Toward Clarity in Monetary Policy> > >
by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
Over the last few years, I have spoken and written frequently about the need to improve the transparency surrounding our monetary policy decision-making and to bring the framework we use for making those decisions into the 21st century.1 The Federal Reserve is accountable to the public, so it needs to clearly communicate its goals and its approach to making policy decisions. In this essay, I discuss recent steps taken by the Federal Open Market Committee (FOMC) to strengthen the framework for U.S. monetary policy through enhanced commitment, credibility, and communication. I also explain how these steps help improve economic stability.
In my view, the monetary policy framework is stronger when the central bank:
To its credit, the Federal Reserve has sought to strengthen its monetary policy framework, particularly with respect to increased transparency about its actions and its policies during the tenure of Chairman Ben Bernanke. For instance, in an effort to improve its communications to the public, the FOMC decided in 2007 to release its Summary of Economic Projections (SEP) four times a year instead of semi-annually. In 2011, Chairman Bernanke introduced press briefings to provide additional context for the FOMC's policy decisions and the projections. Increased transparency is an ongoing process.
Early last summer, Chairman Bernanke asked Vice Chair Janet Yellen, Governor Sarah Bloom Raskin, Chicago Fed President Charles Evans, and me to serve on a communications subcommittee whose task was to develop recommendations to improve the FOMC's communications. In January 2012, the FOMC adopted two initiatives brought forward by the subcommittee. Both initiatives are important steps forward for the FOMC and are intended to serve the Committee and the public over the longer term.
The first initiative improves our communications about FOMC participants' economic projections in the SEP by summarizing individual participants' views of the appropriate path of monetary policy. Until January, the SEP summarized the individual FOMC policymakers' views on the economy as reflected in several key economic variables, including output, inflation, and unemployment, but it did not include any information on the monetary policy assumptions that underlay those projections. It is important to recognize that the projections from this exercise are not forecasts in the usual sense. Each policymaker's projections are conditioned on the policymaker's assessment of “appropriate policy,” that is, the policy path he or she believes will yield the best outcomes for the economy in the absence of further economic shocks.
There is often a diversity of views about the best path for policy going forward. That leads to valuable discussions and, ultimately, better decision-making. So, the FOMC economic projections differ from those of private-sector forecasters who try to predict what the Fed's next move might be. Instead, each policymaker makes economic projections based on an assessment of the best policy path to achieve the most desirable outcomes.
Without information on what the appropriate paths assumed by the participants were, it was difficult for the public to interpret the SEP. For example, participants may project the same value of inflation or the unemployment rate, but they may believe it will take different policy paths to achieve those outcomes. Thus, what appear to be similar projections in terms of outcomes can actually reflect very different views about the evolution of monetary policy.
The FOMC has, at times, communicated assessments about the expected path of policy, or what central bankers call “forward guidance.” For example, the Committee has used phrases like “extended period,” or, in the Greenspan era, it talked about policy moving at a “measured pace.” In the second half of 2011, the Committee indicated that rates were likely to be kept low until a specific date in the calendar. Yet, these approaches are not very satisfactory. “Extended period” is vague and can be interpreted differently by Committee members or market participants, and using calendar dates can be misinterpreted by the markets as suggesting that monetary policy is no longer contingent on how the economy evolves.
I believe a better and more informative way for the public to assess the likely future course of monetary policy is provided in the underlying policy paths assumed by participants as provided in the enhanced SEP. These policy paths are now summarized in two charts. The most relevant chart displays the level of the federal funds rate assumed by each participant at the end of each calendar year over the next three years and for the longer run. This information provides a useful picture of the range of views of future policy assumed by policymakers based on current economic conditions.
Adding policymakers' assumptions to the SEP has two main advantages over using a calendar date. First, it illustrates the full range of views and, in doing so, underlines the uncertainty that truly exists about future policy. Second, it reveals information about how policymakers' views of policy evolve as economic conditions change — this is what economists call the policymaker's reaction function. The new enhanced SEP thus adds an important perspective not just of prospective policy at a point in time but of how the policy projections are influenced as economic conditions change. Such communication will prove useful in periods such as the current unusual circumstances but also in more normal times as well.
|Each shaded circle indicates the value (rounded to the nearest 1/4 percent) of an individual participant's judgment of the appropriate level of the target federal funds rate at the end of the specified calendar year or over the longer run.|
The second important communications initiative adopted by the FOMC in January was to issue a consensus statement of the longer-run goals and policy strategy. When households, firms, and markets have a better understanding of what to expect from monetary policy, they can make better financial plans and better spending and labor market decisions. Thus, greater clarity helps monetary policy become more effective at promoting its goals.
