MONEY RULES: The Role of the Federal Reserve

Wednesday, January 9, 2002

Interest Rate adjustments by the Federal Reserve are among the most closely watched and anticipated of all economic policy decisions. Yet many economists believe the Fed no longer has the power it once did to regulate the economy. So just how powerful is the Fed today? What tools does the Fed have to regulate the economy, and how should they be used?

Recorded on Wednesday, January 9, 2002

Peter Robinson: Today on Uncommon Knowledge: Alan Greenspan, chairman of the Fed--does he really matter anymore?

Announcer: Funding for this program is provided by the John M. Olin Foundation and the Starr Foundation.


Peter Robinson: Welcome to Uncommon Knowledge. I'm Peter Robinson. Our show today, the Fed.

Of all the government's economic policy decisions, none is as closely watched as interest rate adjustments by the Federal Reserve. Yet there are economists who believe the Feds shouldn't be monkeying around with interest rates in the first place and other economists who wonder whether the Fed's power to regulate the economy is fading. So just how powerful is the Fed? What should it be doing to regulate the economy and what tools does it have to do so?

With us today, two guests. Michael Boskin chaired the President's Council of Economic Advisors under President George Bush, the elder. He is currently a Professor of Economics at Stanford University and a Fellow at the Hoover Institution. Janet Yellen shared the President's Council of Economic Advisors under President Bill Clinton. She is currently a Professor of Economics at the University of California at Berkeley.

Title: Breaking the Bank

Peter Robinson: Milton Friedman has long maintained that the Federal Reserve should be abolished and the federal government should instead permit the money supply to grow according to a stable, predictable, publicly known formula. Now Milton Friedman, a friend of Dr. Boskin here, you know him too no doubt?

Janet Yellen: I do.

Peter Robinson: All right. Won the Nobel Prize in 1976 for his efforts. You could call him the father of monetarism, which is this school of economic thought that informs the work of central banks around the world. How is it that Milton Friedman could hold such a view, abolish the Federal Reserve and be so mistaken? Janet?

Janet Yellen: Well I think Milton Friedman had very real concerns that the Federal Reserve in conducting monetary policy, has the potential to make the economy less stable rather than more stable. But, ideally I think the Federal Reserve, if it conducts monetary policy right, can improve the way the economy functions. And I think it's interesting that recently Milton Friedman has been quoted as having said very favorable things about the Feds, particularly the Greenspan Fed's performance.

Peter Robinson: Janet, we did a show about a month ago with Milton Friedman in which he said very nice things about the Fed and Alan Greenspan and said but, of course, I still think it should be abolished. Mike?

Michael Boskin: I think if you go back to when Milton first held this view, the Federal Reserve was not a star performer in the policy apparatus. We had atrocious monetary policy at various times in our history in the 1930's. In the 1970's, we had horrible inflation. In the 1930's, the Fed allowed the depression to get worse and persist longer than it otherwise would have.

Peter Robinson: Of course, I want to talk about the economy and economics, that's what a show on the Fed should be about but I want also to get at this question of political philosophy as well. So throughout American history, you have a large number of Americans including some of the founders who were very wary of the notion of a powerful central bank, let alone an independent, powerful central bank. The Fed isn't even created until 1913 because of this school of thought, this resistance to a central bank. It's not until the Fed reaches a 1951 agreement with President Truman, that it achieves real independence in setting interest rates. Now listen to a brief history of recent Fed actions. Under Fed Chairman, Arthur Burns, the Fed expands the money supply just about in time to help Richard Nixon get elected. You could argue why Arthur Burns did that, but Milton Friedman himself believed it was a politically motivated action. And he and Arthur Burns who were close friends beforehand, didn't speak for years afterwards. Paul Volker--the Fed raises interest rates sharply helping to contribute to a deep recession in the early 1980's, ten percent unemployment. Journalist William Greider says that that was, in effect, in coup. If the American people had known that was going to take place and been able to comment on it through the political system, they'd have preferred a little more inflation, not a wrenching economic experience like that. Last point: Chairman Greenspan--Fed raises rates in 1989, contributing, many argue, to the recession of 1990 and 1991 and contributing to the defeat of George Bush. So in recent history, you've got three instances in which this powerful central bank either intervenes directly in politics (Arthur Burns) or takes actions so dramatic in the economy that they have a direct bearing on American politics. So how is it that you justify the existence of such a powerful, un-elected body? Janet?

