Laurence Meyer

A couple of years ago, I gave the name "opportunistic disinflation" to an alternative strategy for bridging between short-run policy and long-run goals, a strategy that I observed the Federal Reserve to be following at the time. I will use this strategy this evening to describe my own position. But I want to make clear that I am not speaking for others on the FOMC or describing official policy. Under this strategy, once inflation becomes modest, as today, Federal Reserve policy in the near term focuses on sustaining trend growth at full employment at the prevailing inflation rate. At this point the short-run priorities are twofold: sustaining the expansion and preventing an acceleration of inflation. This is, nevertheless, a strategy for disinflation because it takes advantage of the opportunity of inevitable recessions and potential positive supply shocks to ratchet down inflation over time. Proponents of this strategy sometimes describe this approach as reducing inflation cycle-to-cycle or describe the economy as being one recession from price stability. Under this strategy, if growth were to slow to trend, the unemployment rate were to remain where it is, and inflation were to remain stable, monetary policy would remain on hold, ready to respond aggressively to any acceleration of inflation, but otherwise prepared to be patient and accept the lower inflation that will accompany the next recession or favorable supply shock.

At the Board, the staff forecast, presented in the Greenbook prior to each of the eight FOMC meetings each year, is fundamentally judgmental. It is developed by a team of sector specialists who consult, but are not bound by, a number of structural econometric equations describing their sectors, and further armed, in some cases, with reduced-form equations and atheoretical time series models. The team develops the forecast within the context of agreed-upon conditioning assumptions, including, for example, a path for short-term interest rates, fiscal policy, oil prices, and foreign economic policies. They begin with an income constraint and then participate in an interactive process of revisions to ensure that the aggregation of sector forecasts is consistent with the evolving forecast for the overall level of output.

The staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, Taylor-type rules. ...

The focus on rules is much more important ...when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money."

The focus on rules is much more important ...when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money."

Before we can tell the story about favorable supply shocks, I should note that 1996 featured an unusual coincidence of adverse supply shocks. First, the minimum wage was increased; this should boost overall wage gains, labor costs and hence prices. Second, both food and energy prices increased faster than other prices. As a result of the food and energy price increases, there were wide gaps between overall and core measures of inflation for both the PPI and the CPI. The overall CPI increased about 3/4 percentage point more than the core CPI and overall PPI increased more than two percentage points faster than core PPI.

I welcome the opportunity to testify on behalf of the Federal Reserve Board on proposals in S. 1405 to allow the payment of interest on demand deposits and on the required reserve balances of depositories at the Federal Reserve. The Federal Reserve strongly supports these measures. We have commented favorably on such proposals on a number of previous occasions over the years, and the reasons for those positions still hold today. We also believe the legislation should include a provision to allow the Federal Reserve to pay interest on excess reserves.

The ability to pay interest on excess reserves would provide an additional tool that could be used for monetary policy implementation, but one that might not need to be used, if interest on required reserve balances and demand deposits resulted in a sufficient boost to the level of those balances. Even if not used immediately, it is important that the Federal Reserve have the full range of tools available to other central banks, given the inventiveness of our financial markets and the need for the Federal Reserve to be prepared for potential developments that may not be immediately visible.

For banks, interest on demand deposits will increase costs, at least in the short run. Larger banks and securities firms may also lose some of the fees they currently earn on sweeps of business demand deposits. The higher costs to banks will be partially offset by interest on reserve balances, and over time, these measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses.

Eliminating price distortions on demand deposits and on required and excess reserve balances would spare the economy wasteful expenditure, increase the efficiency of our financial markets, and facilitate the conduct of monetary policy.

The payment of interest on reserve balances would tend to reduce the revenues received by the Treasury from the Federal Reserve, while the payment of interest on demand deposits would increase those revenues. Treasury revenues would be directly reduced by the payment of interest on existing reserve balances. However, there would be some offset to this direct revenue loss. The level of reserve balances would rise because of the interest payments, and the Federal Reserve would therefore be able to increase its holdings of government securities.