The consensus statement makes four very significant points in clarifying our policy objectives.
First, the statement reaffirms the Committee's commitment to its congressional mandate to promote “maximum employment, stable prices and moderate long-term interest rates.”2 Because moderate long-term interest rates follow so directly from the price stability mandate, many people have come to refer to the Fed as having a “dual mandate” — price stability and maximum employment.
The statement then gives texture to those objectives.
The statement's second significant point stresses that inflation over the longer run is mainly determined by monetary policy. In this sense, the FOMC acknowledges what every economist has known for over two centuries: inflation is a monetary phenomenon. Therefore, it is appropriate and feasible for a central banker to set an inflation goal and to be held accountable for achieving it.
The Committee adopted a long-term inflation goal of 2 percent, as measured by the year-over-year change in the overall personal consumption expenditures (PCE) chain-weighted price index. By establishing an explicit inflation target, the Federal Reserve is adopting a practice used by most major central banks and one that is acknowledged as a best practice by academics and central bankers. Making such a clear and explicit statement should give the public confidence in the credibility of the Fed's commitment to price stability and provide a tangible metric by which the Fed can be held accountable to the public.
Also, stabilizing inflation expectations and increasing the credibility of the central bank to maintain stable prices can actually change the inflation process itself. In particular, inflation will become less responsive or sensitive to short-run supply and demand disturbances. This means less volatility in monetary policy and less volatility in output and employment.
A third important point made in the statement is that it is not appropriate for the Fed to set an explicit numerical goal for the maximum employment part of its mandate. This is not because the Fed does not seek maximum employment or because it wants to disregard or downplay its importance. Rather, it reflects the differences between the economic determinants of the inflation and employment parts of our mandate. Over the longer run, the economy's inflation rate is primarily determined by monetary policy. So, the FOMC is able to set a longer-run numerical goal for inflation and should be held accountable for achieving that goal.
On the other hand, maximum employment is largely determined by factors that are beyond the direct control of monetary policy. These factors include such things as demographics, technological innovation and productivity, the structure of the labor market, and various governmental policies, including taxes and other policies that impact the level of employment. Since these factors change over time, the concept of maximum employment can also change over time. While policymakers consider a wide range of indicators to assess maximum employment, the value of such indicators is subject to considerable uncertainty. Economists, for example, often have very different assessments of the level of maximum employment attainable at any point in time. This arises because different models suggest different conceptual definitions, most of which are not directly observable. So, monetary policy should not seek to achieve an explicit objective for something it does not directly control and cannot accurately measure.
Moreover, monetary policy cannot and should not be used to offset longer-run changes in maximum employment. Even in the near term, the modern approach to macroeconomics recognizes that employment will fluctuate with forces that affect supply and demand, such as oil price shocks, earthquakes, or decisions by households to save more, or deleverage, perhaps due to a fall in the stock market or in house prices. In my view, it is generally neither desirable nor efficient for monetary policy to try to prevent markets from making adjustments in response to economic events, even if they have consequences for employment. Instead, I believe monetary policy should be set in a way that allows the economy to efficiently use its resources given the economic disturbances it has experienced, thus allowing for the best economic outcome given the environment.
A fourth element of the consensus statement is that it makes clear that the FOMC takes a balanced approach to setting policy. I interpret a balanced approach as one that promotes all of our congressionally mandated objectives of maximum employment, stable prices, and moderate long-term interest rates and does not favor one over the other.
Many people think the employment and price stability parts of the mandate conflict with one another, but in fact, they are complementary. Economists have come to understand that achieving price stability is the most effective means for monetary policy to promote the other goals. Price stability contributes to the economy's growth and employment prospects in the longer term and helps to moderate the variability of output and employment in the short to medium term. Price stability allows the economy to function more efficiently and more productively by giving individuals and businesses more confidence that the purchasing power of the dollar will not erode. Price stability also helps to foster financial stability and moderates long-term interest rates by minimizing the inflation premium that investors demand to hold long-term assets.
Failing to maintain price stability can often lead to more instability in employment and output. If inflation rises to unacceptable levels, as it did in the 1970s, monetary policy may be forced to react to restore price stability. This, in turn, could lead to an increase in unemployment as it did in the recession early in the 1980s. Thus, increases in inflation in the near term risk creating unemployment in the future; as a result, we end up with less stability, not more.