Janet Yellen: Well the Federal Reserve is responsible to Congress. It operates under a system of laws and accountability. And it does have the job of prescribing often very tough and unpopular medicine. Paul Volker's interest rate increases to bring inflation down are a good example of that. And these are actions I think that are in the best interest of the economy. And they've been assigned to an independent Federal Reserve because I think Congress wisely perceived that the political process that Congress itself or elected officials would find it very difficult to take unpopular actions.

Michael Boskin: Do you believe that we get better monetary policy if politicians ran the central bank? There are many places where the central bank is inside the Finance Ministry and controlled by a Prime Minister or a president and some places with a unicameral legislature. And those places historically have very poor monetary policy.

Peter Robinson: As it was in Britain until Tony Blair made the central bank, the Bank of England truly independent. But so what you've got there was Mrs. Thatcher had a pretty good monetary policy. Right? So, I mean, would you say…

Michael Boskin: I think that it would be naïve to expect that people who are conducting monetary policy are totally immune to what's going on outside aggregate macroeconomic data. However, they are charged, they have responsibilities, they have sworn an oath to discharge responsibilities, to do what they think is correct for the interest of the economy. Now I'm not suggesting that there haven't been examples in history--I think the Arthur Burns example you mentioned is one that many economists lament to, is unfortunate.

Peter Robinson: Let me go back to the question I started with. On what methodology should the Fed base its decisions?

Title: Money Rules

Peter Robinson: Should the Fed do its work by establishing rules, that is, effectively hands-off or by using discretion? Now I gave you--here's someone else who holds Milton's point of view. T. J. Rogers, entrepreneur here in Silicon Valley and he wrote about the way the Fed raised rates in the year 2000 as the economy was very hot. "What the Fed did not know was that the economy was about to come to an abrupt halt on its own. There is a fundamental flaw in the Fed's assumption that it can know enough about the future to fine-tune the economy without continually making mistakes." The Fed just can't know the future.

Janet Yellen: Well there's no question that there's uncertainty about what the future holds in store and the Fed cannot forecast it perfectly. The economy clearly operates with vast uncertainty. So the practical question is, can the Fed pursue policies that enhance stability or are the problems so severe in understanding what the economy is doing that things will only be made worse? I think that's an empirical question and I think the data is very clear that certainly since the Green--during the Greenspan period, that output has been much less volatile and has fluctuated much less than in the fifty or seventy-five years before that. So we can look at the data and say it looks like the economy's become more stable. But then beyond that, you can ask how has the Fed behaved? Have they behaved systematically? And I think what's very interesting about the performance of the Greenspan Fed is that you can actually describe what they've done in a very simple way. They've responded simply and sensibly to gaps between the economy's performance with respect to inflation and with respect to unemployment relative to sensible goals. And, in fact, a colleague of Mike's, John Taylor, who's now Undersecretary of the Treasury, did a little exercise in which he looked at how the Fed had actually behaved. And it turned out that their performance corresponded very closely to a strategy that he had shown would lead to very good economic results in a world of uncertainty.

[Talking at same time]

Peter Robinson: Go ahead.

Michael Boskin: Let me get back to this rules versus discretion thing. It's extremely important for the Federal Reserve to be a compass, not a weather vane. In the 1970's, we had the stop-go policies, we had recessions and inflation. We had them both simultaneously. We had horrible economic performance. Once we had the great dis-inflation in the early 1980's, we have had a much more stable monetary policy. And while it hasn't been a purely mechanical rule, it has operated much more as a rough approximation along the lines that Janet was talking about. So I think that a more rules-based monetary policy makes sense. I think that many people would say that leaving it exclusively to a computer or to some un-revised calculations in a world where data are revised all the time, where they're imperfect, where there are very large lags....there's not only uncertainty about what's going on in the economy, since monetary policy takes several quarters to have much of an impact on output and prices, it's going to have--the Fed's going to have to be looking at where the economy's likely to be down the road.

