u.s. monetary policy: an introductiongsme.sharif.edu/~seminars-macro/old/files/4.pdf · many are...

U.S. MonetaryPolicy

Ali ZarifHonarvar

How is theFederalReservestructured?

What are thegoals of U.S.monetarypolicy?

What are thetools of U.S.monetarypolicy?

How doesmonetarypolicy affectthe U.S.economy?

Appropriatesetting for thepolicyinstrument

U.S. Monetary Policy: An IntroductionFederal Reserve Bank of San Francisco / 2004

Ali Zarif Honarvar

Sharif University of Technology

[email protected]

December 11, 2013

U.S. MonetaryPolicy

Ali ZarifHonarvar






Overview

• U.S. monetary policy affects all kinds of economic and fi-nancial decisions people make in this country.

Example

Whether to get a loan to buy a new house or car or to start upa company, whether to expand a business by investing in a newplant or equipment, and whether to put savings in a bank, inbonds, or in the stock market, for example.

• Furthermore, because the U.S. is the largest economy in theworld, its monetary policy also has significant economic andfinancial effects on other countries.

U.S. MonetaryPolicy

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Overview

• The object of monetary policy is to influence the perfor-mance of the economy as reflected in such factors as infla-tion, economic output, and employment.

• While most people are familiar with the fiscal policy toolsthat affect demand-such as taxes and government spending-many are less familiar with monetary policy and its tools.Monetary policy is conducted by the Federal Reserve Sys-tem, the nations central bank, and it influences demandmainly by raising and lowering short-term interest rates.

U.S. MonetaryPolicy

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Overview

1 How is the Federal Reserve structured?

2 What are the goals of U.S. monetary policy?

3 What are the tools of U.S. monetary policy?

4 How does monetary policy affect the U.S. economy?

5 Appropriate setting for the policy instrument

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Federal Reserve Districts

1. Boston 2. New York 3. Philadelphia 4. Cleveland 5.Richmond6. Atlanta 7. Chicago 8. St. Louis 9. Minneapolis 10. KansasCity11. Dallas 12. San Francisco

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How is the Federal Reservestructured?

• The Federal Reserve System (called the Fed, for short) isthe nations central bank. It was established by an Act ofCongress in 1913 and consists of the Board of Governorsin Washington, D.C., and twelve Federal Reserve DistrictBanks.

• The Congress structured the Fed to be independent withinthe government that is, although the Fed is accountable tothe Congress and its goals are set by law, its conduct ofmonetary policy is insulated from day-to-day political pres-sures. This reflects the conviction that the people who con-trol the country’s money supply should be independent ofthe people who frame the governments spending decisions.

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• The seven members of the Board of Governors of the Fed-eral Reserve System are nominated by the President andconfirmed by the Senate. A full term is fourteen years.One term begins every two years, on February 1 of even-numbered years. A member who serves a full term maynot be reappointed. A member who completes an unex-pired portion of a term may be reappointed. All terms endon their statutory date regardless of the date on which themember is sworn into office.

• The Chairman and the Vice Chairman of the Board arenamed by the President from among the members and areconfirmed by the Senate. They serve a term of four years.A member’s term on the Board is not affected by his or herstatus as Chairman or Vice Chairman.

Current Board Members

Ben S. Bernanke(Chairman), Janet L. Yellen(Vice Chair),Daniel K. Tarullo, Sarah Bloom Raskin, Jeremy C. Stein,Jerome H. Powell

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What makes the Fed independent?Three structural features give the Fed independence in itsconduct of monetary policy:

Appointment procedure for Governors

The seven Governors on the Federal Reserve Board are appointedby the President of the United States and confirmed by the Sen-ate. Independence derives from a couple of factors: first, theappointments are staggered to reduce the chance that a singleU.S. President could ”load” the Board with appointees; second,their terms of office are 14 years much longer than elected offi-cial’s terms.

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What makes the Fed independent?

