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The Present Policy Dilemma

Top of the Ninth

November 1, 1990


The Present Policy Dilemma

After nearly eight uninterrupted years of business expansion, the domestic economy is unmistakably showing signs of wear and tear. Economic growth has slowed to marginal proportions, while inflation has proved stubbornly persistent. Recent events in the Middle East and the resulting runup in energy prices have exacerbated these trends, with adverse consequences for both financial markets and consumer and business confidence. The prolonged budget negotiations, together with declining real estate values and a so-called credit crunch, have further contributed to this somber atmosphere.

These circumstances confront the Federal Reserve with a difficult environment in which to establish monetary policy. In a sense, there are no good choices. Responding to economic weakness with an expansionary policy, although tempting, runs the very real risk of adding eventually to inflationary pressures, a consequence frequently overlooked by advocates of such action. Such a response could, in turn, require policy restraint and raise the probability of recession in later years. Alternatively, adopting a more restrictive policy now to slow inflation could magnify the slowdown in the economy.

Overriding these concerns, in my view, is the priority to maintain a disciplined policy consistent with the Federal Reserve's long-run objectives and obligations. Characteristics such as continuity, prudence and balance are hallmarks of sound monetary policy. We have to help establish as sound a long-run footing for the economy as possible.

These considerations strongly suggest maintaining a stable monetary policy, a prescription easier to state than to implement. Stable monetary policy does not necessarily mean constant short-term interest rates. Indeed, knowing what interest rate level is appropriate is difficult in normal circumstances, and the task becomes if anything more complicated when a major destabilizing event, such as the Iraqi invasion of Kuwait, occurs. Not only are the strength of demand and state of supply in the economy called into question, but also expectations about both the course of business activity and the reaction of policymakers may change in significant and unpredictable ways.

As economic theory suggests, when an event like the Kuwait crisis has a destabilizing effect on the economy's production and consumption levels, the preferable approach is to focus on monetary aggregates rather than interest rates. The Federal Open Market Committee (FOMC), the key monetary policy group in the Federal Reserve, specifies long-run ranges for growth in these financial aggregates as guides which help to link monetary policy actions to economic objectives and performance. In July, the Committee selected growth for M2 in 1990 of 3 percent to 7 percent, and currently M2 is running modestly below the midpoint of this range. Consistent with the strategy of stability, the FOMC could continue to pursue M2 growth within and, indeed, close to the midpoint of the range.

Other considerations, related to the recent historical performance of M2, support this policy prescription. From 1987 through 1989, growth in M2 averaged about 4.75 percent per year, perhaps suggesting a reasonable benchmark with which to gauge stability and continuity. And during this three-year period, money growth varied between 4.25 percent and 5.25 percent per year, a relatively narrow band which would seem to appropriately circumscribe the outcome for this year.

We should be under no illusions about what a policy of discipline and stability can accomplish in the current environment. While it may support the level of nominal economic activity anticipated before the oil "shock," the near-term division of nominal activity between inflation and expansion of real output has deteriorated, and monetary policy cannot repair this damage.

Essentially, the strategy proposed is one which seeks to minimize risk by assuring, insofar as possible, that monetary policy adds neither to inflation nor to weakness in business conditions. In a broader sense, of course, it is critical that the strategy remain consistent with the overarching objective of policy, which is to contribute to sustained economic prosperity. In current circumstances, this result is fostered by retention of the M2 growth range initially specified by the FOMC, a range designed to contribute, over time, to price stability, a concomitant of durable prosperity.