Peter Robinson: Now you've both praised John Taylor and John has this formulation called the Taylor Rule, which says roughly speaking that the Fed ought to raise rates by inflation plus something as inflation starts. And then cut rates as inflation drops. Now would it make sense for some sort of formal statement saying, our presumption is the Taylor Rule and we will make an announcement to the markets whenever we depart from it.

Michael Boskin: I think that the markets pretty much understand that that's roughly how the Fed is behaving…

Peter Robinson: Already?

Michael Boskin: …and when they are going to do something radically different from that, that they make sure they have an explanation…

Janet Yellen: I think allowing some discretion so that the Fed roughly, the Greenspan Fed has roughly behaved according to the Taylor Rule, which is intuitive and sensible and yields good performance. But unusual things happen. And so I think the Fed needs some discretion to depart from the Rule.

Michael Boskin: Let me make two key points here though that haven't come up yet. One is, the Fed sometimes is in situations where it's not only doing its normal monetary policy. Sometimes it has to act as a lender of last resort in what could be a very severe short run liquidity crisis as happened after the 1987 stock market crash. This happened right after September 11th. The Fed had roughly eight or ten times as much overnight activity, pumping cash into the economy to make sure we didn't have a whole bunch of activity seize up because people couldn't make timely payment even though they were solvent. So not everything the Fed has to do can be done in that context. Secondly, it's also the case that the third Fed responsibility is as a major player in banking regulation and supervision. And it isn't always the case that all the information about the state of credit, the state of borrowing capacity, the state of the economy is contained in just in interest rates. There are times when you can have a lot of extra covenants being put on by banks. There could be a credit crunch, etc. And the Fed has to have a little give there. So if you just did it mechanically, writing down how to cover all these other circumstances would be very complicated.

Peter Robinson: Onto a very fundamental question, does the Fed still have the power to manage the economy?

Title: Cutting Interest in the Fed

Peter Robinson: I quote The Economist magazine: "Central banks often no longer really understand what they're doing." The argument runs like this, over the last couple of decades, the importance in the creation of credit of banks relative to the capital markets, all kinds of new instruments in the capital markets, has shrunk. The Fed influences banks directly. It influences the capital markets only indirectly. Is the Fed losing control?

Janet Yellen: I would say no. The Fed isn't losing control. Certainly markets filter with the Fed's behavior into the real economy. They play an important role in determining how the Fed affects the economy because long-term rates matter much more to spending decisions, investment, housing, consumer durables. They matter much more than short-term rates. And the Fed only controls the shortest rate and overnight interest rate, which in and of itself, doesn't matter much. But when market participants determine these longer-term rates, they are asking themselves the question, what will short rates be not just today but into the future? And the simplest theory of what determines longer-term rates is that they're based on expectations about how short rates will behave over time. Well what determines short rates over time? It's the Fed, what they're doing not just today but also into the future. And so in that sense, the Fed's current behavior and speculations about its future behavior are what's influencing the market.

Michael Boskin: But I think it's important to understand that the economy's always evolved and always changed in the whole history of the Fed and even prior to 1913 before we had a Federal Reserve. We used to have a lot less formal credit, then we had formal credit. We had the evolution of banks, we had twelve thousand banks and we had a banking consolidation. We had the development of a much more effective and wider spread corporate bond market for a much wider swath of companies. We had the development of other financial instruments. All that is an unambiguously good thing for the economy. However, it is true that at the margin, the Fed has operated primarily and its effect is primarily a very short end so-called Federal Funds Rate. And that's indeed become the instrument that's used and what it's sort of targeting. Back in--a couple of decades ago, it was targeting the money supply per se. It used to have these ranges it was trying to get the money supply to grow in. But then the very definition of money changed as we deregulated financial markets, as we deregulated interest rates, as we allowed innovations to propagate with money market mutual funds and things of this sort. So the traditional, historical relationships that had occurred between a measure of money and of nominal GDP and then of perhaps of real GDP and inflation appeared to break down at various times. So there are times they've been re-established in the last couple of decades but they've never quite held up the way they did previously.

Peter Robinson: Are these trends…

Michael Boskin: So these are trends. They're important and the Fed has to understand what it's doing but it's also important to take a step back. The Fed has never, by its actions, been able to totally manage everything about the economy, keep it stable as a lifeline on a medical instrument chart at good growth with no inflation. The economy's subject to lots of natural shifts, up and down, based on expectations, views about foreign shocks from our trading partners, oil prices going up and down. Lots of things of these sorts happen and the Fed has to try to figure out what best to do in these circumstances. And we've said, I think historically, sometimes they mismanaged. In the last couple of decades, they've done a very good job. But with that said…

Peter Robinson: They're not losing their grip?