Appointment procedure for Reserve Bank Presidents

Each Reserve Bank President is appointed to a five-year termby that Banks Board of Directors, subject to final approval bythe Board of Governors. This procedure adds to independencebecause the Directors of each Reserve Bank are not chosen bypoliticians but are selected to provide a cross-section of inter-ests within the region, including those of depository institutions,nonfinancial businesses, labor, and the public.

Funding

The Fed is structured to be self-sufficient in the sense that itmeets its operating expenses primarily from the interest earningson its portfolio of securities. Therefore, it is independent ofCongressional decisions about appropriations.

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How is the Fed ”independentwithin the government”?

Even though the Fed is independent of Congressionalappropriations and administrative control, it is ultimatelyaccountable to Congress and comes under government auditand review. Fed officials report regularly to the Congress onmonetary policy, regulatory policy, and a variety of other issues,and they meet with senior Administration officials to discussthe Federal Reserves and the federal governments economicprograms. The Fed also reports to Congress on its finances.

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Who makes monetary policy?

The Fed’s FOMC (Federal Open Market Committee) has pri-mary responsibility for conducting monetary policy. The FOMCmeets in Washington, D.C., eight times a year and has twelvemembers: the seven members of the Board of Governors, thePresident of the Federal Reserve Bank of New York, and four ofthe other Reserve Bank Presidents, who serve in rotation.The re-maining Reserve Bank Presidents contribute to the Committeesdiscussions and deliberations.In addition, the Directors of each Reserve Bank contribute tomonetary policy by making recommendations about theappropriate discount rate, which are subject to final approvalby the Governors.

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What are the goals of U.S.monetary policy?

Monetary policy has two basic goals:

• to promote ”maximum” sustainable output andemployment

• to promote ”stable” prices

These goals are prescribed in a 1977 amendment to the FederalReserve Act.

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What do maximum sustainableoutput and employment mean?

In the long run, the amount of goods and services the economyproduces and the number of jobs it generates both depend onfactors(technology and people’s preferences for saving, risk,and work effort) other than monetary policy.But the economy goes through business cycles. Even thoughmonetary policy can’t affect either output or employment inthe long run, it can affect them in the short run.

Example

When demand weakens and there’s a recession, the Fed canstimulate the economy-temporarily-and help push it backtoward its long-run level of output by lowering interest rates.That’s why stabilizing the economy-that is, smoothing out thepeaks and valleys in output and employment around theirlong-run growth paths is a key short-run objective for the Fedand many other central banks.

U.S. MonetaryPolicy

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If the Fed can stimulate theeconomy out of a recession,why

doesn’t it stimulate the economyall the time?

Persistent attempts to expand the economy beyond its long-rungrowth path will press capacity constraints and lead to higherand higher inflation, without producing lower unemployment orhigher output in the long run. In other words, not only arethere no long-term gains from persistently pursuingexpansionary policies, but there’s also a price higher inflation.

U.S. MonetaryPolicy

Ali ZarifHonarvar






What’s so bad about higherinflation?

• High inflation is bad because it can hinder economic growth,and for a lot of reasons. For one thing, it makes it harderto tell what a change in the price of a particular productmeans. For example, a firm that is offered higher prices forits products can have trouble telling how much of the pricechange is due to stronger demand for its products and howmuch reflects the economy-wide rise in prices.

• Moreover, when inflation is high, it also tends to vary alot, and that makes people uncertain about what inflationwill be in the future. That uncertainty can hinder economicgrowth in a couple of ways. It adds an inflation risk premiumto long-term interest rates, and it complicates further theplanning and contracting by businesses and households thatare so essential to capital formation.

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What’s so bad about higherinflation?

• That’s not all. Because many aspects of the tax system arenot indexed to inflation, high inflation distorts economic de-cisions by arbitrarily increasing or decreasing after-tax ratesof return to different kinds of economic activities. In addi-tion, it leads people to spend time and resources hedgingagainst inflation instead of pursuing more productive activ-ities.

