Behind Closed Doors: The Political Economy of Central Banking in the United
Working Paper No. 47
Stephanie A. Kelton(info)
Behind Closed Doors: The Political
Economy of Central Banking in the United States
Since the failed attempt to control inflation by targeting
the growth of monetary aggregates in the late 1970s and early 1980s – the
infamous Monetarist Experiment – the Federal Reserve (‘the Fed’) has explored
the use of various policy guides, including price indices, gold prices,
indicators of future price levels (e.g. P-star), surveys of expected inflation,
Taylor rules and equilibrium “real” interest rates (Wray, 2004). Each was used,
with varying degrees of success, to assist the Fed in carrying out its dual
mandate – the promotion of price stability and maximum employment.
The purpose of this paper is to examine the central bank’s changing philosophy
regarding how best to pursue these objectives during the 1990s.
Two questions are of central importance. First, what kinds of
institutional reforms (i.e. changes in instruments and practices) affected the
way in which the Fed crafted policy during this era? Here, the focus will be on
two key changes, implemented in the 1990s, as a means of enhancing the
effectiveness of the central bank’s policy. Second, we ask whether the central
bank’s changing practices were driven by changing economic conditions or by a
greater acceptance of a common intellectual framework regarding what central
banks can and should do as well as how best to achieve their goals. Our concern
here is with the tension between the ‘New Consensus’ and the ‘New Economy’ and
the manner in which the Fed crafted policy during a period in which supply-side
improvements appeared to be changing the rules of the game.
To gain insight into the above, we rely on the Fed’s own
ruminations and policy deliberations, as captured in the published transcripts
from its secret closed door meetings.
Thus, rather that attempting to infer its motivations from observed
policy actions, the focus will be on the direct testimony contained in
transcripts of the Fed’s deliberations. The testimony contained in these
transcripts provides a behind-the-scenes look at the Fed’s own assessment of
economic conditions, the models it uses to predict future conditions (e.g.
inflationary pressures) and the justification (theoretical or instinctual) for
its ultimate policy moves. It is presumed that, short of acquiring a seat on the
Board of Governors, the best way to understand the political economy of central
banking is to proceed as if we sat “behind closed doors”.
2. THE FED’S THEORETICAL APPROACH TO
POLICYMAKING IN THE 1990s
During the 1990s, the Fed’s own philosophy regarding monetary
policy operations underwent several changes.
Specifically, the Fed made three important changes to the way in which it
communicates with the public. The first two changes occurred in 1994. First, the
Fed began to release transcripts and other materials from the closed-door
meetings of the Federal Open Market Committee (FOMC).
By releasing these transcripts, which provide a complete record of the dialogue
that takes place during the Committee’s policy deliberations, the FOMC increased
the transparency of its policy actions.
Second, the Fed became more forthcoming about the precise degree of interest
rate pressure sought by the Open Market Committee. From 1983, the Committee
issued operating instructions, known as the “directive,” to the Open Market
Trading Desk at the Federal Reserve Bank (FRB) of New York. Prior to 1994, the
directive would simply indicate whether the Fed sought to increase or decrease
the “degree of pressure” on the overnight lending rate, never specifying a
precise target for the federal funds rate (FFR). Beginning in 1994, the Fed
became more forthcoming, telling the public the exact funds rate the
central bank sought to target. The last important change in the Fed’s operating
procedures occurred in 1999, when the central bank sought to further enhance its
communication with the public by once again changing its disclosure procedures.
To better transmit its outlook to the public, the Fed agreed to convey its
“policy tilt” or “policy bias” in order to indicate whether the Fed perceived a
greater chance of a rate hike or a rate cut during the intermeeting period.
Below, we utilize the FOMC transcripts to evaluate the Fed’s philosophy
regarding the way in which its modified instruments – the announcement of a
precise FFR and the policy “tilt” – should, in theory, be used to achieve its
dual mandate of price stability and maximum employment.
