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Interest rates and the conduct of monetary policy
Carnegie-Rochester North-Holland
Conference Series on Public Policy 34 (1991) 31-40
INTEREST CONDUCT
RATES AND THE OF MONETARY POLICY A Comment
WILLIAM Brown
POOLE
University
Central banks almost everywhere usually implement their policies through tight control of money market interest rates. Academic monetary economists almost everywhere usually discuss monetary policy in terms of the money stock. These facts say something about either central bankers or academic monetary economists, or both. In his paper, Marvin Goodfriend has addressed the gulf between central bank practice and academic analysis by concentrating on positive economics propositions concerning central bank behavior. I really do not disagree with much in this paper, which puts me in a difficult position as a discussant. What I am going to do is to discuss the paper using the best arguments I can construct from a central banker’s point of view. It is probably impossible for me to play central banker, but I shall try, anyway. From this vantage point, after reading Goodfriend’s paper I confess to feeling the way I do after having a salad for lunch when I am trying to lose a few pounds. Something is missing, although I am not sure I can identify
what it is. I crave steak but do not know where the butcher
shop is. Monetary analysis has been strongly influenced by the agenda set by Milton Friedman, Anna Schwartz, Karl Brunner, and Allan Meltzer in the 1950s and 1960s. Everyone now agrees, except the most die-hard, primitive Keynesians, that any central bank that permits the money stock to shoot off toward zero or toward infinity will create chaotic economic conditions. The issue is why central banks do not simply control the money stock, or the monetary base, to avoid the risk of chaos. Successful central banks, with the possible exception of the Swiss National Bank, operate by adjusting the interbank rate as necessary to stabilize the economy, and one outcome, whether by design or not, is to keep the money stock within bounds. What
Elsevier Science Publishers B.V.
is the strongest
THE
case we can make to defend this mode of operation?
CASE FOR FEDERAL
In attempting
CONTROLLING FUNDS RATE
to view the world through
a central
banker’s
THE eyes, I must
take seriously the assumption that the central bank wants to contribute to the best possible outcome for the economy, where “best” is defined in terms of the “true” interests somehow aggregated of the individuals who make up the society. I realize that there are very real problems with this publicinterest view of policy, but for present purposes I will accept the view anyway. Maximizing the national interest is certainly the way Fed Board members, Fed bank presidents, and Fed senior staff see their role. The Fed agrees that Friedman-Schwartz-Brunner-Meltzer won the argument on many of the issues debated twenty-five years ago. The procyclical behavior of the U.S. money stock up to and through the 1981-82 recession aggravated and perhaps even caused fluctuations in business activity and the inflation rate. The long-run Phillips curve is vertical, or “approximately so” a careful central banker might add. Changes in inflation expectations can be important, and so the Fed must distinguish between real and nominal rates of interest. The Fed does not accept the political part of the monetarist critique. In the Fed’s view, it is possible for a central bank to run a discretionary monetary policy without caving in to special interest and political pressures to inflate. Independence certainly does not guarantee sound monetary policy; I am confident that, off-the-record anyway, most current Fed governors and Fed bank presidents would be as critical of U.S. monetary policy over the 1965-79 period as most monetarists are. The Fed might agree that if policy had to be run on autopilot, then the only feasible way to do the job would be through a rule based on growth of some monetary aggregate. But since a sound discretionary policy is politically feasible, the central bank can instead control short-term interest rates if it chooses to do so. A good outcome does, of course, depend on the central bank doing a good job in adjusting interest rates; it is easy to botch the job, but not impossible to perform better than a monetary autopilot. We know this statement is correct; central banks in Germany and Japan have run policy quite successfully in this way for many years, and it appears that the Federal Reserve has done so since 1982. It is natural for me to organize my discussion around the instrumentchoice problem. To make life simple, assume that the monetary aggregates policy alternative is to keep some monetary aggregate on a smooth growth path week by week. This path might be adjusted from time to time, perhaps
32
along the lines of McCallum’s analysis of GNP targeting. The other policy alternative is what the Fed does now, which may be most easily described as continuous
control
of the federal funds rate with adjustments
in the rate