• Another problem is that a surprise inflation tends to redis-tribute wealth. For example, when loans have fixed rates,a surprise inflation redistributes wealth from lenders to bor-rowers, because inflation lowers the real burden of makinga stream of payments whose nominal value is fixed.

U.S. MonetaryPolicy

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So should the Fed try to get theinflation rate to zero?

Actually, there’s a lot of debate about that. While someeconomists have suggested zero inflation as a target, othersargue that an inflation rate that’s too low can be a problem.For example, if inflation is very low or close to zero, thenshort-term interest rates also are likely to be very close to zero.In that case, the Fed might not have enough room to lowershort-term interest rates if it needed to stimulate the economy.Of course, the Fed could conduct policy using moreunconventional methods (such as trying to reduce long-terminterest rates), but it’s not clear that those methods would beas easy to use or as effective. Another problem is that, wheninflation is very close to zero, there’s a bigger risk of deflation.

U.S. MonetaryPolicy

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What’s so bad about deflation?

Difference between disinflation and deflation:

• Disinflation just means that the rate of inflation is slowing

• Deflation means that there’s a fall in prices.(inflation rateis negative)

In fact, deflation can be as bad as too much inflation and thereasons are pretty similar:

• A surprise deflation also redistributes wealth, but in theopposite direction from inflation.(from borrowers to lenders)

• A substantial, prolonged deflation, like the one during theGreat Depression, can be associated with severe problemsin the financial system.

• In a deflationary episode, interest rates are likely to be lowerthan they are during periods of low inflation, which meansthat the Fed’s ability to stimulate the economy will be evenmore limited.

U.S. MonetaryPolicy

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So that’s why the other goal is”stable prices”?

Price ”stability” is basically a low-inflation environment wherepeople and firms can make financial decisions without worryingabout where prices are headed. Moreover, this is all the Fed canachieve in the long run.

U.S. MonetaryPolicy

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If low inflation is the only thingthe Fed can achieve in the long

run, why isn’t it the sole focus ofmonetary policy?

• Because the Fed can determine the economy’s average rateof inflation, some commentators and some members of Congressas well have emphasized the need to define the goals of mon-etary policy in terms of price stability, which is achievable.

• But the Fed, of course, also can affect output and em-ployment in the short run. And big swings in output andemployment are costly to people, too. So, in practice, theFed, like most central banks, cares about both inflation andmeasures of the short-run performance of the economy.

U.S. MonetaryPolicy

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Are the two goals ever in conflict?

• Yes, sometimes they are. One kind of conflict involves de-ciding which goal should take precedence at any point intime. It’s important for the Fed to find the balance be-tween its short-run goal of stabilization and its longer-rungoal of maintaining low inflation.

• Another kind of conflict involves the potential for pressurefrom the political arena. Politicians may be tempted toput the emphasis on short-run results rather than on thelonger-run health of the economy.

U.S. MonetaryPolicy

Ali ZarifHonarvar






Why don’t the goals includehelping a region of the country

that’s in recession?

The Fed can’t concentrate its efforts on expanding the weakregion for two reasons.

• First, monetary policy works through credit markets, andsince credit markets are linked nationally, the Fed simplyhas no way to direct stimulus only to a particular part ofthe country that needs help.

• Second, if the Fed stimulated whenever any state had eco-nomic hard times, it would be stimulating much of the time,and this would result in excessive stimulation for the overallcountry and higher inflation.

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Why don’t the goals include tryingto prevent stock market ”bubbles”

like the one at the end of the1990s?

In theory, stock prices should reflect the value of firm’s ”funda-mentals” such as their expected future earnings. Unfortunately,evidence of a bubble is easy to find after it has burst, but it’smuch harder to find as the bubble is forming. The reason is thatpolicymakers-and other observers-can find it hard to tell whetherstock prices are moving up because fundamentals are changingor because prices are out of line with fundamentals.Even if the Fed suspects that a bubble has developed, it’s notclear how monetary policy should respond.

