Eleven years ago today, Alan Greenspan, then Chairman of the Federal Reserve, gave an economic outlook speech. The next days headline in The New York Times read as follows: Greenspan Hints at End to Low Rates, while the headline in The Wall Street Journal read: Greenspan Suggests Continued Patience on Rates. That one speech generated such contradictory messages illustrates the challenges monetary policymakers face when communicating with the public.

I think they'll judge him well, especially on his leadership on monetary policy. I think they'll judge him to have missed some regulatory, supervisory issues, especially toward the end—of having been too optimistic about financial innovations and not seeing how they were misunderstood and misused.

"But, taking the 19 years as a whole, I think on monetary policy, they'll judge him pretty well. I have a stake in that judgment myself, having been a close advisor to the Greenspan FOMC for so long."

In response to a question about how history would judge Alan Greenspan

To start with, central bank credibility and low and stable inflation expectations are of critical importance. Earning that confidence is the most important thing the Fed can do in dealing with shocks as they occur. If the Fed doesn’t have that underlying confidence, then all sorts of things can go wrong and, indeed, the Fed may find itself willy-nilly taking policy actions intended to maintain or restore credibility rather than dealing with the current problem, whatever it might be. So, most of the work in dealing with the crises comes before they even happen. Where the Fed is now is a consequence of earning that credibility starting with Paul Volcker and then dealing successfully with a whole series of issues during the Volcker, Greenspan and now Bernanke eras.

The answer is that Fed Chairman Greenspan guessed correctly that something unusual was going on with productivity. For example, he was hearing from businesspeople that new information technologies were transforming their businesses, making it easier for them to raise productivity. He was also a big fan of the historical work by Paul David (1990), which suggested that new technological innovations often took years to produce accelerations in productivity in the overall economy (Meyer, 2004). Chairman Greenspan was led to the conclusion that the trend in productivity growth was accelerating, a conclusion that the Board staff's forecast did not come to fully accept until late 1999 (Svensson and Tetlow, 2005). Moreover, he appeared to be convinced that the acceleration in productivity would cap inflationary pressures, implying that inflation would not accelerate even with rapid economic growth. His view prevailed in the FOMC (Meyer, 2004).

As a card-carrying monetarist, I argued the steady money growth case vigorously in years past, and it is still my conviction that a central bank ignores money growth at its peril...

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis...

...I believe that the Fed’s actual adjustments of its federal funds rate target have yielded superior outcomes since 1982 to what we would have observed under steady money growth. I also believe that advances in knowledge permit us to say with some confidence that these gains are not just an accident of Alan Greenspan’s special skills and intuition.

The fact that you had very well informed people coming to different conclusions about what the statement meant -- that, in and of itself, is evidence that the statement was not completely successful.   If it were completely clear, well informed people would come to the same conclusion from the same words.

It is very difficult to craft these statements so that well informed people all come to the same conclusion.  Chairman Greenspan often wrote with the expectation that people would read between the lines. I think Chairman Bernanke is trying very hard to have people read the lines and not draw implications from reading between the lines when no implication was meant to be there.

From Q&A session, as reported by Bloomberg News

The closest the Federal Reserve came to a "monetarist experiment" began in October 1979, when the FOMC under Chairman Paul Volcker adopted an operating procedure based on the management of non-borrowed reserves.11 The intent was to focus policy on controlling the growth of M1 and M2 and thereby to reduce inflation, which had been running at double-digit rates.  As you know, the disinflation effort was successful and ushered in the low-inflation regime that the United States has enjoyed since.  However, the Federal Reserve discontinued the procedure based on non-borrowed reserves in 1982. 

Alan Greenspan commented on the eve of his departure from the Fed that confidence in central banking had risen to exceptionally high levels, and he asked whether this was entirely healthy.

What follows is not ours or anyone else’s list of the most cherished central banking principles; we do not wish either to denigrate Bagehot or to displace him. Rather, it is our distillation of economists and central bankers can and should take away as the Greenspan legacy, that is, it is what Alan Greenspan could have told us—if he had chosen to do so.

Two principles that clearly were important in guiding Greenspan’s decisions do not appear on our list: the concern for price stability and the importance of establishing and maintaining credibility. We omit these principles not because we think them unimportant but because they are so obvious and widely shared that they cannot reasonably be said to define the specific legacy of Alan Greenspan.

Principle No. 1: Keep your options open. Academic economists are fond of writing about the conceptual virtues of rules, precommitment devices, and the like. Greenspan, the great practitioner, is unsympathetic. Rather, as we have noted, he believes that the economy changes far too much and far too fast for conventional econometric tools ever to pin down its structure with any accuracy and, for this reason, committing to a rule for monetary policy or even to a fixed response to a specific shock is dangerous. In this context, the concept of option value should perhaps be interpreted literally: In a world of great uncertainty, the value of keeping your options open is high. And that, presumably, makes it wise to move gradually. Alan Greenspan certainly acts as if he believes that.

