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The Process of Policy
January 13, 2004
Remarks by
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland
The Charles J. Pilliod Lecture Series
Kent State University
Thank you for that kind introduction, Ron. I’m
proud to be a part of the Pilliod Lecture Series, and I’m
glad to be here with all of you this evening.
As Ron mentioned, I am approaching the one-year anniversary
of my appointment as president and CEO of the Federal Reserve
Bank of Cleveland. Over the past year, I have spoken to thousands
of people all across this region, and whether the audience
has been business people, bankers, college students, or community
leaders, a couple of topics seem to come up over and over
again.
The first is that people—even people who think they already
know about the Federal Reserve System—really want to
know and understand more. Second, everybody wants to
talk about the economy. So tonight, I’m going to talk
about both of these topics.
I’ll give you some background on the Federal Open Market
Committee and its responsibilities for setting monetary policy.
I’ll share some information on our economy and explain
why—when it comes to policymaking—it makes sense
to consider a wide range of indicators and benchmarks. Finally,
I’ll conclude my comments by explaining how people just
like many of you, in communities all over our region, are
helping me with the process that leads to monetary policymaking.1
To start, I’ll give you a very brief overview of the
Federal Open Market Committee (FOMC), the Federal Reserve’s
policymaking arm. The FOMC’s long-term objectives are
price stability and sustainable economic growth.
The FOMC consists of nineteen members: the seven
members of the Board of Governors and the twelve Reserve Bank
presidents. Twelve of the nineteen are voting members of the
Committee. The seven Governors and the president of the Federal
Reserve Bank of New York always have a vote. Four of the remaining
eleven Reserve Bank presidents vote on a rotating basis. The
presidents of the Cleveland and Chicago Federal Reserve Banks
rotate every year, and the other nine presidents get a vote
every three years.
Last year, I participated in the FOMC meetings as a nonvoting
member of the Committee. Each Reserve Bank president has an
equally important voice in the national policy discussion,
whether he or she is voting that year or not. The only difference
is that voters get one more word at the end of the meeting—“yea”
or “nay.” This year, I become a voting member, which
means I will have a voice and a vote.
I have outlined the structure of the Federal Open Market Committee;
now I want to invite you to attend a meeting of the FOMC.
I can’t literally do that, of course, because these sessions
are not open to the public, but I can try to describe a meeting
for you.
Here, I would like to acknowledge former Federal Reserve Board
Governor Larry Meyer who, in 1998, delivered a lecture called
“Come with Me to the FOMC.” I will walk you through
a typical FOMC meeting agenda in the way Dr. Meyer did.
The FOMC meets in Washington, generally eight times a year.
Just before the 9:00 a.m. start, Committee members gather
around an immense oval table. The first presentation comes
from the manager of the System Open Market Account at the
Federal Reserve Bank of New York, who covers developments
in domestic and international financial markets, as well as
open market operations, since the last FOMC meeting.
Next, we turn our attention to the domestic and international
economic projections. These projections are developed by the
economists at the Federal Reserve’s Board of Governors
and are contained in a document known as the Green Book. The
projections are reviewed with the Committee, whose members
use this time on the agenda to raise questions about the projections
and discuss issues associated with them.
The meeting then shifts to what we call a “go-round,”
when Committee members give their views on the economic outlook.
The Bank presidents usually go first. In addition to commenting
on the national outlook, we present information from our regions.
Later, I’ll explain the nature of this information and
how we collect it.
After each member has spoken, it is time to consider policy
options, which are outlined for the Committee members in advance,
in a document called the Blue Book. The director of the Monetary
Affairs Division at the Board of Governors lays out the policy
options for the Committee. Then it is time for a second go-round,
with members stating their views on which policy option should
be adopted. This time, Chairman Alan Greenspan goes first.
If it is obvious that members generally agree, this go-round
is often fairly brief; otherwise, a more in-depth discussion
takes place. When the go-round wraps up, it is time to vote.