U.S. MonetaryPolicy

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Should the Fed ignore the stockmarket then?

• Not at all. Stock markets provide information about thefuture course of the economy that the Fed may find usefulin conducting policy.

• Beyond concerns about the economy, the Fed also pays at-tention to the stock market because of its concerns aboutfinancial market stability.

U.S. MonetaryPolicy

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What are the tools of U.S.monetary policy?

The Fed can’t control inflation or influence output andemployment directly; instead, it affects them indirectly,mainly by raising or lowering a short-term interest rate calledthe ”federal funds” rate. Most often, it does this throughopen market operations in the market for bank reserves,known as the federal funds market.

U.S. MonetaryPolicy

Ali ZarifHonarvar






What are bank reserves?

Banks and other depository institutions keep a certain amountof funds in reserve to meet unexpected outflows. Banks cankeep these reserves as cash in their vaults or as deposits withthe Fed. In fact, banks are required to hold a certain amount inreserves. But, typically, they hold even more than they’rerequired to in order to clear overnight checks, restock ATMs,and make other payments.

U.S. MonetaryPolicy

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What is the federal funds market?

From day to day, the amount of reserves a bank wants to holdmay change as its deposits and transactions change. When abank needs additional reserves on a short-term basis, it canborrow them from other banks that happen to have morereserves than they need. These loans take place in a privatefinancial market called the federal funds market.The interest rate on the overnight borrowing of reserves iscalled the federal funds rate or simply the funds rate. It adjuststo balance the supply of and demand for reserves. For example,if the supply of reserves in the fed funds market is greater thanthe demand for reserves, then the funds rate falls, and if thesupply is less than the demand, then the funds rate rises.

U.S. MonetaryPolicy

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What are open market operations?• The major tool the Fed uses to affect the supply of

reserves in the banking system is open marketoperations,that is, the Fed buys and sells governmentsecurities on the open market. These operations areconducted by the Federal Reserve Bank of New York.

• Suppose the Fed wants the funds rate to fall. To do this,it buys government securities from a bank. The Fed thenpays for the securities by increasing that bank’s reserves.As a result, the bank now has more reserves than it wants.So the bank can lend these unwanted reserves to anotherbank in the federal funds market. Thus, the Fed’s openmarket purchase increases the supply of reserves to thebanking system, and the federal funds rate falls.

• When the Fed wants the funds rate to rise, it does thereverse, that is, it sells government securities. The Fedreceives payment in reserves from banks, which lowers thesupply of reserves in the banking system, and the fundsrate rises.

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What is the discount rate?

Banks also can borrow reserves directly from the FederalReserve Banks at their ”discount windows,” and the discountrate is the rate that financially sound banks must pay for this”primary credit.” The Boards of Directors of the ReserveBanks set these rates, subject to the review and determinationof the Federal Reserve Board. (”Secondary credit” is offeredat higher interest rates and on more restrictive terms toinstitutions that do not qualify for primary credit.) Setting thediscount rate higher than the funds rate is designed to keepbanks from turning to this source before they have exhaustedother less expensive alternatives. At the same time, the(relatively) easy availability of reserves at this rate effectivelyplaces a ceiling on the funds rate.

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What about foreign currencyoperations?

Purchases and sales of foreign currency by the Fed are directedby the FOMC, acting in cooperation with the Treasury, whichhas overall responsibility for these operations. The Fed doesnot have targets, or desired levels, for the exchange rate.Instead, the Fed gets involved to counter disorderly movementsin foreign exchange markets, such as speculative movementsthat may disrupt the efficient functioning of these markets or offinancial markets in general. For example, during some periodsof disorderly declines in the dollar, the Fed has purchaseddollars (sold foreign currency) to absorb some of the sellingpressure.Intervention operations involving dollars, whether initiated bythe Fed, the Treasury, or by a foreign authority, are not allowedto alter the supply of bank reserves or the funds rate. Theprocess of keeping intervention from affecting reserves and thefunds rate is called the ”sterilization” of exchange marketoperations. As such, these operations are not used as a tool ofmonetary policy.

