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“A Perspective on Monetary Policy”
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland
Remarks to the Association for Corporate Growth
Pittsburgh, Pennsylvania
January 18, 2005
Introduction
Since
I became president of the Federal Reserve Bank of Cleveland
two years ago, I have made a point of getting out
to various communities within our region on a regular basis
to talk with businesspeople—to hear what’s on
their minds and where they think the regional economy is
heading. It is important to bring that regional input with
me in my role as national monetary policymaker.
I
have just completed my second year on the Federal Open
Market
Committee, or FOMC, which is the Federal Reserve’s
monetary policymaking group. We meet eight times a year in
Washington, D.C.; in fact, our next meeting is coming up
in just a couple of weeks. The voting members of the FOMC
include the seven members of the Board of Governors of the
Federal Reserve System, the president of the Federal Reserve
Bank of New York, and four of the other eleven Reserve Bank
presidents. All of the presidents participate in the policy
discussions, but my voting responsibility on the FOMC alternates
each year with the president of the Federal Reserve Bank
of Chicago. In 2004, I had a vote, and this year Michael
Moskow, the Chicago president, votes on FOMC policy actions.
And
that brings me to what I would like to cover in my remarks
to you today—a brief perspective on monetary
policy. First, I will describe the FOMC’s goals in
setting monetary policy. Next, I will talk about why we are
moving the federal funds rate up from exceptionally low levels.
Finally, I will explain why, as we adjust to a more normal
economic environment, we need to pay close attention to the
risks for higher inflation.
The views that I express today are mine alone. I do not
presume to speak for any of my FOMC colleagues.
I. Monetary Policy Goals
Let
me begin by telling you that conducting monetary policy
is more complex than it might appear at first glance. Economic
conditions can be unpredictable, so we need to find out which
policy choices have the best chance of moving us toward our
goals, given the changing environment around us.
Through
the Federal Reserve Act, Congress has instructed the Federal
Reserve to conduct monetary policy in support
of the nation’s economic goals. Specifically, Congress
requires the FOMC "to promote effectively the goals
of maximum employment, stable prices, and moderate long-term
interest rates." In our press releases, we refer to
these requirements in shorthand as “price stability
and sustainable growth.”
You will notice that there are no precise numerical definitions
here. Even so, if we want to be successful in realizing these
goals, we have to make them more concrete for operational
purposes.
For
the price stability goal, the FOMC tends to focus on the
growth
rate of the core Personal Consumption Expenditure
price index, or PCE price index. The core PCE price index
is a measure of average consumer prices, excluding the food
and energy components, which tend to fluctuate quite a lot.
It appears that the core PCE price index will come in at
about 1½ percent for 2004, and most forecasters suggest
that pace will continue in 2005. Inflation around 1½ percent,
if sustained, appears close to what several countries have
chosen as their working definition of price stability.
For
the sustainable growth goal, the approach is not quite
as precise.
The general idea is that monetary policy should do what
it can to support the expansion of gross domestic
product, or GDP, near its “potential.” The tricky
part is that the economy’s potential growth rate can
change over time. Some changes are temporary —such
as when we have oil price shocks. But some changes are more
permanent—for instance, when there are major upward
shifts in productivity. These changes can make it difficult
to measure potential GDP.
Although
we have more than one goal, I believe that in the
long run, maintaining price stability is the unique contribution
that the Federal Reserve can make to promoting maximum employment
and moderate long-term interest rates. In many, if not most,
cases this is true in the short run as well. The bottom line
is that you cannot have maximum employment and moderate long-term
interest rates without price stability.
II. Moving from Unusual Levels of Policy Accommodation
Now
that I’ve discussed our goals, let me turn to
the primary policy tool we use—the federal funds rate.
When you boil down monetary policy, you find out that the
Federal Reserve supplies the banking system with a highly
liquid form of money, which banks hold as balances on deposit
with us. Banks can buy and sell these funds in the money
market, but since we control the supply, we essentially set
the price. That price is the federal funds rate, the interest
rate that banks pay for overnight funds.
By targeting a specific federal funds rate, the FOMC influences
the level of other interest rates and the quantity of bank
lending. Changes in the federal funds rate trigger a chain
of events that affect other short-term interest rates, foreign
exchange rates, long-term interest rates, and the amount
of money and credit. Ultimately, interest rate changes affect
a range of economic variables, including employment, output,
and prices of goods and services.
Since last June, the FOMC has increased its target federal
funds rate from an extremely low level of 1 percent to its
current level of 2.25 percent. We have increased that rate
by 25 basis points at each of our last five meetings, and
the federal funds futures market shows a 95 percent probability
that the FOMC will increase the federal funds rate target
by another 25 basis points at our next meeting on February
2.
I’d
like to give you a bit of history of how we got to the
low level of 1 percent, and explain why the federal
funds rate is trending up.
We had a brief and mild recession in 2001, followed by a
slow and prolonged recovery period. By early 2003, the economy
was being confronted by an unusual combination of forces:
The nation was launching the war in Iraq, energy markets
were volatile, and business confidence was low. At the same
time, productivity growth stayed strong, adding to forces
that were keeping inflation at low levels. It almost seemed
like a perfect storm of uncertainty in how economic conditions
would unfold.
Soon,
though, we had enough information to conclude that we faced
a remote but unacceptable risk – the risk
of “an unwelcome fall in inflation.” With interest
rates already low and the economy struggling to regain its
momentum, it seemed possible that short-term interest rates
could fall to zero and that we could experience an outright
deflation. This possibility was unprecedented in our recent
experience. Economists may disagree about the potential effects
of deflation on spending, production, and investment, but
we know that actual deflations are rare and we think they
are best avoided.