The Committee strives to reach consensus on the policy decision
and, more often than not, a unanimous vote results.
Each meeting concludes with a decision—or policy directive—designed
to achieve the objectives I mentioned earlier, price stability
and sustainable economic growth. The primary tool to execute
the policy directive is targeting the federal funds rate through
open market operations. By this I mean that the Federal Reserve
buys or sells government securities on the open market. These
operations enable us to affect the liquidity of the banking
system, thereby enabling us to achieve our target for the
federal funds rate—the interest rate that banks charge
each other for funds on an overnight basis.
The Committee’s decision is publicly announced at around
2:15 that afternoon. By then, the meeting has ended and it
is time for me to return to Cleveland and begin preparing
for the next FOMC meeting.
That’s the process in a nutshell. My brief description
might sound quite cut and dried—but I’ll tell you,
even though I’ve been part of the Federal Reserve System
for more than 20 years, my first year as president has left
me with a deep appreciation for the complexity of the task
of policymaking.
This brings me to the second area I’d like to cover this
evening. The forces driving the economy at any point in time
are complex—which makes formulating the appropriate policy
a real challenge. This is especially true in times like the
present. We are in the third year of an economic recovery,
but the lack of employment growth has made this a very unusual
recovery. At this stage of recovery from the 2001 recession,
many economists expected much stronger employment growth than
we have seen to date.
Ordinarily, at this stage of a business cycle, the level of
employment returns to—or exceeds—its level prior
to the onset of the last recession. Unfortunately, employment
growth in this phase of the current cycle is the slowest in
50 years, a situation that remains something of a puzzle.
Businesses are adjusting to rapid technological advances and
rising global competition. Changing trade patterns are not
only affecting the manufacturing sector, as has been the case
for decades; they are also having an impact on the service
sector. We’ve all read press accounts about companies
moving their software development, call centers, and back-office
operations offshore.
Productivity growth during this recovery has been high compared
with other postwar recoveries—indeed, productivity growth
has not stayed this strong this long into a recovery in over
30 years. I view this as a favorable development, since rapid
productivity growth is usually followed by growth in wages
and employment. However, the pick-up in wages and employment
might lag the productivity spurt in the short run.
Businesses often require some time to restructure their operations
to take advantage of new technologies. In the process, we
may find that there is a mismatch between the skills required
by sectors of the economy that are growing and the skills
of our current labor force. The very slow growth in employment
that we are seeing could be indicative of this type of restructuring,
even while other indicators of economic activity appear satisfactory.
How can we make sense of these developments as we formulate
policy?
Most economists rely on a concept known as the output gap.
Output gaps represent a divergence between what we actually
produce in our economy and what we estimate we could produce
if all of our labor and capital resources were fully utilized.
We call what we actually produce GDP, and the estimate
of what we could produce potential GDP.
Many economists theorize that disinflationary, or even deflationary,
pressures can arise if GDP is too far below its potential.
Inflationary pressures can loom if GDP is too far above its
potential.
Application of the output gap concept is complicated because
the potential of the economy is not something we can directly
observe. Weak labor markets might mean that there is
deficient spending in the economy and the economy is performing
below its potential. However, a weak labor market might also
reflect a fundamental restructuring of the economy that, for
a time, somewhat lowers potential output.
It is important to be mindful of the possibility that restructuring
can alter the historical relationships among the variables
policymakers typically look at. Uncertainty about whether—and
how—the economy might be changing inevitably leads policymakers
to look for supplemental indicators to help us understand
how to best depict the economic environment.
Financial markets are another important source of information.
Just as economists have found the concept of potential output
to be a useful guide to policy, they have found another concept,
the natural rate of interest, to be a helpful policy
guidepost. You can think of the natural rate of interest as
the rate of return to capital that is consistent with an economy
growing at its potential.
