Monetary policy objectives and strategy

Business Economics, Jan, 1997 by Laurence Meyer

I want to share with you my perspective on the challenges facing monetary policy in the current economic environment. But I also want to emphasize the importance of setting monetary policy as part of a longer-run strategy that provides guidance of how to juggle multiple targets in the short run while maintaining a focus on achieving price stability in the long run.

I will begin with a brief discussion of the objectives of monetary policy, then turn to the outlook issues that are, in my judgment, central to near-term policy decisions, and end with a few comments on one aspect of longer-run strategic considerations.

IDENTIFYING THE OBJECTIVES

I am used to delivering my intermediate macro lectures this time of year. I always start out identifying the norms of good macroeconomic performance that, in turn, become the objectives for macroeconomic policy. This is a good place to start. I include full employment, growth (meaning the growth in productive capacity), and price stability.

From my new perspective on the Federal Reserve Board, it is important to appreciate that economic theory suggests some specialization among the objectives between monetary and fiscal policies. Understanding this specialization will prevent us from expecting more from monetary policy than it can promise to deliver and help us better appreciate the singular nature of the long-run objective for monetary policy.

Economic theory, in the form of the long-run neutrality of money, tells us that monetary policy cannot affect the level or growth rate of output in the long run. So don't saddle monetary policy with responsibilities for stimulating the growth of productive capacity. If it were easy to produce more long-run growth simply by printing money, we would have monetized our way to dramatically higher living standards a long time ago. What monetary policy does do, according to economic theory, is set the rate of inflation in the long run. As I said in my opening statement in my confirmation hearings, when it comes to assigning responsibility for inflation, the buck literally stops at the Federal Reserve. Price stability is therefore the singular and unique long-run objective for monetary policy. Fiscal policy, on the other hand, can be an instrument of growth policy, through its effect on national saving via the structural budget deficit, through incentive effects on work, saving and investment via tax rates and tax structure, and through public investment in human capital and physical infrastructure. While we should not overstate what fiscal policy can deliver on this score, we should remember where the levers for growth policy are located.

There is less agreement about what economic theory and empirical macroeconomics tell us about the potential for stabilization policy. My reading is that both monetary and fiscal policies, via their influence on aggregate demand, affect output and employment in the short run. While we should not forget the lecture on inside and outside lags, parameter uncertainty, and other cautionary tales that preclude fine tuning, neither should we dismiss the stabilization role that can be played by some combination of the two policies. In practice, recently and for the indefinite future, fiscal policy is dominated with the task of reducing the deficit, leaving the stabilization objective almost exclusively in the hands of the Federal Reserve.

OUTLOOK ISSUES CHALLENGING MONETARY POLICY TODAY

There are two questions related to the current economic outlook that, in my view, challenge monetary policy in the near term.

1. In the absence of policy adjustment, is the economy slowing or likely to slow to trend quickly enough to stabilize the unemployment rate at its current level?

2. Is the current unemployment already so low that remaining at this level would trigger a steady increase in the rate of inflation?

I note that most of the private sector forecasts I follow, along with the Blue Chip Consensus, all provide an affirmative answer to the first question. All have growth near 2 percent in the second half of 1996 and through 1997. Of course, one has to be careful in interpreting these forecasts, because some of the private sector forecasts that have growth slowing to trend do so in the context of an assumed modest tightening of monetary policy, but many suggest a slowing to trend without such an adjustment. But you appreciate the issue here. Any answer, of course, is provisional, subject to adjustment to incoming data and therefore to be reviewed as appropriate over time.

Growth itself does not cause inflation. However, above-trend growth, without an accompanying increase in participation rates, implies further decline in the unemployment rate, which may already be at or even below its full employment level. A further decline in the unemployment rate, from its current level, would, in turn, increase the risk of an acceleration of inflation.

That brings me to the second question. Are we already below the nonaccelerating inflation rate of unemployment (NAIRU)? In that case, a slowdown to trend would not be sufficient to prevent an acceleration in inflation. The answer is, unfortunately, not that easy. On the one hand, estimates of NAIRU from a data sample that covers the past twenty to thirty years suggest a value close to 6 percent. This indicates we are below NAIRU and should expect a steady rise in the inflation rate going forward. The problem with this conclusion is that we would have expected, in this case, some upward pressure on prices over the past two years. I do not want to ignore the possibility that transitory favorable supply shocks can, for a while, offset the effect of a below-NAIRU unemployment rate on inflation. But I do not believe that special factors alone can explain away the tension between an unemployment rate persistently below traditional estimates of NAIRU and the stable to declining inflation over the past two years.