Michael Boskin: With that said, they're not losing their grip but somehow the expectations that the Fed could exactly control the kind of the minute the economy started to shrink, it would know it and could stop it or the minute the tiniest inkling of inflation. Now we've gotten more market mechanisms telling us--feeding us that information as Janet was talking about and the Fed uses those but it's important to understand that these are human beings doing as best human beings can do. They're very talented…

Peter Robinson: You will confirm that?

[Talking at same time]

Michael Boskin: They're very talented human beings--they're very talented…

Peter Robinson: This brings us to the man, Alan Greenspan himself.

Title: The Man, the Myth

Peter Robinson: The journalist James Glassman: "Of all the alternatives out there, Greenspan is far ahead of whoever is in second place, a fact that George W. Bush should keep in mind when the Chairman's fourth term ends. How good is Alan Greenspan? Oh, he's very good."

Janet Yellen: He is very good. I would agree with the essence of the statement.

Peter Robinson: Mike?

Michael Boskin: I think he's done an excellent job. Again, I would caution us against either judging him against perfection historically or expecting perfection in the future but he's done--under the circumstances, given the cards he's been dealt, given the problems he's confronted, on balance, he's done an excellent job.

Peter Robinson: But you see the discussion you're now setting up, I didn't even think of this, not even in my script, but you forced it to mind, is that Arthur Burns plays a little politics, messes things up so badly Milton Friedman doesn't speak to him for years. Carter appoints William Miller who also loses his grip and gets bounced out of the job after fifteen or seventeen months. Then Paul Vo--so really when you look at the recent history of the Fed, you've got two guys, Paul Volker did a good job and Alan Greenspan, blessings upon his name, has done a good job. It really depends on personalities. No?

Michael Boskin: It's partly…

Peter Robinson: Fight me back because…

Michael Boskin: …a function of the quality of the Chairman and the other members of the Board of Governors and the District Bank Presidents that are on the FOMC. However, it's also important to understand how thinking about the economy, about the role of inflation and its relation to unemployment, has evolved over time. Back in the 1970's, it was not my view but it was an extant view, a majority of professional economists thought that higher inflation could be traded off kind of smoothly against lower unemployment and the…

Peter Robinson: The Phillips Curve, that's the old…

Michael Boskin: Yes, yes. And I think the lesson of the last--of the period since the early 1980's, has been that stable low inflation is an input to stronger long-term growth, not a detriment to it and that the Fed, as I said earlier, needs to be a compass, not a weather vane. And I think--I hope Alan will be there for--Alan Greenspan will be there for a long time. If and when he finally retires, when he finally retires, that lesson will be there for his successors and my view is that we'll be able to hopefully keep something similar going, maybe not…

[Talking at same time]

Peter Robinson: Let me put something to you Janet. Let me put something to you and I hope that you reassure me by saying yes. It's not just a matter of personality although having someone talented in the job is better than having someone untalented but economics really does have a large component of science. It is a discipline that makes progress and we now know much more, it has distilled throughout the profession about managing the American economy than we used to do and Alan Greenspan has benefited from these progress--this progress within the discipline itself.

Janet Yellen: I think that's what makes him such a strong Chairman is that he understands the science, he follows the science, he acts according to the science. In a way intuitively he has done something without--even before all of the scientific literature showed that his mode of operation was really a very sensible one. It was something he grasped intuitively.

Peter Robinson: Now were Alan Greenspan's comments on the stock market appropriate for a Chairman of the Fed?

Title: (Not So) Tiny Bubbles

Peter Robinson: Famous speech, December, 1996, Alan Greenspan warns of "irrational exuberance" in the stock market. The market blips down the next day and then says the heck with you and takes right off again. Was it his business to worry not just about the price level in the economy generally or interest rates overnight but the price level in the capital markets?

Janet Yellen: I think it was his job to worry about that because-- not as a goal in itself, it's not that he has a target for the stock market and doesn't want to see it rise. Other things equal higher stock market prices...

