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Recipes for Monetary Policy

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December 1, 2000


Recipes for Monetary Policy

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 phenomenon—that 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 economy.

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 itself—data, 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 and growth.

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 developments—changes in energy prices or equity values, for example—to 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 can—and does—change upon careful consideration of the factors described above.