from time to time as the Fed thinks appropriate. Goodfriend’s analysis of the instrument-choice problem yields the conclusion that if interest-rate smoothing is in fact a goal, then the central bank adjusts the money stock to smooth rates and sacrifices output and pricelevel stability to some degree. This analysis, it seems to me, does not go to the heart of the Fed’s position on interest-rate smoothing. Suppose there is no weight on the goal of interest-rate stability per se. The Fed regards its experience with controlling reserves growth from October 1979 to October 1982 as demonstrating that a policy based on short-run control of monetary aggregates is inferior to interest-rate control for the purpose of output and price-level stabilization Academic economists can complain that the Fed did not manage its monetary aggregates policy correctly. The Fed’s response is that it really did try and that the system just does not work well. As far as I know, neither the Fed nor anyone else has provided a satisfactory hypothesis explaining why short-run monetary aggregates control does not work well. Recall that for purposes of this discussion, I am accepting the Fed’s position on this matter ~ I think we need to take the Fed’s position seriously given the success of German and Japanese monetary policy. Arguments for interest-rate targeting based on the short-run variability of velocity are unsatisfactory when everyone agrees that in the long run it is necessary to constrain money growth. Expectations link the present and the future; if market participants know that excessive money growth causes inflation in the long run, then they also know that in the end a responsible monetary policy will have to constrain money growth. To keep matters simple, suppose we want to minimize deviations of nominal GNP around a target path. Arguments against monetary aggregates targeting that depend on short-run volatility of velocity are incomplete without the added step that a major part of this volatility would occur even if money were kept on a smooth track. We can see this point by noting that those who assert that velocity shocks make a monetary aggregates policy ill-advised seem to assume, implicitly or explicitly, that velocity shocks are exogenous. They argue that changes in money growth are needed to offset velocity shocks. But what if variable money growth is the cause of variable velocity? Many of those who are least sympathetic with a policy of fixing money growth seem to hold internally inconsistent positions. They believe: (1) that changes in money growth will not cause, at the margin, reliable changes in GNP, and (2) that changes in money growth are needed to offset velocity shocks. The extreme version of the first belief is the old Keynesian argument concerning pushing on a string; changes in money growth will not affect GNP, or not
33
much, but simply affect measured velocity. If observed short-run changes in velocity have been due at least in part to variable money growth, then it is a non-sequitur to argue the second position that the Fed must permit variable money growth to offset velocity shocks. The issue is not whether stable money growth stabilizes velocity but whether it stabilizes nominal GNP growth. If observed velocity changes in part reflect changes in money growth that agents do not respond to, agents are presumably acting optimally in permitting variations in their short-run holdings of money relative to their spending. Money is a buffer. In this case, agents could easily adjust to a policy of steady money growth; it would make sense for them to permit shocks to create short-run discrepancies between long-run equilibrium money balances and actual money balances rather than for them to change spending to eliminate the discrepancies. Put another way, there is no reason why the central bank must respond to short-run velocity shocks; agents can respond to them. Still, this analysis leaves us back at square one; we do not have a good argument for why the Federal Reserve should control the fed funds rate. The Fed is convinced from “experience” that it is better to implement policy through the interbank rate than through monetary aggregates control. Can we construct a sound argument to support this view?
SMOOTHING ARGUMENTS FOR INTEREST-RATE CONTROL Goodfriend reviews the argument for interest-rate smoothing based on smoothing the flow of revenue from the inflation tax. He does not find this argument convincing, and neither do I. Let me supplement his argument with several additional considerations. First, the amount of revenue raised by the inflation tax in countries with relatively low inflation is not large. It is hard to believe that this small tax would command much attention. Second, if smoothing the inflation tax were important, the government could realize some revenue-smoothing by varying the reserve requirement and/or by varying the rate of interest paid on bank reserves; the government does not pursue either of these policies. Third, to the extent that the tax-smoothing argument applies to the overall tax burden, it might well be optimal not to smooth the inflation tax. The reason is that the inflation tax might offset changes in the real burden of specific taxes on such things as tobacco, alcohol, and gasoline. These specific taxes decline in real terms when the price level rises. Finally, if we treat interest on government debt not as a transfer expenditure but as a negative tax, as some macro models do, then we might end up with a quantitatively important argument for interest-rate smoothing. Interest on government debt is a 34
large item. Moreover, it is true that governments not infrequently express displeasure with their central banks on the ground that higher interest rates will cause a larger budget rical, however -
deficit.