The consensus statement does not provide answers for all the hard policy choices. How best to implement this balanced approach requires judgments that may well differ across policymakers who may have different models of the economy. Thus, policymakers may have different assessments of the appropriate policy even as they work to promote the same long-term goals.
Overall, the enhancements to our SEP and the articulation of our long-run goals and objectives clarify and strengthen the Fed's monetary policy framework. In so doing they move us closer to the modern textbook view of how to conduct monetary policy. This view is commonly referred to as flexible inflation targeting. The approach combines a credible commitment to a medium-term inflation objective, which, in turn, allows monetary policy to adjust to economic shocks in a manner that helps promote the return of output or employment to a more desirable value without undermining inflation expectations. It emphasizes clear and transparent communication with the public about policymakers' views of current economic conditions, the economic outlook, and its decision-making framework.
Flexible inflation targeting is widely practiced by major central banks around the world. While details often differ, key themes include a commitment to an explicit medium-term inflation objective and transparent communication about the economic outlook and the policy process. It also increases accountability to the public. It is harder to make commitments that you will be unable or unwilling to keep if you know the public can call you to task for failing to meet your commitments.
By being more explicit about its objectives and more transparent and systematic about its decision-making framework, the central bank enhances its credibility.
Improving the transparency of our communications and strengthening our policy framework is a work in progress. More can be done and here I would like to focus on two possible steps.
First, I believe the Federal Reserve could further improve communication by publishing a more comprehensive monetary policy report four times a year. Currently, the Chairman testifies before Congress twice a year and submits an accompanying written report. In addition, the Chairman holds press briefings four times a year to summarize the SEP and the subsequent minutes further elaborate and discuss policymakers' views on the economy. I think there is an opportunity to combine these efforts to create a more comprehensive report on monetary policy. Most central banks that have adopted an inflation target have also sought to improve communication and transparency through the publication of a regular policy report. In the U.K., for example, the Bank of England issues a quarterly Inflation Report. Other countries produce a Monetary Policy Report that discusses the central bank's forecasts and the longer-term context of policy.
I think the Fed should consider producing a similar report to elaborate and reinforce its policy framework and how it relates to economic conditions. These reports will help improve the public's understanding of policy, which will help make policy more effective and the central bank more accountable.
Second, I believe the FOMC should adopt clearer guidelines on how policy evolves with economic conditions. The better the public and the markets understand how policy is likely to be adjusted as the economy changes, the more predictable policy becomes, which promotes price stability and better economic outcomes.
The history of U.S. monetary policy is filled with stops and starts and changes in direction, yet the Fed has communicated little about what drives those decisions. Indeed, historically, central bankers have tended not to reveal such information, since they have preferred discretionary policy over systematic policy. But economic research in the past 30 years has shown that setting monetary policy in a systematic or rule-like manner leads to better economic outcomes — lower and less volatile inflation and greater economic stability in general.3 As I have discussed on many occasions, there is value in conducting policy in a systematic manner in both good times and bad.4 This means making policy decisions using available economic information in a consistent and predictable manner.
Of course, policymakers do not know with any degree of certainty how economic conditions will evolve. So they cannot and should not say with any certainty what policy will be in the future. But policymakers can provide information about the factors that will influence their policy decisions and so be more systematic about how they use economic data in formulating their policy. Some call this a policy rule. Milton Friedman advocated a rule in the form of a k-percent growth rate of the money supply. John Taylor devised a rule that depends on a measure of inflation relative to a target and some measure of resource utilization. Other versions of the Taylor rule involve a degree of smoothing to minimize sharp swings in the policy rate. A policy rule is also called a reaction function or response function because it describes how policy will evolve as key economic conditions evolve.
I believe that the Fed should provide more information about its reaction function. The practice of using systematic rules as guides to monetary policy imposes an important discipline on policymaking and improves communication and transparency. This is because systematic rules make policy more predictable and therefore help the public and markets make better decisions. Moreover, if policymakers choose to deviate from the guidelines, they are forced to explain why and how they anticipate returning to normal operating practices. Systematic policy also reduces the temptation to engage in discretionary policies.
I believe the FOMC is still some way from agreeing on one systematic policy rule or reaction function. Such choices will involve elaborate discussions and agreement on the appropriate class of models and an agreed-upon loss function. One way to move toward a more systematic policy would be to describe the variables that are important for our reaction function. The academic literature suggests using rules that respond aggressively to deviations of inflation from the central bank's target and less aggressively to deviations of output from some concept of “potential output.” Research has found that such rules perform fairly well in a variety of models and frameworks.5
Thus, it is reasonable and feasible for the Fed to describe policy in terms of the variables in a rule that is robust across models. We would not have to articulate a precise mathematical rule but would provide the key variables and then communicate policy decisions in terms of changes in these key variables. If policy were changed, then we would explain that change based on how the variables in our response function have changed. If we choose a consistent set of variables and systematically use them to describe our policy choices, the public will have a greater ability to form judgments about the likely course of policy. This would reduce uncertainty about policy and promote stability.
