In September the Federal Reserve Bank of Minneapolis organized and hosted,
in conjunction with the University of Minnesota's School of Journalism,
a program titled "Supply, Demand and Deadlines: A
Workshop on Economics for Journalists." At the symposium I described
how I prepare for meetings of the Federal Open Market Committee (FOMC),
the group in the Federal Reserve responsible for monetary policy. What
follows is based on those remarks.
Preparing for an FOMC meeting is a mental exercise; it is an attempt
to arrive at a comprehensive, coherent view of the U.S. economy,
its prospects and the policy stance appropriate under the circumstances.
With some obvious caveats, one can think of the exercise as one
thinks of cooking. That is, there is an objective, similar to serving
"dinner for eight": The ultimate objective of monetary policy is
to help the economy achieve maximum sustainable economic growth
and rising living standards. To achieve this objective, one needs
a plan, a way of organizing activity, similar to the recipe in cooking.
In the long run, real growth of the U.S. economy depends on growth
of the labor force and growth of labor productivity. Monetary policy
has little direct influence on either of these variables, but evidence
and experience suggest that our economy performs best over time
in a stable, low-inflation environment. Moreover, there is a considerable
body of empirical research which indicates that inflation is a monetary
phenomenonthat is, monetary policy determines the economy's
long-run rate of inflation. Putting these observations together,
the FOMC's proximate objective is to establish and maintain a stable,
low-inflation environment, one in which the private sector can thrive.
Or, to extend our cooking metaphor, this is the Fed's primary contribution
in the recipe for economic growth; what then, are the ingredients
that determine monetary policy?
In the short-run time frame of FOMC meetings, and given the volume
of uncertainties the committee normally confronts, policymaking
frequently is challenging, to perhaps understate things. A series
of relevant issues and questions quickly come to mind, for example:
Is the economy currently on the path of maximum sustainable growth?
If it is, is it likely to stay on the path?
Are policy adjustments necessary to keep to or to attain the path?
These questions only scratch the surface, so there is no shortage
of things to consider in preparing for an FOMC meeting. Consider
the kinds of information and analyses that are required just to
address these three questions. Data on the state of the economy
are essential to assessing its current path, but some uncertainty
will necessarily persist. Moreover, experience in analyzing the
data and organizing principles about how the economy functions are
required in order to make sense of the statistics.
A forecast of future economic performance is necessary to address
the issue of the prospective path of the economy, and this forecast
will lead naturally to consideration of appropriate policy adjustments.
To develop the forecast and consider alternative policy adjustments,
one has to draw on economic theory, empirical estimates of how the
economy works and models of the effects of monetary policy on the
At this point, and this is premised on only a subset of issues
that might arise, we have a policy objective, a set of organizing
principles based on theory and/or evidence and the evidence itselfdata,
anecdotes, experience and models of relations between significant
measures of economic activity. The task is to turn all of this into
a policy position which, over time, will contribute to stability
Going back to the three questions posed above, a place to start
to develop a policy position is with the current performance of
the economy. It is difficult to make good policy without a reasonable
understanding of the state of the economy. Fortunately, there are
lots of ingredients available for this task, including data measuring
various business sectors and markets, inflation, financial variables
and so forth. These data are not entirely reliable and frequently
do not present a fully consistent picture, so it is advisable to
try to identify trends persisting over several calendar quarters
or more and to avoid the temptation to react (or overreact) to short-term
fluctuations in various series.
In addition to published statistics on the economy, we have anecdotes
about activity from a wide range of business and community leaders
and, from questions asked and issues raised at various public events,
we get a sense of what is of relatively broad interest and concern.
Commentary in the financial press contributes in this way as well.
Anecdotes can be particularly helpful with variables that are notoriously
hard to measure accurately, like productivity. We were hearing about
large productivity gains from business contacts long before such
improvement appeared in the data.
With all this information, it is usually not too difficult to
form a comprehensive picture of the current performance of the economy,
but the outlook presents a formidable challenge: How would we expect
the economy to perform in the future, say over the next one to three
years, given its current state, current and anticipated economic
performance abroad and given current policies? Several tools are
available to assist with this effort, including formal empirical
models of the economy and hands-on experience in studying business
cycles and in understanding the necessary relations between, say,
productivity, wages, nonlabor costs and profits. At this stage,
one may want to incorporate previously unexpected developmentschanges
in energy prices or equity values, for exampleto understand
what they may imply for the economic future. Anecdotal reports can
be valuable here as well, in part because models rarely reveal a
significant impact from such events.
Let's suppose we have arrived at a reasonable assessment of the
state of the economy and at an economic forecast with which we are
not uncomfortable. We now come to our third question, and the consideration
of monetary policy options, including, of course, the option of
leaving policy unchanged. To do this rigorously and systematically,
we need to call on many of the same tools upon which we have already
relied: economic theory and empirical regularities that characterize
the economy. Examples are the central role of productivity in the
long-run performance of the economy, the amazing resilience of the
economy and the money-inflation relation. Basic economic research
also contributes importantly to the framework that guides consideration
of policy options. The theory of rational expectations clearly puts
boundaries on what monetary policy can be expected to accomplish,
and research has also shown, for example, that to the extent policymakers
are uncertain about the source of shocks buffeting the economy,
they should proceed with caution in making policy adjustments.
The preparation process, then, draws from a mass of data and information
about the economy, from organizing principles about how the economy
works, from personal experience and from a body of economic theory
and empirical models to try to form a thorough understanding of
the complex real world. We want a comprehensive picture of the current
state of the economy and knowledge of the most likely outlook for
the economy, given current policies. Then we can consider if policy
changes are necessary to achieve our objective and, if so, of what
magnitude and when. And as additional information becomes available
and more research is done, we can incorporate these developments
systematically and ask if the economy remains on course or if policy
changes are required and appropriate.
This last point can be restated by revisiting our cooking metaphor;
namely, if what we end up taking out of the oven doesn't quite suit our
tastes, we can always tweak the recipe. Monetary policy canand doeschange
upon careful consideration of the factors described above.