governments
seems better not to call it Goodfriend notes that rate through indirection. depends on its view that
Because
this argument
never argue against
is never symmet-
lower interest
rates -
it
a “smoothing” argument. the Fed has typically controlled the federal funds He argues that the Fed’s behavior in this regard there is a policy advantage in moving quietly. I
think this advantage is 100 percent political, or at least 99 percent; I see no economic reason for controlling the funds rate through indirection. The quoted passage by Alan Greenspan is not convincing; if the Federal Reserve were to peg the federal funds rate, or the Treasury bill rate, by posting buying and selling rates at which the Fed itself would deal with banks, then daily and routine changes of a few basis points in the Fed’s buying and selling rates would not attract the same attention as discount rate changes do now. The way to get a certain action off the front pages is to do it every day. The only reason I can see for the Fed not to run an adjustable peg system for the funds rate is that it wants to be able to deny responsibility for interest-rate changes, at least before the Congress. What is strange about the present system is that the Fed is successful in maintaining deniability when everyone in the money markets knows that the federal funds rate will not change unless the Fed permits it to change. Perhaps the Fed can indeed confuse most of the people most of the time. Should we really be surprised that the Fed can run things in such a way that only experts can understand what is going on? There may well be a genuine advantage in keeping Congress and the general voting public in the dark about these things. If people cannot understand the implications of Fed adjustments of interest rates, why should they be given the political ammunition to hang the Fed when it acts to increase rates? Goodfriend raises, but then does not really analyze, what seems to me to be the key issue concerning central bank interest-rate smoothing. On page 17 he assumes that the Fed controls the fed funds rate “in an effort to stabilize unemployment and inflation as best it can.” Suppose fed funds control is less successful in stabilizing the economy than control of some monetary aggregate would be. Then, because interest rates respond to fluctuations in economic activity and inflation, the policy of controlling the fed funds rate might yield less rather than more instability in interest rates than would monetary aggregates control. Goodfriend’s analysis of how fed funds rate control might stabilize rates at all maturities is interesting. He reviews his 1987 paper showing how the Fed might optimize given objectives of stabilizing both the economy and interest rates. However, the issue is not whether this policy might stabilize rates but rather whether it does in fact stabilize rates. It is certainly possible
35
that the Fed has decreased the amplitude of high-frequency fluctuations in rates while increasing the amplitude of lower-frequency fluctuations. The Fed would certainly agree that we know that poor decisions in adjusting the funds rate will increase the amplitude of fluctuations in economic activity and inflation and therefore of nominal interest rates. The Fed is also convinced that good decisions in adjusting the funds rate can yield greater output and inflation stability than a policy based on monetary aggregates. If so, how and why? In Goodfriend’s model, stabilizing interest rates requires that the central bank sacrifice some stability in output and/or the price level. My question concerns what we would have to believe for the usual central bank view on this issue to be correct. In Section IV, Goodfriend discusses interest-rate smoothing in terms of what he calls “continuity.” Part of his argument seems to involve the uncertain flow of information. I do not think the argument goes through; why should the Fed wait for information to accumulate rather than change the funds rate basis point by basis point as information arrives? Perhaps the reason comes from another part of the argument involving the term structure. To have reliable effects on longer-term rates, the Fed must implement policy in such a way as to provide clear signals to the market about future Fed policy - that is, about the future level of the federal funds rate. We can link this discussion to Goodfriend’s later discussion of evidence from term structure studies. The Fed is very conscious of the problem of conveying information - certain information, anyway - to the market. One of the reasons the Fed adjusts the funds rate slowly is that it wants to see how longer-term rates respond. The Fed can move the funds rate a little, watch what happens, and then move the rate a little more if need be. I think this is a perfectly good argument for the Fed to adjust the funds rate in small steps, assuming that we accept the assumption that the Fed should control the interbank rate instead of money growth in the short run. Goodfriend concludes this part of his analysis by saying that his argument explains inflation persistence “as the outcome of an expected continuity that the central bank builds into the short rate in the pursuit of stabilization policy.” (p. 18). H owever, we still do not have a reason for central banks to pursue the interest-rate strategy in the first place.