There is one more item on my list of things to do. At the beginning of this essay, I noted that the fourth principle of sound central banking is maintaining the independence of the central bank. Unfortunately, over the past few years, the combination of a financial crisis and sustained fiscal imbalances has led to a breakdown in the accepted barriers between monetary and fiscal policy. The pressure has come from both sides. Governments are pushing central banks to exceed their monetary boundaries and central banks are stepping into areas not previously viewed as acceptable for an independent central bank.
While monetary policy and fiscal policy are intertwined through the government's budget constraint, there are good reasons to maintain clear boundaries between the two. Specifically, in a world where fiscal discipline is lacking, governments without the institutional or constitutional guarantees of an independent central bank often resort to money creation as a solution to fiscal problems. This, of course, is a recipe for high rates of inflation and, in the extreme, hyperinflation. For this reason, countries throughout the world have moved over the last 60 years to strengthen the independence of their central banks. It is simply good governance to keep a healthy degree of separation between those responsible for tax and spending policies and those responsible for monetary creation.
The pressure on independence stems, in part, from fiscal imbalances and the inability of governments to develop credible and sustainable plans to finance public expenditures. In turn, the pressure can manifest itself in calls for higher inflation or for central banks to act as lenders of last resort for failing governments. Governments can also pressure central banks to engage in lending to the private sector as a means to avoid the explicit appropriation of funds by the fiscal authorities.
Yet central banks have also contributed to the breakdown of the boundaries by engaging in credit allocations to particular sectors, such as housing, and bailouts to particular firms, such as Bear Stearns. Thus, both the fiscal authorities and the supposedly independent central banks have acted in ways that undermine central bank independence. We need to restore the boundaries.
In last year's essay, I outlined a framework for a “new accord” between the Federal Reserve and the Treasury. It would enable the central bank to act in emergencies when requested by the Treasury or the fiscal authorities, but it would be clear up front that any non-Treasury assets that accrued on the central bank's balance sheet would be swapped for government securities within a specified period of time. This would ensure that fiscal policy decisions remain under the purview of the fiscal authorities, not the central bank.
To summarize, the FOMC has taken significant actions toward greater transparency, most recently with the historic steps adopted in January 2012. These steps in turn help to promote better public understanding of the rationale behind the FOMC's decisions. First, we released a statement clarifying the long-run goals of monetary policy and our policymaking strategy. Second, we began releasing information about the policy paths that underlie our economic projections.
Yet, I believe more can be done. We can and should improve our discussion of the economy and our approach to policy through the publication of a more comprehensive monetary policy report to the public. We can also better define our reaction function, to enable the public to better understand and anticipate future policy actions. Economic research has shown that increased transparency can improve the effectiveness of monetary policy, as well as the Fed's accountability with the public. But the benefit depends on the public's understanding of the policymaking framework.
Lastly, I believe that we must seek ways to ensure that our central bank preserves its independence and that the boundaries between monetary and fiscal policy are restored. Thus, I remain committed to working to increase the clarity of the Fed's public communications about current economic conditions, the economic outlook, and our policymaking framework.
Dotsey, Michael, and Charles I. Plosser “Designing Monetary Policy Rules in an Uncertain Economic Environment,” Federal Reserve Bank of Philadelphia Business Review (First Quarter 2012).
Kydland, Finn E., and Edward C. Prescott “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, 85 (January 1977), pp. 47391.
Orphanides, Athanasios, and John C. Williams “Robust Monetary Policy Rules with Unknown Natural Rates,” Brookings Papers on Economic Activity (2002), pp. 63-118.
Plosser, Charles “The Benefits of Systematic Monetary Policy,” speech to the National Association for Business Economics, Washington Economic Policy Conference, March 3, 2008.
Plosser, Charles “Credible Commitments and Monetary Policy After the Crisis,” speech to Swiss National Bank Monetary Policy Conference, Zurich, Switzerland, September 24, 2010.
Plosser, Charles “Strengthening Our Monetary Policy Framework Through Commitment, Credibility, and Communication,” speech at the Global Interdependence Center's Global Citizen Award Luncheon, Philadelphia, November 8, 2011.