Principle No. 2: Don’t let yourself get trapped in doctrinal straitjackets. Similarly, one of Greenspan’s great strengths has been flexibility. He has never let himself get locked in to any economic doctrine (e.g., monetarism), any treasured analytical approach (e.g., the expectational Phillips curve), nor any specific parameter value (e.g., the 6% natural rate). Indeed, you might argue that Greenspan, the empiricist, has shown limited interest in doctrines of any kind. He has also been known to change his mind—without, of course, saying so!—on certain issues (e.g., transparency). The downside of all this flexibility is that nobody knows what “the Greenspan model” of the economy is; that will not be part of his legacy. But the upside is more important. To paraphrase the wise words of James Duesenberry in another context, Greenspan will not “follow a straight line to oblivion.” That’s a good principle for any central banker to remember.

Principle No. 3: Avoid policy reversals. Greenspan believes that rapid changes of direction are damaging to the reputations of both the central bank and its leader, and might also cause volatility in markets. This, of course, both helps explain the importance of “option value” and provides a reason for monetary policymakers to move gradually once they start moving, for there is no going back—at least not for a while.

Principle No. 4: Forecasts and models, though necessary, are unreliable. Greenspan is deeply skeptical about the accuracy of economic forecasts—a result, perhaps, of a lifetime of seeing forecasts go awry. So he is constantly examining what’s going on in the economy right now and trying to figure out which of these developments will be lasting and which will be fleeting. This, we believe, is another reason why Greenspan prefers to move gradually once he starts moving. Like an attentive nurse, he is constantly taking the economy’s temperature. Similarly, even though many staff resources at the Fed are devoted to building models of the economy, Greenspan treats these models as but a small part of the information set 85 relevant for monetary policy. He sees some economists as confusing models with reality, and he doesn’t make that mistake. Nor does he rely on models for forecasting.

Principle No. 5: Act preemptively when you can. A paradox is defined as an apparent contradiction. Here’s one: While skeptical of forecasts (see Principle No. 4), Greenspan has nonetheless been credited with the idea of “preemptive” monetary policy—which, of course, entails acting on the basis of a forecast.109 While the uniqueness of the idea is sometimes exaggerated, it is true that Greenspan has frequently argued that the Fed should tighten preemptively to fight inflation or ease preemptively to forestall economic weakness—and has done so prominently on a number of occasions. This attitude contrasts with traditional central banking practice, which often moves too late against either inflation, unemployment, or both.

Principle No. 6: Risk management works better in practice than formal optimization procedures—especially as a safeguard against very adverse outcomes. In Greenspan’s view, economists don’t know enough to compute and follow “optimal” monetary policies, and we delude ourselves if we pretend we can. So robustness, and probably even satisficing, rather than optimizing (as that term is normally understood) are among the touchstones of the Greenspan standard. As we have seen, Greenspan has characterized himself as practicing the art of risk management— somewhat like a banker does. And like a commercial or investment banker, a central banker must be constantly on guard against very adverse scenarios, even if they have low probabilities of occurring. So, for example, Greenspan’s preoccupation with the dangers of deflation in 2002 and 2003 was seen by some observers as excessive, given the actual risk. But he was determined not to allow the Fed to follow the Bank of Japan into the zero-nominal-interest-rate trap.

Principle No. 7: Recessions should be avoided and/or kept short, as should periods of growth below potential. It may seem silly even to list this principle, much less to credit it to Greenspan—until you remember some of the most cherished traditions in central banking. While he has certainly enjoyed his share of good luck, we think it is no accident that there have been only two mild recessions on his long watch and that he is now in the process of attempting his fourth soft landing (note the adjective). The Greenspan standard internalizes the fact that society finds recessions traumatic; it therefore takes the Fed’s dual mandate seriously. When the economy has appeared to need more running room—in the late 1990s and, one might say, into 2004—Greenspan was less then eager to withdraw the punch bowl.

Principle No. 8: Most oil shocks should not cause recessions. As we have noted, up to the present time, almost all oil shocks—defined as sharp increases in the relative price of oil—have been temporary. And a short-run change in a relative price is not a good reason to have a recession. (See Principle No. 7.) By focusing on core rather than headline inflation, the Greenspan standard has not only used a more reliable indicator of future headline inflation but has also avoided the error of piling tight money on top of an adverse oil shock—which is a pretty sure recipe for recession.