IS IT OPTIMAL FOR THE CENTRAL BANK TO CONTROL THE INTERBANK RATE? I think there is a hint in Goodfriend’s paper as to what is behind the central bank view. In discussing the continuity of rates, Goodfriend refers to 36
the need for the central
bank to provide information
to the markets,
and he
mentions the possibility that transitory real rate shocks may occur. I am not sure what “transitory real rate shocks” are. If these shocks involve the real rate of return on capital for a year, say, then they should have little effect on long-term interest rates and on capital formation. But if we are talking about transitory changes in the real rate of interest on long-term bonds, we must be talking about a market bubble or market crash or some such phenomenon. Central banks really believe that the market misprices securities from time to time, and that an important central banking function is to anchor the interest rate so that it does not depart wildly from the “correct” rate. Goodfriend refers to this central bank view briefly when discussing liquidity crises and the central bank’s lender-of-last-resort function. Central banks believe that this anchoring function should be continuous and not just an occasional exception to a policy that controls money growth If the central bank pegs the interbank rate, and if it as a regular matter. does so in a way that provides the market with a reasonable expectation about the average of the interbank rate in the future, then the outcome will be to anchor the long-term rate. I think this is what the Fed did after the stock market crash of October 1987. The Fed made clear to the market that it would provide funds as necessary to keep short rates down for as long as necessary to prevent a cumulative debt-deflation process from getting started. This interest-rate anchoring function cannot, be performed under a monetary aggregates policy. One reason involves the characteristics of the moneyFor given levels of the arguments of the money-demand demand function. function, it seems reasonable to believe that the cost of holding money is a shallow U-shaped function of the amount of money held. The agent’s optimal level of money balances is at the point where this U-shaped curve is at a minimum, but since the U is shallow there is little penalty to holding more or less than the optimal level of money for a while. The present value of permanently holding the wrong amount of money is large, and that is what eventually brings agents back to the minimum point, but period by period, the loss is not large. Thus, if the Fed were to control the money stock, then GNP and the other arguments of the money-demand function would have plenty of room to vary. This argument does not involve disturbances to money demand to justify
interest-rate
control but instead
a degree
of short-run indeterminacy in velocity because money is held as a buffer. The asset-bubble part of the argument is also essential, for that is what permits the market to bid asset prices to the “wrong” levels from time to time. Because the future is uncertain, there is a range of reasonable prices at any particular time. No economist and no market expert could, for example, provide a convincing case that stock prices would be “wrong” if they were 5 percent higher or 5 percent lower than they are today. In fact, stock prices
37
frequently change by 5 percent or more in a week without any obvious new information justifying the change. Economists, some economists anyway, often assume that there must be some such information even if they do not know what it is. However, it seems impossible
to test this hypothesis
against
the alternative that prices could be 5 percent higher or lower without any change in the information set available to the market. This same argument holds for long-term bond prices. In thinking about this matter, I do not see why we should ignore the fact that economists and market participants who are experts on the markets often disagree substantially as to what the “right” prices are, as indicated by their differing views on whether an investor should buy or sell. Whenever asset prices turn out to be wrong on a sustained basis, corrective mechanisms set in, but the mechanisms may operate only slowly. Economic activity and/or the price level will begin to change in such a way that the wrong asset prices will eventually be seen to be wrong, and agents will bid the prices toward their correct levels. The process that brings asset prices to their correct levels may involve unwanted changes, and perhaps cumulative changes for a time, in economic activity and/or inflation, which the central bank wants to avoid if possible. We also need to find an argument to justify the Fed being able to determine, roughly, the “right” prices when the market cannot. It does not make sense to argue that the Fed has information that well-informed market participants do not have. We have to assume instead that the Fed and informed market participants have access to the same information but that the Fed can do a better job than the market in acting on the information. This is obviously the key assumption in the whole argument. Because of its size, the Fed can anchor interest rates in a way no private agent can. The argument is not that the Fed is better informed or smarter than private agents but simply that it is the dominant player in the market. Market mechanisms to keep rates near their long-run equilibrium levels are weak, as discussed in my observation about money demand. The Fed controls the fed funds rate not for the sake of interest-rate stability per se but rather to keep interest rates at levels consistent with the desired performance of the economy. The Fed adjusts rates as information on the state of the economy arrives, and if the Fed does the job right the economy grows along a relatively smooth, noninflationary path. In sum, it seems to me that if the traditional central bank view on the superiority of implementing monetary policy through control of short-term interest rates is correct, we will have to believe that asset prices could, under the alternative policy of steady money growth, differ significantly from full-employment equilibrium levels. We also will have to believe that the central bank can anchor interest rates at approximately the correct level
38
when the market
cannot
do so, or cannot
do so as well. We would have to
take seriously Keynes’s views on how animal spirits and beauty contests “bubbles” - control securities markets in the short run. I have constructed these arguments in an effort to make the best case I can to support what central banks actually do. The German and Japanese central banks have implemented their successful policies by controlling money-market rates in the short run. They permit short-run fluctuations in money growth but adjust money-market interest rates as necessary to prevent money growth from going off track over the longer run. Would these central banks have been even more successful if they had followed rigorous monetary control in the short run as well as the long run ? The traditional monetarist position is to answer this question in the affirmative. I am not so sure anymore. Successful central banks seem to be able to anchor the credit markets in the short run by their money-market strategies and in the long run by maintaining confidence in low money growth and low inflation. I do not understand exactly why the money-market strategy seems to work so well when implemented as I have described, but perhaps the case for traditional, hide-bound central banking is stronger than I had thought!