These legislative proposals are important for economic efficiency: Unnecessary restrictions on the payment of interest on demand deposits and reserve balances distort market prices and lead to economically wasteful efforts to circumvent them.

A second tradition is to try to reach a consensus on the policy decision. It is quite common for there to be differences of opinion and yet a unanimous vote. This would be the case, for example, where the question was one of timing rather than of principle. Unanimous votes are common. One or two dissents are not unusual, but more than two dissents at a meeting are rare.

Because of these two traditions—that the chairman is always on the winning side of a vote and that the committee strives to reach a consensus—the chairman's presentation at the start of the policy go-round is so important. It is the key moment, other than the vote itself at the meeting. There is a special sense of anticipation here because the chairman often will provide some new data or some new insight in support of his position.

The wording of the directive was changed late last year to make it more transparent. Previously, it instructed the manager, for example, to tighten reserve positions slightly, somewhat or significantly. A "slight" increase in reserve positions was, in fact, code for a 25 basis point increase in the funds rate; "somewhat" of an increase was code for a 50 basis point increase; and a "significant" increase signaled a 75 basis point increase in November of 1994. Of course, the manager of the System Open Market Account attends the meeting and knows the vote was explicitly for a 25, 50, or 75 basis point increase. The revised practice is to report in the directive precisely the outcome of the vote—a 25 or 50 basis point increase or whatever. This is further progress in terms of transparency.

The directive also indicates whether there is a symmetric or asymmetric posture for policy by the use of "woulds" and "mights" in the discussion of possible adjustments to the federal funds rate in the period between meetings. For example, a symmetric policy would be indicated by the wording: "In the context of the committee's long-run objectives for price stability and sustainable economic growth and giving careful consideration to economic, financial and monetary developments, a slightly higher federal funds rate or a slightly lower federal funds rate might be acceptable in the intermeeting period." The symmetry is indicated by the use of slightly in this case with respect to both a higher and lower federal funds rate and by the use of might with respect to both options. Sometimes, but not lately, symmetric directives have used "would" instead of "might" to apply to both options. An asymmetric posture, with a greater likelihood of a rise in the federal funds rate than a decline, would be indicated by the wording: "a somewhat higher federal funds rate would and a slightly lower federal funds rate might be acceptable in the intermeeting period." The asymmetry is evidenced by the use of "would" in one case and "might" in the other, with the "would" indicating the direction that is more likely; and by using "somewhat" to describe the size of any increase and "slightly" to describe the size of any decline.

I would remind you that in the 20 years prior to this recent episode, the Phillips curve based on NAIRU was probably the single most reliable component of any large-scale forecasting model. It was very useful in understanding the inflation episode over that entire period. Certainly, there is greater uncertainty today about where NAIRU is, but I would be very cautious about prematurely burying the concept.

It is useful to distinguish two broad classes of hard landings. The first involves the reversal of an imbalance between aggregate supply and aggregate demand. The classic example is the boom-bust scenario. The second class involves the unwinding of sector or market imbalances that either initiate a downturn in the economy or aggravate a downturn that would otherwise have occurred. A classic example of this genre is a stock market correction...I associate many of the second class of hard landing scenarios with the work of a former colleague and friend, Hyman Minsky, who died in 1996. He emphasized the development of financial vulnerabilities in expansions and their contribution to serious recessions. In his view, serious recessions are typically the result of a coincidence of adverse shocks on an already vulnerable economy. Minsky emphasized the role of vulnerabilities arising from financial imbalances, including excessive debt burdens or increases in the price of risky assets relative to safe assets.

Monetary policy could use such a [productivity] shock as an opportunity to temporarily move below the unemployment rate sustainable in the long run while keeping the inflation rate unchanged. Alternatively, monetary policy could convert the temporary disinflationary effect into a permanent one. This would be an example of "opportunistic disinflation": monetary policy could take advantage of a disinflationary surprise to lower inflation without a temporary increase in the unemployment rate.

