Searching for a Monetary Policy Target
Jordan, Jerry L., Morris, Frank E., Contemporary Economic Policy
Jordan: I am not sure that the issue here should be "searching for a monetary aggregate or monetary target," but rather, "searching for an objective for monetary policy." Almost three decades ago, Karl Brunner hosted at UCLA two conferences called "Targets and Indicators for Monetary Policy." This was when Lee Hoskins and I were young students at UCLA. All of the eminent people in the profession participated--some 50 or 60 of the leading names in monetary theory and policy, both within the Federal Reserve and the academic profession. The conferences were fascinating, both times.
At that time, I failed to appreciate that those conferences were conducted in the context of more than a decade of under 2 percent inflation, followed by a couple of years (1964 and 1965) when inflation jumped into the range of 3 or 4 percent. It was thought at that time that the problem was only one of choosing the appropriate targets and indicators--that is, the levers or handles for monetary policy--that would serve as guides to formulation and implementation of our policy objectives. The mindset of the American people at that time, I think, was that increases in inflation and interest rates were temporary, destined to go back down.
Now, after more than three decades of inflation, the mindset of the American people is that declines of inflation and interest rates are temporary. People believe that the permanent condition is for inflation and interest rates to go back up.
Coming back to the Fed after some 15 years out of the System, I initially thought the question was "which M" (monetary aggregate)? The subject of this session might imply more debate about M1 versus M2 and the various measures of the monetary base. In fact, three months before rejoining the Fed, I did an analysis of what was going on with M2 in 1991. Already there was concern about the extent to which it was or was not giving a reliable indication of the thrust of policy actions. Now, however, I have spent 15 months or so not only going to meetings, but worse, living with the staff that I inherited from Lee Hoskins. The staff persistently said to me, "It's the objective, stupid, not the target, that is the real issue!" And I kept saying not only to myself but also to my colleagues that I thought the objective was quite clear. The staff kept telling me I was naive.
But after sitting with the Federal Open Market Committee (FOMC) for 10 meetings--watching the deliberations and tracking the interaction between our decisions, the financial market participants, the people's elected representatives, and the media--I, too, am now convinced. It is the objective, not the target, that is the real issue of monetary policy.
Some years back, I heard about "Goodhart's Law."(1) I think Henry Wallich first told me about it and wrote about it. The idea is that once a central bank reveals that it is using a certain variable as an indicator or intermediate target because of some past empirical relationship to a specific objective, that variable ceases to be reliably related to the objective.
The analogy was something from physics called the Hiesenberg Principle, which states that focusing a high-powered microscope on an electron alters the behavior of the electron. Therefore, you can never see it behaving as it would behave if it were not being observed. Similarly, once the central bank has a target that the people know it is responding to, the behavior of the people changes--the behavior of traders in the markets such as bond markets, equity markets, and foreign exchange market, as well as the behavior of real people. Then, because people change their behavior in anticipation of what the central bank is going to do based on these indicators, the outcome is not the same as it otherwise would be.
So, we went through the silly season in the late 1970s when the Thursday night money numbers would cause the interest rate futures markets to do wild gyrations. …