Peter Robinson: He was right to try talk down the capital market?

Janet Yellen: He saw that as a potential looming source of instability to the economy. He worried that a speculative bubble was developing. He made those comments in the context of a discussion of Japan. He had witnessed what Japan had gone through.

Peter Robinson: Should he have tried harder to talk the market down?

Michael Boskin: I think it would be a mistake to target the level of stock prices. However, if stock prices are feeding back into the economy and people are spending, businesses and consumers are spending at a horribly unsustainable rate that is likely to lead to inflation getting out of control, then that's something that's a legitimate concern.

Peter Robinson: Okay, by 1999, the Chairman had stopped suggesting that stock prices might be in a bubble or that there was irrational exuberance and he began to suggest instead that something new had happened in the economy, something involving higher productivity. Now he gives another speech. Noting that output per hour had been growing at 3.5 percent since 1995, which is about twice the rate of the previous quarter century. Listen to this wonderful Greenspan prose and tell me if you can figure out what he's talking about. "It is the growing use of information technology throughout the economy that makes the current period unique. At a fundamental level, the essential contribution of information technology is the expansion of knowledge and its adverse, the reduction in uncertainty." I read that as saying, something new is happening here. And that's very important whether the Chairman believes that and the Fed believes it because if they really believe it, they'll let the economy grow a little, they'll loosen up, right?

Janet Yellen: What you say is true within limits. First of all…

Peter Robinson: Is he right about it?

Janet Yellen: It's something he realized well before 1999. It's something that was in his mind as early as 1992, 3, 4. You could find speeches going back to 1994 but he became more and more certain that something really was happening and he began--and the data began to show that productivity growth was improving. And if you look at the record, it simply strengthened and got stronger and stronger between '95 and 2000.

Peter Robinson: And the implication for Fed policy is?

Janet Yellen: The implication for Fed policy is that the economy at least for a time, might be able to enjoy a combination of unusually low unemployment without inflation taking off. Because as Michael said previously, we learned during the unhappy experience of the '70s and '80s that when you push--when the economy goes to unemployment rates that are unduly low, eventually inflation accelerates. The huge surprise in the '90s, in the second half of the '90s is unemployment is drifting from six and a half percent to five and a half percent to five, to four and a half, ultimately as low as 3.9 and…

Peter Robinson: Did it really get down to 3.9?

Janet Yellen: …inflation instead of taking off which is what previous economic theory would have predicted, continues to fall throughout that period.

Michael Boskin: There are some pretty important things going on here and I--I would mention two that I think are very important. One is, the Fed's notion of what the economy's normal or capable of growing at without putting undue pressure on the prices, or put pressure on inflation, is very important because if it fears that the economy's growing too rapidly and in anticipation of inflation taking off nine months or a year from now because remember it has to be forward looking because of the lags, it is fairly restrictive, fairly tight on credit, raises interest rates, you could wind up having a self-fulfilling prophecy and having the economy growing at very modest rates when it could be doing better. I myself believe there has been a substantial increase in productivity. I think there's an open question how much of it is a one-time transition from a lower level to a higher level.

Peter Robinson: Oh I see so it may be…

Michael Boskin: …and along the way we have a higher growth rate and how much of it's permanent. I think some of it's permanent and some of it's transitory.

Peter Robinson: So let me ask you this then. Give me one sentence. What will be the legacy, Volker you can say he crunched inflation. What will be the legacy in one sentence of Alan Greenspan? Mike?

Michael Boskin: Well I think there would be two. I apologize for lack of brevity. One is that he moved to a more rules-based policy while maintaining some adjustability. And secondly, he was able to demonstrate that we could continue low inflation, indeed bring it down another notch in a strong economy, not in a sub part economy.

Peter Robinson: Janet?

Janet Yellen: Well I think he kept inflation low and maintained a very clear focus on the importance of doing that. And I think he proved even to the satisfaction of people like Milton Friedman that it is possible to conduct monetary policy in a way that stabilizes the economy by relying on the science. And he had a very good feeling for the art as well.

Peter Robinson: Janet and Mike, thank you very much.

Michael Boskin: You're welcome, Peter.

Peter Robinson: I'm Peter Robinson for Uncommon Knowledge. Thanks for joining us.