Edward Gramlich

The uncertainties implicit in using any rule of thumb, however well it might have performed in the past, are probably sufficient that policy-makers should retain their discretion. There can also be periods when the Fed is pursuing multiple goals. At the same time, the science of rule-building may have advanced to the point where monetary rules of thumb might play some useful role in the conduct of monetary policy. Myriad short term uncertainties and special factors mean that rules still cannot deal with many ad hoc situations. But in view of the deeper uncertainties about how hard monetary authorities should lean against what wind, rules of thumb might give good guidance to policy-makers. They might help authorities avoid large and persistent mistakes. Rather than replacing judgment, in the end rules may aid judgment.

This strategy of conducting monetary policy has been widely adopted around the world, and it has seemed to be successful in lowering inflation and perceptions of future inflation. It has a potential drawback in ignoring explicit consideration of output gaps and unemployment, but perhaps because it has been applied flexibly and in a forward-looking manner, in fact it has not seemed to generate more unemployment than other monetary regimes would have. It also may not work as well in times of negative supply shocks, though this point remains to be tested.

Other instances in which inflation targeting might not work so well are negative supply shocks, such as most economies experienced in the mid-1970s when oil prices exploded. In these times, inflation rises just as output falls. The most flexible and competent central bank in the world would be faced with a difficult dilemma in such circumstances--forestall the recession by making inflation worse or limit the inflation by making the recession worse. But at least such a central bank would have a choice. In general, an inflation-targeting central bank would not have much of a choice. It would be forced to try to limit the inflation by contractionary policies, hence making the recession worse. Even a flexible, forward-looking inflation-targeting central bank would not have much freedom in such a situation, because in the end the central bank would be evaluated much more on its success in meeting inflation targets than in meeting output growth targets.

Many potential inflation targeters ask, "Why not zero?"...[One] reason for shooting at a rate of inflation slightly above zero is known as the zero bound problem. If a country's real interest rates are close to zero and its inflation rate is close to zero, its nominal interest rates will also be close to zero. Since costs of holding cash are minimal, a central bank cannot push nominal interest rates much below zero. This means that countries that target for zero inflation could get in the bind of being unable to ease monetary policy in response to recessionary shocks.

Recently a number of housing and banking agencies, including the Federal Reserve, have announced their intention to study possible restrictions on predatory lending. The Department of Housing and Urban Development (HUD) has set up a national task force on the topic. Members of Congress on both sides of the aisle have bills that limit predatory practices.

The ultimate difference between subprime and predatory lending comes back to the competitive assumptions. If one is a market optimist and believes that both lenders and borrowers are rational and well-informed, then subprime credit markets with proper rate differentials will open up. If one is a market pessimist and believes that borrowers are not well-informed and may not be fully rational, then some lenders will have opportunities to exploit these borrowers with predatory practices. Distinguishing positive subprime lending from negative predatory lending is obviously important, particularly for regulators trying to encourage one type of lending and discourage the other.

I doubt we’d be worried very much at all about inflation if it weren't for what I'll call NAIRU guilt pangs. Estimates of the NAIRU have always been weak econometrically in the sense of having high standard errors. Moreover, point estimates of NAIRU are bound to be reduced the longer the economy goes without accelerating inflation. We are now nearing the end of the fourth year where the unemployment rate is less than the conventional estimates of NAIRU, with very little evidence of accelerating inflation. Sure, there have been special factors, such as the rise in the dollar and the productivity shock. But as time goes on, I still become less and less convinced that unemployment is below the imperfectly estimated NAIRU level.

A simple argument for arriving at this judgment is based on a standard I've used before.  The real interest rate from the TIPS market is about 3.8 percent now, and if we build in an anticipated inflation rate of about 2 percent, the equilibrium funds rate should be slightly less than 6 percent. The actual funds rate is more than that, indicating that monetary policy is on the tight side.  It made perfect sense to tighten monetary policy to this level last May when we were leaning against the inflation rates, but things have changed now and I no longer believe it makes sense to keep the funds rate this high.

