend-
ent, we should not expect correlations such as
between money growth and nominal GDP growth
or between unit labor costs and inflation to be
independent of the policy regime. This is a famil-
iar proposition in the securities markets, where
it is stated as the efficient markets hypothesis.
Observable information should be quickly
reflected in securities prices, leaving no risk-
adjusted profit opportunities from trading on
publicly available information. There is, of course,
an opportunity to exploit nonpublic information.
In the monetary policy context, research sug-
gests that inflation-forecasting models have not
worked very well in recent years. The reason, I
believe, is that the Federal Reserve has been pretty
successful in exploiting all available public infor-
mation in its monetary policy decisions aimed at
maintaining low and stable inflation. However,
there is an opportunity to exploit non-public
information. The Federal Reserve has an exten-
sive process of gathering anecdotal information
from business contacts. Much of this information
is published in the Beige Book two weeks before
every FOMC meeting. The policy model I’m
sketching certainly leaves room for greater and
more systematic effort to gather and exploit anec-
dotal information.
What does the model imply about the value
of financial-market information to policymakers?
Consider the fed funds futures market. Does that
market’s response to, say, the employment report
help policymakers to assess the significance of
the new data? In the RE model the clear answer
is “no.” The behavior of the fed funds futures
market tells us what the market believes will be
the Fed’s response to the news. That is useful
The Monetary Policy Model
3information for the Fed, but does not help in
understanding what the new information itself
means for the evolution of the economy. The same
argument holds for other financial prices, which
reflect a mixture of direct effects from new infor-
mation and indirect effects from anticipated pol-
icy responses to the new information. The
implication for policymakers is that we need to
provide our own analysis of the implications of
new information and cannot rely on financial
markets to do that job for us.
The model also contains a surprising impli-
cation for central bank communication. Consider
the most extreme version of the model, in which
there are no information asymmetries. The central
bank and the private markets have the same infor-
mation. The economy evolves as stochastic shocks
occur. When shocks are observed, the central
bank and the markets get the new information at
the same time and both understand the implica-
tions of the new information for each others’
actions. Moreover, and this is the surprising result,
the central bank does not need to say anything
about the policy implication of any particular
shock. The markets already know the implica-
tions because there is full knowledge and no
information asymmetry.
The practical import of this implication for
central bank communication policy is that com-
munications should focus on policy fundamen-
tals of goals and the model of how the economy
works. The economy works best when policy-
makers disclose the systematic part of policy
and minimize the random part. That is, policy
should not itself be a source of random distur-
bance. In the extreme, austere version of the
model I am now discussing, central bank com-
munication about policy responses to individual
shocks is unnecessary and more likely to create
market disturbances than enlightenment. Only
when the central bank believes that the market is
misinterpreting the policy significance of a shock
is comment on the particular shock desirable.
We can think of such communication as being
designed to reduce an information asymmetry.
You may believe that my argument from an
extreme, austere model is far-fetched. However,
as one who routinely talks with the press after
every speech, I can tell you that imparting the
correct interpretation of the policy significance
of recent data is not a simple matter. It is all too
easy to create an unintended market disturbance.
Thus, I personally really do take seriously the
practical relevance of the extreme model.
I have discussed the implication of the RE
model for central bank communication because
it seems to me that there are many opportunities
for improving communication, and many possi-
ble communications pits into which it is easy to
fall. Central bank communications are not just
“PR” issues, which I put in quotes to indicate
how some might dismiss their importance, but
essential to the monetary policy process. Expec-
tations are critical to how markets perform and
expectations are affected both by what the central
bank says and by what it does.
CONCLUDING REMARKS
The economics profession has converged to
a basic conception of how the economy works
based on a rational expectations view of the world.
That core idea is at the heart of every model today
and at the heart of monetary policy practice.
Nevertheless, there is ample room for disagree-
ment and further development. Some—and I
include myself in this group—think about policy
in a way that is pretty close to an austere version
of the model in which information asymmetries
play a minimal role, while others see a much
larger role for imperfections in the market’s infor-
mation set. In any event, the RE model provides
an organizing framework and common language
for analyzing monetary policy issues. Adam
Smith posed fundamental issues well, but in the
context of the gold standard. Since Smith’s day,
we’ve come a long way. Indeed, we’ve come a
long way since the 1960s and 1970s when fun-
damental differences between Keynesians and
monetarists, as the split was then described, left
monetary policy in a state that could only be
described as incoherent. Fundamental advances
in economics really have made a difference.
MONETARY POLICY AND INFLATION
4

The monetary policy model

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The monetary policy model

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