39
Conference Series on Public Policy 34 (1991) 31-40
INTEREST CONDUCT
RATES AND THE OF MONETARY POLICY A Comment
WILLIAM Brown
POOLE
University
Central banks almost everywhere usually implement their policies through tight control of money market interest rates. Academic monetary economists almost everywhere usually discuss monetary policy in terms of the money stock. These facts say something about either central bankers or academic monetary economists, or both. In his paper, Marvin Goodfriend has addressed the gulf between central bank practice and academic analysis by concentrating on positive economics propositions concerning central bank behavior. I really do not disagree with much in this paper, which puts me in a difficult position as a discussant. What I am going to do is to discuss the paper using the best arguments I can construct from a central banker’s point of view. It is probably impossible for me to play central banker, but I shall try, anyway. From this vantage point, after reading Goodfriend’s paper I confess to feeling the way I do after having a salad for lunch when I am trying to lose a few pounds. Something is missing, although I am not sure I can identify
what it is. I crave steak but do not know where the butcher
shop is. Monetary analysis has been strongly influenced by the agenda set by Milton Friedman, Anna Schwartz, Karl Brunner, and Allan Meltzer in the 1950s and 1960s. Everyone now agrees, except the most die-hard, primitive Keynesians, that any central bank that permits the money stock to shoot off toward zero or toward infinity will create chaotic economic conditions. The issue is why central banks do not simply control the money stock, or the monetary base, to avoid the risk of chaos. Successful central banks, with the possible exception of the Swiss National Bank, operate by adjusting the interbank rate as necessary to stabilize the economy, and one outcome, whether by design or not, is to keep the money stock within bounds. What
Elsevier Science Publishers B.V.
is the strongest
THE
case we can make to defend this mode of operation?
CASE FOR FEDERAL
In attempting
CONTROLLING FUNDS RATE
to view the world through
a central
banker’s
THE eyes, I must
take seriously the assumption that the central bank wants to contribute to the best possible outcome for the economy, where “best” is defined in terms of the “true” interests somehow aggregated of the individuals who make up the society. I realize that there are very real problems with this publicinterest view of policy, but for present purposes I will accept the view anyway. Maximizing the national interest is certainly the way Fed Board members, Fed bank presidents, and Fed senior staff see their role. The Fed agrees that Friedman-Schwartz-Brunner-Meltzer won the argument on many of the issues debated twenty-five years ago. The procyclical behavior of the U.S. money stock up to and through the 1981-82 recession aggravated and perhaps even caused fluctuations in business activity and the inflation rate. The long-run Phillips curve is vertical, or “approximately so” a careful central banker might add. Changes in inflation expectations can be important, and so the Fed must distinguish between real and nominal rates of interest. The Fed does not accept the political part of the monetarist critique. In the Fed’s view, it is possible for a central bank to run a discretionary monetary policy without caving in to special interest and political pressures to inflate. Independence certainly does not guarantee sound monetary policy; I am confident that, off-the-record anyway, most current Fed governors and Fed bank presidents would be as critical of U.S. monetary policy over the 1965-79 period as most monetarists are. The Fed might agree that if policy had to be run on autopilot, then the only feasible way to do the job would be through a rule based on growth of some monetary aggregate. But since a sound discretionary policy is politically feasible, the central bank can instead control short-term interest rates if it chooses to do so. A good outcome does, of course, depend on the central bank doing a good job in adjusting interest rates; it is easy to botch the job, but not impossible to perform better than a monetary autopilot. We know this statement is correct; central banks in Germany and Japan have run policy quite successfully in this way for many years, and it appears that the Federal Reserve has done so since 1982. It is natural for me to organize my discussion around the instrumentchoice problem. To make life simple, assume that the monetary aggregates policy alternative is to keep some monetary aggregate on a smooth growth path week by week. This path might be adjusted from time to time, perhaps
32
along the lines of McCallum’s analysis of GNP targeting. The other policy alternative is what the Fed does now, which may be most easily described as continuous
control
of the federal funds rate with adjustments
in the rate