CHAIRMAN GREENSPAN:  So I think the real choices here are 25 basis points plus asymmetry toward the down side or zero change now with downside asymmetry and the understanding that it is quite conceivable that we may have to have a telephone conference and move the rate before the next meeting. That's because we may find in this interval the answer concerning whether or not the decline in the rate of economic growth has stabilized.  What I conclude at the end of the day is that we need to recognize that we really do not know the answer for the intermediate period. I would encapsulate that into no change in the funds rate, but with a bias toward the down side and the recognition that, if the erosion continues, we very likely will have to move before the next meeting. And that move would be triggered, I would presume, by a telephone conference sometime in the early days of January--the first week or maybe the second week at the latest.

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MR. GRAMLICH. Thank you, Mr. Chairman. As you know, the policy you suggested is not my first choice. Obviously, there is a lot of uncertainty out there, but I share the view of a few others around the table who think that we've seen enough to ease fairly soon. On the other hand, if we all agree to stand by our telephones, [Laughter] the policy you suggested "morphs" into what I would prefer, so I will support it on that basis. But I think we ought to be alert and stand by our telephones.

The first question is whether the U.S. central bank should adopt a more formal inflation-targeting regime. I personally would not go that far. My reading of the empirical evidence is that the key ingredient in keeping inflation low and stable is that the central bank be firmly determined to achieve and maintain stable prices in the long run. I believe the Fed is already so determined, with every member of the Federal Open Market Committee (FOMC) since I have been here repeating this mantra often. To me, there does not seem to be huge value in further tying down the committee through a formal inflation-targeting regime, and there could be some costs.

On the other hand, it may be possible to get some of the transparency and accountability advantages of inflation targeting, and to lock in the gains from having reduced inflation, by going to an intermediate approach. The FOMC might simply announce its preferred long-run range for inflation. This range should be understood as a preferred range that would not bind the committee or override other important objectives of monetary policy. It should clearly be understood as a long-term objective, not a short-term objective. The FOMC would not have to defend any deviations from the preferred range. Perhaps such a step would increase transparency without limiting central bank flexibility to any appreciable degree.

If we were to adopt a preferred range, what should it be? In light of the strategic considerations mentioned above, along with quantifiable measurement error, I would personally set the bottom of the range at slightly above 1 percent per year for the core PCE deflator, the Fed's preferred inflation measure. Because of audience polls, and at least until they are replaced by more rigorous information, I would set the top of the range at about 2.5 percent per year. The midpoint of this range is then slightly less than 2 percent per year, which turns out to be about what U.S. core PCE inflation has averaged over the past eight years. But I would stress the range more than the point estimate.

Finally, if the FOMC were to adopt a preferred range, I feel that efforts to quantify measurement bias in price indexes have, on the whole, been too conservative. My own personal preference is that the top of the range could go as high as 2.5 percent per year.

A potentially more appropriate way to ascertain the true degree of inflation was suggested by Richard Ruggles of Yale University. I learned about this test in graduate school many years ago, and Ruggles may have made his suggestion many years before that.

What inflation rates should really measure is the decline in the utility value of a nation's currency. In principle the right test is to offer a sample of the population a constant amount of currency, say $1,000, along with the opportunity to spend it on a menu of all goods and services available this year or a menu of all goods and services available a while back, say five years ago. If this sample of the population votes in equal numbers for this year's menu and for that available five years ago, one can conclude that prices have been stable over the five-year period. If the majority vote is for the earlier menu of goods and services, one can conclude that prices have risen, or that the utility value of the $1,000 has decreased. If the majority vote is for the recent menu, one can conclude the reverse--that true prices have actually declined.

I have seen no rigorous polling evidence on this question. But for years in teaching college macroeconomics courses, and recently at the Fed, I have conducted such a poll among my audiences. All audiences have reported that their understanding of what inflation is all about was much improved by this thought experiment. Generally, college students have voted for the current menu even in times when the aggregate rate of price increase averaged 3 percent or more, implying that they felt that true prices had actually declined.