Principle No. 9: Don’t try to burst bubbles; mop up after. First of all, you might fail—or bring down the economy before you burst the bubble. (Again, see Principle No. 7.) Furthermore, bubble bursting is not part of the Fed’s legal 87 mandate, and it might do more harm than good. Finally, the “mop up after” strategy, which may require large injections of central bank liquidity, seems to work pretty well.

Principle No. 10: The short-term real interest rate, relative to its neutral value, is a viable and sensible indicator of the stance of monetary policy. The idea of using the real short rate as the main instrument of monetary policy appears to have been a Greenspan innovation, one which was highly controversial at the time (how can the Fed control a real rate?) but has since found its way into scores of scholarly papers. While the neutral rate can never be known with certainty, the potential errors in estimating it seem no larger than for other candidate instruments. (Who would like to guess the optimal growth rate for M2?)

Principle No. 11: Set your aspirations high, even if you can’t achieve all of them. Sure, a central banker needs to be realistic about what monetary policy can accomplish. (See Principles No. 4 and 6.) But that is not a reason to set low aspirations. Even if an attempt at fine tuning fails (as happened in 1988-1989), it is likely to do more good than harm as long as it is done gradually and with flexibility (see Principle No. 1). And if it succeeds (as in 1994-1995 and perhaps in 1999-2000), society benefits enormously. While the Jackson Hole conference was going on, a poster in the lobby of the hotel warned guests that “A Fed Bear Is a Dead Bear.” Alan Greenspan has definitely been a Fed bull, and that may be one of the chief secrets behind his remarkable longevity and success. 

One Greenspanian innovation that surely can (and, we believe, will) survive Greenspan’s reign is his choice of monetary policy instrument. Greenspan focused—or perhaps we should say refocused—the Fed on setting the federal funds rate. More important, however, he has made it clear since 1993 that he thinks of the Fed as trying to set the real federal funds rate and, more particularly, the deviation of that rate from its “neutral” level...

The concept of the neutral (real) rate of interest dates back to Wicksell (1898), who called it the “natural” interest rate, meaning the real rate dictated by technology and time preference. In modern New Keynesian models of monetary policy, it often appears as the real rate of interest that makes the output gap equal to zero, which makes the difference between r and r* a natural indicator of the stance of monetary policy.  As with the natural rate of unemployment, there are also many ways to estimate the neutral rate of interest. Some propose measuring the neutral interest rate as the rate at which inflation is neither rising nor falling (Blinder, 1998); others use low-frequency movements in output and real interest rates (Laubach and Williams, 2005); and still others prefer to “back it  out” of an economic model as the real rate that would obtain under price flexibility (Neiss and Nelson, 2003). 
 

[1]  This concept first appeared in his July 1993 Humphrey-Hawkins testimony (Greenspan, 1993), and was controversial at the time. There, Greenspan referred to judging the stance of monetary policy “by the level of real short-term interest rates” and noted that “the central issue is their relationship to an equilibrium interest rate,” which he defined as the rate that “would keep the economy at its production potential over time.”

Greenspan’s initial image was not that of an inflation “dove.” In fact, he was typically portrayed by the media as an inflation “hawk” in the early years of his chairmanship. It took the media almost a decade to catch on to the fact that, relative to the center of gravity of the FOMC, Greenspan was actually a dove—which became crystal clear when he repeatedly restrained a committee that was eager to  raise rates in 1996-1997.  But it should have been evident earlier. After all, over the first eight years of the Greenspan chairmanship, inflation was consistently above the Fed’s likely long-run target, and yet the core CPI inflation rate fell by less than one percentage point.  That hardly looks like the handiwork of an “inflation nutter.”

Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk. Whatever might have once been thought about the existence of a "Greenspan put," stock market investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside by asymmetric monetary policy.

Lower inflation has been accompanied by inflation expectations that are not only lower but better anchored, so far as we can tell. Most striking, Greenspan's tenure aligns closely with the Great Moderation, the reduction in economic volatility I mentioned earlier, as well as with a strong revival in U.S. productivity growth--developments that had many sources, no doubt, but that were supported, in my view, by monetary stability. Like Volcker, Greenspan was ahead of academic thinking in recognizing the potential benefits of increased price stability.

[I]n the short time I have today, I cannot do justice to all the accomplishments, innovations, and successes the Fed has achieved under {Greenspan's} leadership. So I'll focus on two aspects of policy that I believe have been especially important to this sterling record—a systematic, and therefore understandable and predictable approach to policy, and a growing emphasis on communication and transparency.

This systematic, consistent approach has enhanced the ability of financial markets to anticipate the Fed's response to economic developments and to respond themselves in advance of the Fed.