from time to time as the Fed thinks appropriate. Goodfriend’s analysis of the instrument-choice problem yields the conclusion that if interest-rate smoothing is in fact a goal, then the central bank adjusts the money stock to smooth rates and sacrifices output and pricelevel stability to some degree. This analysis, it seems to me, does not go to the heart of the Fed’s position on interest-rate smoothing. Suppose there is no weight on the goal of interest-rate stability per se. The Fed regards its experience with controlling reserves growth from October 1979 to October 1982 as demonstrating that a policy based on short-run control of monetary aggregates is inferior to interest-rate control for the purpose of output and price-level stabilization Academic economists can complain that the Fed did not manage its monetary aggregates policy correctly. The Fed’s response is that it really did try and that the system just does not work well. As far as I know, neither the Fed nor anyone else has provided a satisfactory hypothesis explaining why short-run monetary aggregates control does not work well. Recall that for purposes of this discussion, I am accepting the Fed’s position on this matter ~ I think we need to take the Fed’s position seriously given the success of German and Japanese monetary policy. Arguments for interest-rate targeting based on the short-run variability of velocity are unsatisfactory when everyone agrees that in the long run it is necessary to constrain money growth. Expectations link the present and the future; if market participants know that excessive money growth causes inflation in the long run, then they also know that in the end a responsible monetary policy will have to constrain money growth. To keep matters simple, suppose we want to minimize deviations of nominal GNP around a target path. Arguments against monetary aggregates targeting that depend on short-run volatility of velocity are incomplete without the added step that a major part of this volatility would occur even if money were kept on a smooth track. We can see this point by noting that those who assert that velocity shocks make a monetary aggregates policy ill-advised seem to assume, implicitly or explicitly, that velocity shocks are exogenous. They argue that changes in money growth are needed to offset velocity shocks. But what if variable money growth is the cause of variable velocity? Many of those who are least sympathetic with a policy of fixing money growth seem to hold internally inconsistent positions. They believe: (1) that changes in money growth will not cause, at the margin, reliable changes in GNP, and (2) that changes in money growth are needed to offset velocity shocks. The extreme version of the first belief is the old Keynesian argument concerning pushing on a string; changes in money growth will not affect GNP, or not
33
much, but simply affect measured velocity. If observed short-run changes in velocity have been due at least in part to variable money growth, then it is a non-sequitur to argue the second position that the Fed must permit variable money growth to offset velocity shocks. The issue is not whether stable money growth stabilizes velocity but whether it stabilizes nominal GNP growth. If observed velocity changes in part reflect changes in money growth that agents do not respond to, agents are presumably acting optimally in permitting variations in their short-run holdings of money relative to their spending. Money is a buffer. In this case, agents could easily adjust to a policy of steady money growth; it would make sense for them to permit shocks to create short-run discrepancies between long-run equilibrium money balances and actual money balances rather than for them to change spending to eliminate the discrepancies. Put another way, there is no reason why the central bank must respond to short-run velocity shocks; agents can respond to them. Still, this analysis leaves us back at square one; we do not have a good argument for why the Federal Reserve should control the fed funds rate. The Fed is convinced from “experience” that it is better to implement policy through the interbank rate than through monetary aggregates control. Can we construct a sound argument to support this view?
SMOOTHING ARGUMENTS FOR INTEREST-RATE CONTROL Goodfriend reviews the argument for interest-rate smoothing based on smoothing the flow of revenue from the inflation tax. He does not find this argument convincing, and neither do I. Let me supplement his argument with several additional considerations. First, the amount of revenue raised by the inflation tax in countries with relatively low inflation is not large. It is hard to believe that this small tax would command much attention. Second, if smoothing the inflation tax were important, the government could realize some revenue-smoothing by varying the reserve requirement and/or by varying the rate of interest paid on bank reserves; the government does not pursue either of these policies. Third, to the extent that the tax-smoothing argument applies to the overall tax burden, it might well be optimal not to smooth the inflation tax. The reason is that the inflation tax might offset changes in the real burden of specific taxes on such things as tobacco, alcohol, and gasoline. These specific taxes decline in real terms when the price level rises. Finally, if we treat interest on government debt not as a transfer expenditure but as a negative tax, as some macro models do, then we might end up with a quantitatively important argument for interest-rate smoothing. Interest on government debt is a 34
large item. Moreover, it is true that governments not infrequently express displeasure with their central banks on the ground that higher interest rates will cause a larger budget rical, however -
deficit.