I also think it is better to move at meetings.  I like to have a full forecast in front of me and to have detailed presentations by the staff on recent developments and the outlook.  If we're going to move between meetings, then I think we need to have an appropriate justification.  I think moving today at a time when the markets have been pricing out the probability of an intermeeting move would only lead to a great deal of confusion about what we are doing and how we are viewing the economy.

The central bank is capable of achieving an inflation objective, at least on average over a period of years. In contrast, if we define full employment in terms of a threshold for the unemployment rate consistent with maximum sustainable employment, the central bank has no choice about what this threshold should be. It is determined by the structure of the economy, including the effectiveness of institutions and markets in matching vacancies and unemployed workers, and by policies, such as the levels of unemployment compensation and minimum wage rates.

I am often asked, by the way, whether I believe that the economy drives psychology or psychology drives the economy. I always respond that I believe the economy drives psychology; and that, if I believed the reverse, I would have become a psychologist.

The spread of computers, advances in telecommunications, and the dramatic growth in the use of the Internet point to innovations in e-money. These will ultimately reshape the payment system and, along the way, present challenges to the Federal Reserve and monetary policy.

Given the slow pace of progress and the strong likelihood that stored-value cards will substitute only for a portion of currency, there is little danger that the Fed's portfolio will shrink to the point at which the Fed will be unable to cover its costs of operation.

The spread of network money, on the other hand, might not reduce the demand for reserves, if network money is subject to reserve requirements. In the absence of reserve requirements against network money, it is still likely that central bank balances would dominate settlement balances at private banks, given the former's lack of default risk. In this case, a system featuring floors and ceilings appears well designed to allow the Fed to continue to implement monetary policy by controlling the federal funds rate.

If a country ran a trade deficit that exceeded private capital inflows, it would, in principle, finance the difference by shipping gold to other countries. Doing so reduced the money supply--and hence income and prices--in the country with the balance of payments deficit and increased the money supplies, incomes, and prices in the countries with balance of payments surpluses. As a result, the system had a built-in tendency to move the deficit and surplus countries toward balance. In fact, drains on a country's gold or foreign exchange reserves were typically countered by an increase in central bank's discount rate. The effect on income and prices was, in this case, not due directly to changes in the gold supply, but to the changes in interest rates that were implemented to limit the drain on gold.

However, principle and practice differed under the gold standard. Richard Cooper (1992) summarizes the contrast in the following terms: "The idealized gold standard . . . conveys a sense of automaticity and stability--a self-correcting mechanism with minimum human intervention, which ensures rough stability of prices and balance in international payments. . . .The actual gold standard could hardly have been further from this representation."

Barry Eichengreen (1996) describes the gold standard as "one of the great monetary accidents of modern times," owing to England's "accidental adoption" of a de facto gold standard in 1717. Sir Isaac Newton was master of the mint at the time and, according to Eichengreen, set too low a price for silver in terms of gold, inadvertently causing silver coins to mostly disappear from circulation. As Britain emerged as the world's leading financial and commercial power, the gold standard became the logical choice for many other countries that sought to trade with and borrow from, or emulate, England, replacing silver or bimetallic standards.

England officially adopted the gold standard in 1816. The United States moved to a de facto gold standard in 1873 and officially adopted the gold standard in 1900. The international gold standard refers to the period from the 1870s to World War I, during which time the major trading countries were simultaneously on the gold standard. Though many countries went off the gold standard during World War I, some returned to a form of gold standard in the 1920s. The final blow to the gold standard was the Great Depression, by the end of which the gold standard was history.