U.S. MonetaryPolicy

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How does monetary policyaffect the U.S. economy?

The point of implementing policy through raising or loweringinterest rates is to affect people’s and firm’s demand for goodsand services. This section discusses how policy actions affectreal interest rates, which in turn affect demand and ultimatelyoutput, employment, and inflation.

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What are real interest rates andwhy do they matter?

For the most part, the demand for goods and services is notrelated to the market interest rates quoted in the financialpages of newspapers, known as nominal rates. Instead, it isrelated to real interest rates-that is, nominal interest ratesminus the expected rate of inflation.

Example

For example, a borrower is likely to feel a lot happier about acar loan at 8 percent when the inflation rate is close to 10percent (as it was in the late 1970s) than when the inflationrate is close to 2 percent (as it was in the late 1990s). In thefirst case, the real (or inflation-adjusted) value of the moneythat the borrower would pay back would actually be lower thanthe real value of the money when it was borrowed. Borrowers,of course, would love this situation, while lenders would bedisinclined to make any loans.

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So why doesn’t the Fed just setthe real interest rate on loans?

Remember, the Fed operates only in the market for bankreserves. Because it is the sole supplier of reserves, it can setthe nominal funds rate. The Fed can’t set real interest ratesdirectly because it can’t set inflation expectations directly, eventhough expected inflation is closely tied to what the Fed isexpected to do in the future. Also, in general, the Fed hasstayed out of the business of setting nominal rates forlonger-term instruments and instead allows financial markets todetermine longer-term interest rates.

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How can the Fed influencelong-term rates then?

Long-term interest rates reflect, in part, what people infinancial markets expect the Fed to do in the future. Forinstance, if they think the Fed isn’t focused on containinginflation, they’ll be concerned that inflation might move upover the next few years. So they’ll add a risk premium tolong-term rates, which will make them higher. In other words,the market’s expectations about monetary policy tomorrowhave a substantial impact on long-term interest rates today.

Researchers have pointed out that the Fed could informmarkets about future values of the funds rate in a number ofways. For example, the Fed could follow a policy of movinggradually once it starts changing interest rates. Or, the Fedcould issue statements about what kinds of developments theFOMC is likely to focus on in the foreseeable future; the Fedeven could make more explicit statements about the futurestance of policy.

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How do these policy-inducedchanges in real interest rates affect

the economy?Changes in real interest rates affect the public’s demand forgoods and services mainly by altering borrowing costs, theavailability of bank loans, the wealth of households, and foreignexchange rates.In addition, lower real rates and a healthy economy mayincrease bank’s willingness to lend to businesses andhouseholds. This may increase spending, especially by smallerborrowers who have few sources of credit other than banks.Lower real rates also make common stocks and other suchinvestments more attractive than bonds and other debtinstruments; as a result, common stock prices tend to rise.Households with stocks in their portfolios find that the value oftheir holdings is higher, and this increase in wealth makes themwilling to spend more. Higher stock prices also make it moreattractive for businesses to invest in plant and equipment byissuing stock.

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In the short run, lower real interest rates in the U.S. also tendto reduce the foreign exchange value of the dollar, which lowersthe prices of the U.S. produced goods we sell abroad and raisesthe prices we pay for foreign produced goods. This leads tohigher aggregate spending on goods and services produced inthe U.S.The increase in aggregate demand for the economy’s outputthrough these different channels leads firms to raise productionand employment, which in turn increases business spending oncapital goods even further by making greater demands onexisting factory capacity. It also boosts consumption furtherbecause of the income gains that result from the higher level ofeconomic output.

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How does monetary policy affectinflation?

