Monetary Policy: From There to Here to Where?
Sniderman, Mark, Economic Commentary (Cleveland)
Drawing from his long experience participating in the policymaking process at the Federal Reserve, chief policy officer Mark Sniderman shares his views on how the Federal Reserve's framework for conducting monetary policy has evolved over the past decade. He explains how changes in economic theory have helped shaped this new framework and how lessons learned from the Great Depression and Japan's recent struggle with deflation have contributed. This Commentary is based on a speech delivered at the Global Interdependence Conference, Tokyo, Japan, on December 4, 2012.
The Federal Reserve's framework for conducting monetary policy has evolved significantly during the past decade. Its evolution has been strongly influenced by developments in economic theory, lessons from the Great Depression, and ongoing economic challenges in Japan. Although much has been written about the Federal Reserve's use of unconventional monetary policy in response to the global financial crisis, I would suggest that this response is a very natural progression in applying economic knowledge and experience. Basing unconventional policies on knowledge and experience does not, of course, guarantee unqualified success, but it should provide a high degree of confidence in the Federal Reserve's approach to policy over the past few years.
I will elaborate on this perspective in this Commentary and conclude with some thoughts about the potential costs and risks associated with U.S. monetary policy.
Insights from Rational Expectations Theory
I'll begin with a quick review of how economic thinking has evolved over the past few decades. By necessity, this review will be highly selective, focusing on the developments that I regard as the most important for conducting monetary policy, and will concentrate on what economists call rational expectations.
That phrase is just a shorthand way of saying that the behavior of people and businesses inside our economic models must accord with the way the economy actually performs. For example, people cannot be modeled as systematically underestimating the inflation rate that the model generates; they know how the real economy actually works and cannot be persistently fooled.
The rational expectations revolution in economics took shape in academic circles in the 1970s, but had not yet affected the development and implementation of economic policy, including monetary policy. In those days, we didn't fully appreciate that our models rested on several flawed principles and that we were not characterizing monetary policy in a very satisfactory way. One major flaw was that models typically generated inflation expectations that were inconsistent with other equations specifying how economic actors behaved.
Another flaw was in in the use of policy models. Nobel laureate Robert Lucas demonstrated that economic models estimated under one policy regime could not be relied on to provide accurate predictions about the economy if policymakers were to behave differently in the future than they did during the past. That meant that we should not rely on such models to assess how the economy would perform if the strategy driving monetary policy were to change.
Third, we did not realize the usefulness of defining monetary policy as a rule for systematically adjusting a variable under the central bank's control- for example, the federal funds rate or the monetary base- in response to the economy's movements away from desired outcomes, such as full employment and price stability.1-2 We did not fully appreciate that the public would be formulating its own "rule" of central-bank behavior and acting accordingly. The seminal work of Nobel laureates Finn Kydland and Edward Prescott spawned a literature that taught policymakers how to use rules as "commitment devices" for implementing policy strategies that would be durably optimal through time.
Clearly, monetary policy as practiced had failed to stabilize inflation and inflation expectations. …