Eichengreen argues that the emergence of the gold standard reflected the specific historical conditions of the time. First, governments attached a high priority to currency and exchange rate stability. Second, they sought a monetary regime that limited the ability of government to manipulate the money supply or otherwise make policy on the basis of other considerations. But by World War I, economic and political modernization was undermining the support for the gold standard. Fractional reserve banking, according to Eichengreen, "exposed the gold standard's Achilles' heel." The threat and, indeed, reality of bank runs created a vulnerability for the financial system and encouraged governments to seek a lender of last resort to provide liquidity at times of distress. Such intervention was, however, inconsistent with the gold standard.

...

... In fact, drains on a country's gold or foreign exchange reserves were typically countered by an increase in central bank's discount rate. The effect on income and prices was, in this case, not due directly to changes in the gold supply, but to the changes in interest rates that were implemented to limit the drain on gold.

However, principle and practice differed under the gold standard. Richard Cooper (1992) summarizes the contrast in the following terms: "The idealized gold standard . . . conveys a sense of automaticity and stability--a self-correcting mechanism with minimum human intervention, which ensures rough stability of prices and balance in international payments. . . .The actual gold standard could hardly have been further from this representation."

The basic relationship between money and prices is often described in terms of the "quantity theory of money." In the long run, according to this proposition, the price level moves proportionately to the money supply. As a result, the rate of inflation depends on the rate of money growth. Though this proposition holds precisely only under restrictive conditions, it identifies in a more general sense an essential link between money and prices. It is therefore useful in understanding the way changes in the nature of money might affect the determination of the price level.⁵

While both respecifications [suggested by Reifschneider and Williams] improve the performance of the economy during periods subject to the zero nominal bound, they raise a question about the credibility of the commitment implied by the rule. In particular, the effectiveness of such a commitment hinges directly on the ability of the central bank's promise of future actions (perhaps several years into the future) to influence the public's expectations today. In such a case, transparency may offer an important benefit. In particular, if workers, firms, and investors can be convinced through public statements that an unusual situation calls for unusual action, the central bank's ability to affect expectations about its future policy--when the promised future policy is different from its normal conduct--may be enhanced.

By the time I arrived at the Fed, however, the discussions about the ranges for the money supply were the only times the words money supply were uttered at FOMC meetings. The discussion about the ranges was generally mechanical and disinterested, with the main objective being to avoid making any changes to them that would suggest that the Committee was paying more attention to the monetary aggregates than they had recently.

While the presidents begin the outlook go-around, the order of presentations is otherwise set through what I call the "wink" system. When a Committee member wants to make his presentation, he winks at the deputy secretary, who then puts the member on the list, in the order of the winks. 

I also learned that FOMC meetings are more about structured presentations than discussions and exchanges. This surprised me. Each member spoke for about five minutes, then gave way to the next speaker. Many read from a prepared text or spoke from a de tailed outline, diverging only occasionally to include a comment on what was said earlier in the meeting. To my surprise, what evolved was not a spontaneous discussion, but a series of formal, self-contained presentations. (11) 

_______________________
Note 11:  I am told that the presentations used to be more spontaneous and interactive. But this changed once the decision was taken to release the transcripts after five years. Committee members apparently want to make sure that their remarks, when read five years later, will be coherent and graceful. So most would write them down and read them. I quickly fell into the practice of doing the same.

Anecdotal information delivers a different perspective from that of the data and is especially valued in that it arrives fresh and without the time lag of the data...

___________________________________

(9.) Some disparage the usefulness of such anecdotal reports, viewing them as unreliable "gossip." I always think of a quote I once heard, attributed to George Stigler, an economies professor at the University of Chicago for most of his career: "Data is just the plural of anecdote." 

(10.) Such anecdotal information likely plays a more important role for the Fed than for other forecasters, in part because Reserve Bank presidents specialize in collecting such information and can be expected, over time, to learn to sort through the comments they receive and identify early signs of changes in the outlook. In addition, they might have access to higher-quality anecdotes than others, because firms will more candidly share information on their spending and hiring plans with the Fed than with others.