Wages and prices will begin to rise at faster rates if monetarypolicy stimulates aggregate demand enough to push labor andcapital markets beyond their long-run capacities. In fact, amonetary policy that persistently attempts to keep short-termreal rates low will lead eventually to higher inflation and highernominal interest rates, with no permanent increases in thegrowth of output or decreases in unemployment. As notedearlier, in the long run, output and employment cannot be setby monetary policy. In other words, while there is a trade-offbetween higher inflation and lower unemployment in the shortrun, the trade-off disappears in the long run.Policy also affects inflation directly through people’sexpectations about future inflation. For example, suppose theFed eases monetary policy. If consumers and businesspeoplefigure that will mean higher inflation in the future, they’ll askfor bigger increases in wages and prices. That in itself will raiseinflation without big changes in employment and output.

U.S. MonetaryPolicy

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Doesn’t U.S. inflation depend onworldwide capacity, not just U.S.

capacity?

In this era of intense global competition, it might seemparochial to focus on U.S. capacity as a determinant of U.S.inflation, rather than on world capacity. For example, someargue that even if unemployment in the U.S. drops to very lowlevels, U.S. workers wouldn’t be able to push for higher wagesbecause they’re competing for jobs with workers abroad, whoare willing to accept much lower wages. The implication is thatinflation is unlikely to rise even if the Fed adopts an easiermonetary policy.

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How long does it take a policyaction to affect the economy and

inflation?

It can take a fairly long time for a monetary policy action toaffect the economy and inflation. And the lags can vary a lot,too. For example, the major effects on output can takeanywhere from three months to two years. And the effectson inflation tend to involve even longer lags, perhaps one tothree years, or more.

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Why are the lags so hard topredict?

So far, we’ve described a complex chain of events that links achange in the funds rate with subsequent changes in output andinflation. Developments anywhere along this chain can alterhow much a policy action will affect the economy and when.The effect of a policy action on the economy also depends onwhat people and firms outside the financial sector think theFed action means for inflation in the future. If people believethat a tightening of policy means the Fed is determined to keepinflation under control, they’ll immediately expect low inflationin the future, so they’re likely to ask for smaller wage and priceincreases, and this will help achieve low inflation. But if peoplearen’t convinced that the Fed is going to contain inflation,they’re likely to ask for bigger wage and price increases, andthat means that inflation is likely to rise. In this case, the onlyway to bring inflation down is to tighten so much and for solong that there are significant losses in employment and output.

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What problems do lags cause?

The Fed’s job would be much easier if monetary policy hadswift and sure effects. Policymakers could set policy, see itseffects, and then adjust the settings until they eliminated anydiscrepancy between economic developments and the goals.But with the long lags associated with monetary policy actions,the Fed must try to anticipate the effects of its policy actionsinto the distant future. To see why, suppose the Fed waits toshift its policy stance until it actually sees an increase ininflation. That would mean that inflationary momentumalready had developed, so the task of reducing inflation wouldbe that much harder and more costly in terms of job losses.Not surprisingly, anticipating policy effects in the future is adifficult task.

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How does the Fed decide theappropriate setting for the

policy instrument?

The Fed’s job of stabilizing output in the short run andpromoting price stability in the long run involves severalsteps. First, the Fed tries to estimate how the economy isdoing now and how it’s likely to do in the near term say, overthe next couple of years or so. Then it compares theseestimates to its goals for the economy and inflation. If there’s agap between the estimates and the goals, the Fed then has todecide how forcefully and how swiftly to act to close that gap.Of course, the lags in policy complicate this process. But so doa host of other things.

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What things complicate theprocess of determining how the

economy is doing?

Even the most up-to-date data on key variables likeemployment, growth, productivity, and so on, reflect conditionsin the past, not conditions today; that’s why the process ofmonetary policymaking has been compared to driving whilelooking only in the rearview mirror. So, to get a reasonableestimate of current and near-term economic conditions, the Fedfirst tries to figure out what the most relevant economicdevelopments are; these might be things like the government’staxing and spending policies, economic developments abroad,financial conditions at home and abroad, and the use of newtechnologies that boost productivity. These developments canthen be incorporated into an economic model to see how theeconomy is likely to evolve over time.