When the federal funds rate lies below the natural rate, policy
is described variously as stimulative or accommodative. Conversely,
when the funds rate lies above the natural rate, policy is
commonly described as restrictive or tight.
As is the case with potential output, the natural rate of
interest cannot be directly observed; what is just as problematic,
the natural rate can fluctuate as part of the economic restructuring
process.
When you hear people say that policymaking is both art and
science, you can now see why: Policymakers must exercise considerable
judgement when interpreting the information we receive.
A significant part of my preparation for FOMC meetings essentially
involves sifting through the different explanations that might
lie behind the data we observe. The research staff at the
Bank and I review a wide variety of data and attempt to match
it to a set of plausible underlying explanations. At the FOMC
meeting itself, I share this information—and my interpretation
of it—with my colleagues.
So how exactly do I go about getting the information that
allows me to assess which models of the economy best fit the
facts at a given time? That’s my third area of focus
tonight—the process that precedes and supports my preparations
for policy meetings and the role that people all over the
region are playing in this important work.
Obviously, I rely on my research staff to sift through the
latest economic information and help me think through the
issues that the upcoming Committee deliberations are likely
to deal with. While this is an essential part of the process,
it is insufficient by itself.
Very often, the official data that are available are just
not current enough for a forward-looking enterprise like monetary
policymaking. So I must rely not only on my team of economists—as
talented as they are—to prepare for FOMC meetings, but
also on people in the community. Input from people like you
provides me with good information on the economy far ahead
of when the official statistics are released. But there is
a more subtle value as well.
You might think of the statistical data that we get on the
economy as being a bit like the readout on your car’s
dashboard: All of the information is meant to tell you what
is happening to your car, but typically does not tell you
why it is happening. When the oil light on your car’s
dashboard begins to flash, you know that the oil is probably
low, but you don’t know why. Maybe there’s a leak,
or maybe your mechanic left the cap off. To find out, you
have to look under the hood.
In a sense, meeting with people in the region is my way of
looking under the economy’s hood. The conversations help
me understand the why behind the what. That’s
extremely important in helping me judge the reasonableness
of the various explanations being offered for the condition
of the national economy and in correctly calibrating policy.
There are a number of vehicles that I rely on to collect these
anecdotal accounts from people across the region.
First, members of my Board of Directors brief me on business
conditions in their industries and communities every two weeks.
As a matter of fact, providing information on the economy
is an important role of Directors in the Federal Reserve System.
I also have two advisory councils made up of banking and business
leaders from across the region. I meet with these councils
a few times a year and I view them as another important source
of information in preparing me for policy meetings.
Finally, I hear from individuals in the region through the
Beige Book process. The Beige Book is a Federal Reserve System
publication that assembles anecdotal accounts of current economic
conditions. These accounts are usually collected through telephone
interviews conducted by each of the Reserve Banks.
The aim is to survey a broad cross-section of contacts in
the region to form as complete a picture of economic conditions
as we are able to produce. These interviews, conducted in
advance of all scheduled FOMC meetings, involve a mix of contacts
who provide new insights and noteworthy patterns over time.
As you can see, as a Reserve Bank president, I have a lot
of formal ways of gathering information. I also have a less
formal, but equally important, way to find out what’s
going on. I talk with people—people just like you. I
travel all over the region, meeting with bankers and business
people. Every time I am invited to speak at an event like
this one, I try to listen just as much as I talk. The comments
and feedback I get help to sharpen the focus of the current
policy debate.
This evening I have given you some background on the Federal
Open Market Committee and its role in formulating monetary
policy. I have explained why policymaking is such a challenge
in today’s economy, and I’ve given you a glimpse
into the process of policymaking—and the vital role people
all across our region play in that important work.
For me, being at the table to chart the most prudent and sensible
economic course is both a rare experience and a humbling responsibility,
and I am extremely proud to be a part of it.
Thank you..
1As always, the views expressed
in this speech are those of the speaker and do not reflect
official positions of the Federal Reserve System.
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