Making Monetary Policy: What Do We Know and When Do We Know It? Based on a Speech Given by President Santomero to the National Economists Club, April 7, 2005
Santomero, Anthony M., Business Review (Federal Reserve Bank of Philadelphia)
Conducting a successful monetary policy presents real-world challenges, such as evaluating where the economy is, where it is going, and where it should be going. But how do monetary policymakers make decisions about the economy in a world with imperfect information? In his message this quarter, President Anthony Santomero discusses how policymaking is affected by both the availability and reliability of economic information.
I'd like to take this opportunity to share my thoughts on the difficult task of conducting monetary policy for the U.S. In particular, I would like to focus on how policymaking is affected by both the availability and reliability of information on how well the economy is performing. I want to emphasize that my message this quarter reflects my own thoughts on the subject and does not necessarily reflect the views of the Federal Open Market Committee.
We all know that monetary policy responds to economic circumstances and hence to incoming economic data. Therefore, it is important every once in a while to take a closer look at what we know about the data we rely on and, simultaneously, what we do not know about the economy from the information that is available.
However, this is more than a philosophical discussion; after all is said and done, we must conduct monetary policy. So I would like to focus on what conducting real-time monetary policy is like in a world with less-than-perfect information about the economy we are attempting to affect.
At the outset, I want to reinforce my view that appropriate monetary policymaking requires attention to long-run goals, not just short-term dynamics. Or to state it another way, our short-run actions must take account of our long-run objectives if we are to be prudent and successful central bankers.
The most important long-run goal of good monetary policy is straightforward enough: a responsible central bank must guarantee price stability. Price stability is crucial to a well-functioning market economy. Prices are signals to market participants. A stable overall price level allows people to see shifts in relative prices clearly and adjust their decisions about spending, saving, working, and investing optimally. Inflation, by contrast, jumbles and distorts price signals and generates suboptimal economic decisions.
For the past 25 years, the Fed has been relatively successful in achieving the goal of price stability. Equally important, as the relatively low level of market interest rates attests, we have succeeded in reducing long-run inflation expectations over the past 15 years.
Maintaining confidence in sustained price stability is crucial to fostering the most productive saving and investment decisions. In addition, it affords the Federal Reserve considerably more latitude to take short-run policy actions to help stabilize economic performance.
As you all know, the Federal Reserve is charged with setting monetary policy so as to meet its dual mandate of maintaining price stability and ensuring maximum sustainable output growth. When the economy is weak, monetary policy generally needs to be accommodative, and when the economy is growing strongly, policy needs to be tighter. In this way policy remains consistent with underlying economic fundamentals. It is entirely appropriate and consistent with our long-term goals for monetary policy to be counter cyclical as long as we remain cognizant of the inflationary environment.
But we must all recognize that a central bank's power is limited. One thing we have learned--and it has been an expensive lesson--is that the best the Fed can do is cushion the economy. It cannot in and of itself force stronger growth than the economy is capable of delivering. Trying to push an economy beyond its potential may temporarily accelerate growth, but it also creates imbalances and increases inflationary pressures that must be addressed, and so boom leads to bust. …