By
June of 2003, the FOMC had cut the federal funds rate
target
to 1 percent--the lowest level it had reached since
the late 1950s. We wanted to head off further disinflation.
I think that by focusing on our price stability goal—in
this case not letting the price level actually decline—our
actions also promoted sustained economic growth.
We
did not have the data to confirm it at the time, but it
turns out that the economy had already begun to improve.
It strengthened more in the second half of 2003.
Employment
growth remained sluggish, but investment spending jumped.
In turn, market interest rates rose sharply, and did not
retreat for the balance of the year.
The
Committee still took a cautionary stance. Although we
judged the
probability of an unwelcome disinflation as fairly
small by the end of 2003, we decided to keep the funds rate
target low—or, as we stated in our press release,
keep monetary policy accommodative—to support the ongoing
economic expansion. Strong productivity growth provided some
extra confidence that inflation would remain benign.
By the first half of 2004, the expansion seemed to be on
firmer ground. Growth was solid, investment was largely holding
up, and at long last employment growth appeared to be on
the rebound. At the same time, we had to begin to consider
the possibility that inflationary pressures could rise if
monetary policy did not respond appropriately. After all,
the deflation concern had now passed and our policy was still
highly accommodative. So last June, we began moving the federal
funds rate up.
It
all boils down to changing economic circumstances. In
2003,
the FOMC faced an unusual situation that caused us
to adopt a highly accommodative policy—meaning that
we wanted to provide plenty of liquidity at a low price.
Since the middle of last year, we have been removing that
accommodation gradually, causing an increase in short-term
interest rates. How far will we go? That all depends on how
the economy evolves.
III. Moving to a More Normal Environment
As
the new year begins, I expect to find the economy growing
on
a more sustained path. The FOMC is adjusting to this more
normal environment. I believe we are moving toward a more “neutral” monetary
policy, one that is neither accommodative nor restrictive.
My
way of thinking about neutral does not imply a particular
numerical
resting place for our policy target. I want to
emphasize that our knowledge of the economy is not precise
enough to encourage me to latch onto a specific number for
the federal funds rate. If the economy strengthens further
this year—and I hope it will—market interest
rates are likely to rise as business and consumer confidence
takes hold, and spending will increase along with growing
production and employment. Under these circumstances, maintaining
the same policy stance will probably mean that the federal
funds rate will have to rise, too. In other words, interest
rates can go up without changing the stance of monetary policy.
Of
course, there are differences of opinion on how much
rates will
need to rise at any given time. Over time, central
bankers have learned some important lessons—namely,
that there is a lot of inertia in the inflation process,
and that we cannot underestimate the possibility of inflation
creeping in. And once an inflationary psychology takes hold,
it can be difficult and costly to reverse.
I recognize that on the surface, some of the recent price
statistics might seem to present little cause for alarm.
For example, even though the overall PCE price index increased
by 2.6% during the past 12 months, the core PCE price index
increased by only 1.5%. As I mentioned earlier, this is roughly
consistent with a working definition of price stability.
We also see few signs that labor costs are increasing significantly
faster than productivity, a development that often can signal
a step-up in inflationary pressures.
But in my opinion, the momentum in the inflationary process
has clearly shifted away from disinflation. And, unfortunately,
it is not always possible to distinguish short-term movements
in the price indexes from the emergence of an inflationary
trend until after the fact.
We
know that as the expansion lengthens, and rates of resource
utilization tighten, the demand for credit tends to increase,
which pushes real interest rates up. This is just a normal
cyclical phenomenon. In these circumstances, monetary policy
makers have to anticipate the potential for inflation to
creep up over time if the policy rate does not move up as
well—in other words, if policy unintentionally becomes
accommodative.
The minutes from our December FOMC meeting reflect this
thinking. Even though we have been moving rates higher at
a measured pace during the past six months, we still see
signs that the current level of the real federal funds rate
target remains below the level that is most likely needed
to keep inflation stable and economic output at its potential.
Business
cycle developments are not the only factors that can affect
real interest rates. Looking ahead, I see the
potential for additional pressures on market interest rates
coming from two other sources. One variable is our federal
budget deficit. It is too simplistic to claim that fiscal
deficits necessarily lead to higher interest rates. The economic
impact of any given deficit almost certainly depends on the
spending and tax policies that give rise to the budget shortfall – the
fine print beneath the red ink, as it were. But it would
not be shocking to find that there might be some interest-rate
pressure from this source, at least in the short run.
The foreign sector provides another potential source of
real interest rate pressure. Capital flows from abroad have
helped to hold market interest rates in check. Imports have
been meeting domestic demand that would otherwise have to
be satisfied out of U.S. production. If foreign sources for
financing our consumption and investment shrink, then it
would be logical to see greater upward pressures on interest
rates in the financial markets, as long as overall economic
growth remains solid.
Regardless
of the source, upward pressure on real interest rates will
change the stance of monetary policy unless our
nominal monetary policy targets are adjusted higher as well.
Recognizing how difficult it is to know when policy is truly
neutral, I think it is prudent to move the federal funds
rate up to a position that gives me more confidence that
monetary policy is no longer accommodative. I would prefer
this strategy to finding out the hard way—for example,
through a deterioration in inflation expectations or in the
inflation picture itself—that we had maintained an
overly accommodative stance for too long.
Conclusion
This
afternoon, I have explained why the federal funds rate
is trending up and how the FOMC has kept its focus on our
fundamental policy goals. Economic trends are notoriously
difficult to predict, and there are always surprises. I know
that during my two years as a member of the FOMC, I have
seen more than a few twists and turns in the path. But in
every sense, the Federal Reserve begins with the end in mind—to
maintain price stability and promote sustainable economic
growth.
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