College students may be unusually influenced by fads that do not truly improve goods (narrow or wide ties, etc.), and the implicit bias in measured price indexes may well be overstated by collegiate polls. Since coming to the Fed, I have had the opportunity to talk to and poll many banker groups about inflation, and as one would expect, they are generally more inclined to vote for the earlier menu of goods than were my college students, at any given rate of inflation. But these days, when measured rates of inflation are running at 1.5 percent to 2 percent, even bankers consistently vote for the current menu of goods by fairly wide margins. If even bankers feel that the implicit measurement bias in price indexes exceeds 2 percent, that may be a phenomenon worth noting. The upshot of this highly anecdotal test is that I have long suspected that true price stability might really be achieved in the vicinity of measured inflation rates of 2 percent or even more.

It is generally agreed that the biases are about 1 percentage point per year for the CPI and about 1/2 percentage point per year for the PCE deflator (Lebow and Rudd, 2003).

A few industrial countries--the United States, Japan, and Switzerland--have resisted pressures to adopt formal inflation-targeting regimes. Debates continue in these countries about the desirability of adopting more formal inflation-targeting procedures. The inflation targeters point to the advantages of transparency, commitment, and accountability; non-targeters point to the loss of flexibility and the reduction in the ability to meet alternative goals such as high employment and financial stability. Rudebusch and Walsh (1998) give a good summary of this debate.

Before the 1980s, research papers, economic commentary, and textbooks here and abroad were full of discussions of the causes and consequences of high inflation and of the political difficulty of bringing it under control. It looked then like inflation had become a more or less permanent feature of the economic landscape. Concepts associated with deflation such as liquidity traps and the zero bound on nominal interest rates had, for practical purposes, disappeared from economic thought.

One of the key financial developments of the 1990s was the emergence and rapid growth of subprime mortgage lending... The increased availability of subprime mortgage credit has created new opportunities for homeownership and has allowed previously credit-constrained homeowners to borrow against the equity in their homes to meet a variety of needs. At the same time, increased subprime lending has been associated with higher levels of delinquency, foreclosure, and, in some cases, abusive lending practices. On a social level, one question is whether the gains afforded by these new market developments outweigh the losses. Another question is whether anything can be done to limit foreclosures. These are my topics today.

In line with this record, many authors have been predicting for some time that the combination of interest rates, income, prices, and exchange rates would adjust to end the U.S. trade deficits. But the deficits have not ended, and international economists are searching for reasons to explain the situation...[One] possibility is that the so-called "home bias" in international saving-investment choices is gradually eroding.10 In this view, globalization has generally reduced the barriers to international asset diversification, and we are witnessing a rebalancing of wealth portfolios which, in the transition, can lead to persisting current account deficits or surpluses.

[The US] could raise national saving with some combination of fiscal tightening and measures to raise private saving, coupled with other measures, here and abroad, to increase demand throughout the world economy.

The real question is whether the large-scale borrowing is sustainable...Since 1990 the United States has embarked on a long-term period of high trade deficits, and now the international liability rate is close to 25 percent of GDP and rising sharply. International wealth portfolios are getting increasingly heavy in dollar-denominated assets. How long can this process continue?

Given the low national saving rates, and the fact that many American households do not save enough to avoid a big cut in their standard of living in retirement, it would seem desirable to have Social Security reforms that also raise national saving. One obvious and immediate way to do that would be to raise payroll taxes; another obvious, and perhaps less painful, way to do that would be to have individual accounts on top of Social Security

In the short run, output growth is healthy and inflation rates are stable. Investment shares are reasonable, but that is largely because the United States is borrowing such a huge amount from world capital markets. The key question is whether this borrowing is sustainable. However sustainable it is, the United States would seem well-advised to minimize risks by raising its own national saving to finance its own investment.

It is much more stable for the United States to increase its own national saving and finance its own investment. This approach would support investment in the short run and make this investment more profitable in the long run, because the returns on capital would not be sent abroad.

The trends, especially for Medicare, are so alarming that these two programs [Medicare and Social Security] alone could, in the space of little more than a decade, account for about half of federal spending. Changes have to be made in these large entitlement programs to avoid a real fiscal disaster.