governments
seems better not to call it Goodfriend notes that rate through indirection. depends on its view that
Because
this argument
never argue against
is never symmet-
lower interest
rates -
it
a “smoothing” argument. the Fed has typically controlled the federal funds He argues that the Fed’s behavior in this regard there is a policy advantage in moving quietly. I
think this advantage is 100 percent political, or at least 99 percent; I see no economic reason for controlling the funds rate through indirection. The quoted passage by Alan Greenspan is not convincing; if the Federal Reserve were to peg the federal funds rate, or the Treasury bill rate, by posting buying and selling rates at which the Fed itself would deal with banks, then daily and routine changes of a few basis points in the Fed’s buying and selling rates would not attract the same attention as discount rate changes do now. The way to get a certain action off the front pages is to do it every day. The only reason I can see for the Fed not to run an adjustable peg system for the funds rate is that it wants to be able to deny responsibility for interest-rate changes, at least before the Congress. What is strange about the present system is that the Fed is successful in maintaining deniability when everyone in the money markets knows that the federal funds rate will not change unless the Fed permits it to change. Perhaps the Fed can indeed confuse most of the people most of the time. Should we really be surprised that the Fed can run things in such a way that only experts can understand what is going on? There may well be a genuine advantage in keeping Congress and the general voting public in the dark about these things. If people cannot understand the implications of Fed adjustments of interest rates, why should they be given the political ammunition to hang the Fed when it acts to increase rates? Goodfriend raises, but then does not really analyze, what seems to me to be the key issue concerning central bank interest-rate smoothing. On page 17 he assumes that the Fed controls the fed funds rate “in an effort to stabilize unemployment and inflation as best it can.” Suppose fed funds control is less successful in stabilizing the economy than control of some monetary aggregate would be. Then, because interest rates respond to fluctuations in economic activity and inflation, the policy of controlling the fed funds rate might yield less rather than more instability in interest rates than would monetary aggregates control. Goodfriend’s analysis of how fed funds rate control might stabilize rates at all maturities is interesting. He reviews his 1987 paper showing how the Fed might optimize given objectives of stabilizing both the economy and interest rates. However, the issue is not whether this policy might stabilize rates but rather whether it does in fact stabilize rates. It is certainly possible
35
that the Fed has decreased the amplitude of high-frequency fluctuations in rates while increasing the amplitude of lower-frequency fluctuations. The Fed would certainly agree that we know that poor decisions in adjusting the funds rate will increase the amplitude of fluctuations in economic activity and inflation and therefore of nominal interest rates. The Fed is also convinced that good decisions in adjusting the funds rate can yield greater output and inflation stability than a policy based on monetary aggregates. If so, how and why? In Goodfriend’s model, stabilizing interest rates requires that the central bank sacrifice some stability in output and/or the price level. My question concerns what we would have to believe for the usual central bank view on this issue to be correct. In Section IV, Goodfriend discusses interest-rate smoothing in terms of what he calls “continuity.” Part of his argument seems to involve the uncertain flow of information. I do not think the argument goes through; why should the Fed wait for information to accumulate rather than change the funds rate basis point by basis point as information arrives? Perhaps the reason comes from another part of the argument involving the term structure. To have reliable effects on longer-term rates, the Fed must implement policy in such a way as to provide clear signals to the market about future Fed policy - that is, about the future level of the federal funds rate. We can link this discussion to Goodfriend’s later discussion of evidence from term structure studies. The Fed is very conscious of the problem of conveying information - certain information, anyway - to the market. One of the reasons the Fed adjusts the funds rate slowly is that it wants to see how longer-term rates respond. The Fed can move the funds rate a little, watch what happens, and then move the rate a little more if need be. I think this is a perfectly good argument for the Fed to adjust the funds rate in small steps, assuming that we accept the assumption that the Fed should control the interbank rate instead of money growth in the short run. Goodfriend concludes this part of his analysis by saying that his argument explains inflation persistence “as the outcome of an expected continuity that the central bank builds into the short rate in the pursuit of stabilization policy.” (p. 18). H owever, we still do not have a reason for central banks to pursue the interest-rate strategy in the first place.