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Sounds easy plug the numbers intothe model and get an answer. So

what’s the problem?There are lots of problems. One problem is that models areonly approximations they can’t capture the full complexity ofthe economy. Another problem is that, so far, no single modeladequately explains the entire economy at least, you can’t geteconomists to agree on a single model; and no single modeloutperforms others in predicting future developments in everysituation.Another problem is that the forecast can be off base because ofunexpected, even unprecedented. So in practice, the Fed triesto deal with this uncertainty by using a variety of models andindicators, as well as informal methods, to construct a pictureof the economy. These informal methods can include anecdotesand other information collected from all kinds of sources, suchas the Directors of the Federal Reserve Banks, the Fed’svarious advisory bodies, and the press.

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So now are we in a position tocompare the Fed’s estimates with

its goals?

Not so fast. Coming up with operational measures of the goalsis harder than you might think, especially the goal for the rateof maximum sustainable output growth. Unfortunately, this isnot something you can go out and measure. So, once again,the Fed has to turn to some sort of model or indicator toestimate it. And it’s hard to be certain about any estimate, inpart because it’s hard to be certain that the model or indicatorthe estimate is based on is the right one. There’s one moreimportant complication in estimating the rate of maximumsustainable growth, it can shift over time!

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What problems does a shift in therate of maximum sustainable

growth cause?The experience of the late 1990s provides a good example ofthe policy problems caused by such a shift. During this period,output and productivity surged at the same time that rapidinnovation was transforming the information technologyindustry. In the early stages, there was no way for the Fed-oranybody else-to tell why output was growing so fast.This was a crucial issue because policy would responddifferently depending on exactly why the economy was growingfaster. If it was largely due to the spread of new technologiesthat enhanced worker and capital productivity, implying thatthe trend growth rate was higher, then the economy couldexpand faster without creating inflationary pressures. In thatcase, monetary policy could stand pat. But if it was just theeconomy experiencing a more normal business cycle expansion,then inflation could heat up. In that case, monetary policywould need to tighten up.

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Does the trend growth rate everfall?

Yes, it does. A good example, with a pretty bad outcome, waswhat happened in the early 1970s, a period marked by asignificant slowdown in the trend growth rate. A number ofeconomists have argued that the difficulty in determining thatsuch a slowdown had actually taken place caused the Fed toadopt an easier monetary policy than it might otherwise have,which in turn contributed to the substantial acceleration ininflation observed later in the decade.

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What happens when the estimatesfor growth and inflation are

different from the Fed’s goals?

Let’s take the case where the forecast is that growth will bebelow the goal. That would suggest a need to ease policy. Butthat’s not all. The Fed also must decide two other things:

• (1) how strongly to respond to this deviation from the goal

• (2) how quickly to try to eliminate the gap.

Once again, it can use its models to try to determine theeffects of various policy actions. And, once again, the Fed mustdeal with the problems associated with uncertainty as well aswith the measurement problems we have already discussed.

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Uncertainty seems to be a problemat every stage. How does the Fed

deal with it?

Uncertainty does, indeed, pervade every part of the monetarypolicy-making process. There is as yet no set of policies andprocedures that policymakers can use to deal with all thesituations that may arise. Instead, policymakers must decidehow to proceed by going case by case.Indeed the Fed spends a great deal of time and effort inresearching various ways to deal with different kinds ofuncertainty and in trying to figure out what kind of model orindicator is likely to perform best in a given situation. Sincethese issues aren’t likely to be resolved anytime soon, the Fedis likely to continue to look at everything.

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Suggested Reading

• The Federal Reserve System: Purposes and Functions, 8thed. Washington, DC: Board of Governors, Federal ReserveSystem, December 1994

• The Federal Reserve System in Brief. Federal ReserveBank of San Francisco

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