Other types of Social Security reform seem less promising from a national saving point of view. If, for example, the individual accounts were to be "carved out" of present payroll tax payments, as President Bush has recently proposed, household saving would go up but government saving, in the first instance, would go down by the same amount, meaning that the initial impact on overall national saving would be nil.

Among very unpleasant alternatives, raising the retirement age seems to be one of the fairest approaches across generations.

Disaster [in Social Security] is not imminent, but it seems pretty clear that in the not too distant future the United States...will have to confront some distinctly unpleasant policy choices.

While the present situation of the United States may not be alarming, the outlook comes closer to being so. Outlays are projected to rise slightly more than program revenues for Social Security and much more than program revenues for Medicare. The recent annual report of the trustees of Social Security and Medicare projected rapid deterioration in the trust funds financing both programs, with the Medicare fund being exhausted in fifteen years.

The United States [Social Security system] is in relatively good shape by international standards.

Demographic movements of this magnitude will require significant policy changes. The public costs of retirement systems will rise markedly unless countries raise their age of eligibility for retirement program benefits or cut these benefits. Moreover, small tax increases or benefit cuts will not do the job--the implicit actuarial deficits of these programs are so large that halfway measures will not be adequate.

For the Fed to interpret the broad language of the Full Employment and Balanced Growth Act as an invitation to write rules instituting a strict form of inflation targeting would be an extreme stretch, though perhaps not for a soft form of inflation targeting.

Although academic economists and many others have for years been urging the Federal Reserve to adopt inflation targeting, legislators have shown very little interest in the issue.

Administration and congressional support [for an inflation target] has ranged from weak to non-existent. This lack of support could well change as the Administration and the Congress became more familiar with inflation targeting and, in particular, the possible flexibility of the regime. But if it does not change, or if it takes the form of inappropriate targets for other macroeconomic objectives, it becomes a definite impediment to the adoption of inflation targeting by the United States.

Given the already good inflation performance in the United States, the benefits of adopting inflation targeting are likely to be modest. But in an inappropriately constrained system, the costs could be enormous.

Congress probably will not move ahead on the Saxton bill or anything like it. But what if the Fed were actually to propose a soft form of inflation targeting? Such a proposal might change the dynamics and raise the possibility that the Congress could at least tacitly endorse inflation targeting.

[A] potential political cost of inflation targeting involves loss of flexibility...Specific goals for inflation are important, yes, but not under any and all circumstances. Real-world economies are subject to unanticipated shocks and unanticipated financial crises. Sometimes monetary authorities, even under inflation targeting, must respond to these shocks by going outside the price stability band for a short period.

Were the inflation rate temporarily outside the target band, even for good economic reasons, the mere existence of inflation targets could be another excuse for tension between the Fed and the Congress. There is almost always at least potential tension between the Fed and the Congress, and both sides have learned how to handle it. But at least some danger lies in introducing new possibilities for tension.

Given the good inflationary performance of the American economy in the past decade, the question of whether to adopt inflation targeting has never been an all-out do-or-die issue. The most that pro-targeters have been able to claim is some possible benefits; and anti-targeters, some possible costs.

There would be many more complications in the United States [than in other inflation-targeting countries]--the Federal Reserve would have to coordinate with the Treasury secretary, representing the executive branch, and members of the Congress...All political actors might recognize the value of price stability and might appreciate inflation targeting, at least in its softer form. But at a minimum, political issues are much more complicated in congressional systems than in parliamentary systems.

Lenders can gain an increased awareness of the lending and pricing practices of their organizations, and of their competitors, through analysis of HMDA [Home Mortgage Disclosure Act] data. As a result, lenders may take opportunities to compete in areas where the data show concentrations of high-priced lending. Competitive pressures in such markets should increase efficiency in pricing, ensuring that prices for mortgages are commensurate with risk and do not just reflect an absence of competition.

Because these important determinants of price are missing, one cannot draw definitive conclusions about whether particular lenders discriminate unlawfully or take unfair advantage of consumers based solely on a review of the HMDA data.

For the vast majority of banks here in the United States, I see no reason to replace the Basel I-based regulatory framework with a complex framework similar to advanced Basel II.