IS IT OPTIMAL FOR THE CENTRAL BANK TO CONTROL THE INTERBANK RATE? I think there is a hint in Goodfriend’s paper as to what is behind the central bank view. In discussing the continuity of rates, Goodfriend refers to 36
the need for the central
bank to provide information
to the markets,
and he
mentions the possibility that transitory real rate shocks may occur. I am not sure what “transitory real rate shocks” are. If these shocks involve the real rate of return on capital for a year, say, then they should have little effect on long-term interest rates and on capital formation. But if we are talking about transitory changes in the real rate of interest on long-term bonds, we must be talking about a market bubble or market crash or some such phenomenon. Central banks really believe that the market misprices securities from time to time, and that an important central banking function is to anchor the interest rate so that it does not depart wildly from the “correct” rate. Goodfriend refers to this central bank view briefly when discussing liquidity crises and the central bank’s lender-of-last-resort function. Central banks believe that this anchoring function should be continuous and not just an occasional exception to a policy that controls money growth If the central bank pegs the interbank rate, and if it as a regular matter. does so in a way that provides the market with a reasonable expectation about the average of the interbank rate in the future, then the outcome will be to anchor the long-term rate. I think this is what the Fed did after the stock market crash of October 1987. The Fed made clear to the market that it would provide funds as necessary to keep short rates down for as long as necessary to prevent a cumulative debt-deflation process from getting started. This interest-rate anchoring function cannot, be performed under a monetary aggregates policy. One reason involves the characteristics of the moneyFor given levels of the arguments of the money-demand demand function. function, it seems reasonable to believe that the cost of holding money is a shallow U-shaped function of the amount of money held. The agent’s optimal level of money balances is at the point where this U-shaped curve is at a minimum, but since the U is shallow there is little penalty to holding more or less than the optimal level of money for a while. The present value of permanently holding the wrong amount of money is large, and that is what eventually brings agents back to the minimum point, but period by period, the loss is not large. Thus, if the Fed were to control the money stock, then GNP and the other arguments of the money-demand function would have plenty of room to vary. This argument does not involve disturbances to money demand to justify
interest-rate
control but instead
a degree
of short-run indeterminacy in velocity because money is held as a buffer. The asset-bubble part of the argument is also essential, for that is what permits the market to bid asset prices to the “wrong” levels from time to time. Because the future is uncertain, there is a range of reasonable prices at any particular time. No economist and no market expert could, for example, provide a convincing case that stock prices would be “wrong” if they were 5 percent higher or 5 percent lower than they are today. In fact, stock prices
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frequently change by 5 percent or more in a week without any obvious new information justifying the change. Economists, some economists anyway, often assume that there must be some such information even if they do not know what it is. However, it seems impossible
to test this hypothesis
against
the alternative that prices could be 5 percent higher or lower without any change in the information set available to the market. This same argument holds for long-term bond prices. In thinking about this matter, I do not see why we should ignore the fact that economists and market participants who are experts on the markets often disagree substantially as to what the “right” prices are, as indicated by their differing views on whether an investor should buy or sell. Whenever asset prices turn out to be wrong on a sustained basis, corrective mechanisms set in, but the mechanisms may operate only slowly. Economic activity and/or the price level will begin to change in such a way that the wrong asset prices will eventually be seen to be wrong, and agents will bid the prices toward their correct levels. The process that brings asset prices to their correct levels may involve unwanted changes, and perhaps cumulative changes for a time, in economic activity and/or inflation, which the central bank wants to avoid if possible. We also need to find an argument to justify the Fed being able to determine, roughly, the “right” prices when the market cannot. It does not make sense to argue that the Fed has information that well-informed market participants do not have. We have to assume instead that the Fed and informed market participants have access to the same information but that the Fed can do a better job than the market in acting on the information. This is obviously the key assumption in the whole argument. Because of its size, the Fed can anchor interest rates in a way no private agent can. The argument is not that the Fed is better informed or smarter than private agents but simply that it is the dominant player in the market. Market mechanisms to keep rates near their long-run equilibrium levels are weak, as discussed in my observation about money demand. The Fed controls the fed funds rate not for the sake of interest-rate stability per se but rather to keep interest rates at levels consistent with the desired performance of the economy. The Fed adjusts rates as information on the state of the economy arrives, and if the Fed does the job right the economy grows along a relatively smooth, noninflationary path. In sum, it seems to me that if the traditional central bank view on the superiority of implementing monetary policy through control of short-term interest rates is correct, we will have to believe that asset prices could, under the alternative policy of steady money growth, differ significantly from full-employment equilibrium levels. We also will have to believe that the central bank can anchor interest rates at approximately the correct level
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when the market
cannot
do so, or cannot
do so as well. We would have to
take seriously Keynes’s views on how animal spirits and beauty contests “bubbles” - control securities markets in the short run. I have constructed these arguments in an effort to make the best case I can to support what central banks actually do. The German and Japanese central banks have implemented their successful policies by controlling money-market rates in the short run. They permit short-run fluctuations in money growth but adjust money-market interest rates as necessary to prevent money growth from going off track over the longer run. Would these central banks have been even more successful if they had followed rigorous monetary control in the short run as well as the long run ? The traditional monetarist position is to answer this question in the affirmative. I am not so sure anymore. Successful central banks seem to be able to anchor the credit markets in the short run by their money-market strategies and in the long run by maintaining confidence in low money growth and low inflation. I do not understand exactly why the money-market strategy seems to work so well when implemented as I have described, but perhaps the case for traditional, hide-bound central banking is stronger than I had thought!
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