2.A. The Federal Funds Rate and the
failed “monetarist experiment” conducted by Chairman Volker in the late 1970s
and early 1980s, the Fed returned to return to a policy of using the FFR as the
dominant instrument of monetary policy. And, even though Federal Reserve Board
Governor Laurence Meyer (2001) has conceded that there is no simple transmission
mechanism through which aggregate demand responds to changes in the FFR, it is
clear from the transcripts that the FOMC believes that the FFR primarily affects
the macro economy through two important channels: the ‘demand channel’ and the
‘expectations channel’ (Mosler, 2004; Arestis and McCombie 2005). Below, we
examine the Fed’s current thinking on interest rates.
The Fed believes that its interest rate policy can be
accommodative, restrictive, or ‘neutral.’ An accommodative (restrictive) stance
will generate (relieve) inflationary pressures as new borrowing and spending
reduce (increase) the size of the output gap.
Working through this ‘demand channel,’ accommodative policy generates inflation
by increasing aggregate demand and hence reducing the degree of slack in the
As the Fed sees it, its job is to continually assess economic conditions in
order to determine how much tightening/easing is needed to properly manage the
degree of slack in the economy:
How do we know when an economy is overheating? We cannot tell
from the rate
of economic growth by itself. . . . We cannot tell until we look
combination of aggregate supply and aggregate demand. The reduced
form view of
this is whether or not we have slack in the product and/or the
If we have a situation in which effective demand exceeds
prices rise. If it is the other way around, they fall (Greenspan,
June, pp. 85-86).
In the late
1990s and again beginning in late 2004, the Fed began gradually raising the FFR
(¼ percent at a time) in order to reverse a policy stance that it believed had
become too accommodative. In the late 1990s, as now, the goal was to gradually
move to a more ‘neutral’ position. In practice, this has meant moving toward a
FFR that was neither accommodative nor restrictive.
The Fed believes that once the FFR reaches its ‘neutral’ rate – a rate the FOMC
readily admits it cannot know until it is discovered – price stability should
prevail, and there should be no inflationary pressure working through the
Similarly, the Fed believes that a ‘neutral’ rate of interest
will prevent rising inflation via the ‘expectations channel.’ As Greenspan has
defined it, price stability exists “when economic agents no longer take account
of the prospective change in the general price level in their economic
decision-making” (Greenspan, 2001, p. 2). As a counter example, consider what
happens when the Fed adopts an accommodative stance. The Fed believes that
inflation expectations respond to the degree of monetary ease so that an
accommodative stance fuels rising inflationary expectations. Market participants
incorporate these expectations into their decision-making process, sparking
inflationary pressure as the anticipation of higher prices leads to the bidding
up of wages and an attempt to make purchases before prices begin to rise. But
the ‘expectations channel’ becomes impotent when the Fed’s interest rate policy
is ‘neutral’ as people no longer take inflation into account when making
In terms of the Fed’s strategy for achieving ‘neutrality,’ it
is clear from the transcripts that the Fed believes that “monetary policy is not
unlike a military campaign. It involves strategy, tactics, uncertain
information, and a rapidly changing environment” (Broaddus, Transcript, June, p.
99). In practice, this means that the Fed must begin moving interest rates
several quarters before it desires to achieve neutrality because of the lags
with which monetary policy operates. Thus, when the Fed believes that its policy
has become too accommodative, it will begin a campaign of gradual rate hikes
even before it has any actual evidence of increasing inflationary pressure. By
raising the FFR preemptively, the Fed is attempting to coordinate the delay in
the effects of its operations with forecasts of inflationary pressure so that
markets react to its policy at the appropriate time:
If there is
little economic slack, as measured, say, by unemployment and discouraged
workers, and if there are lags in monetary policy, the main
way the Fed can
control inflation is to control growth – that is, to keep the prospective growth
in aggregate demand close to that of aggregate supply (Gramlich, Transcript,
June 1999, p. 59).
Implicit in Governor Gramlich’s statement is the theoretical
construct known as the NAIRU – the Non-Accelerating Inflationary Rate of
Unemployment. Here, the idea is that too much growth, as indicated by the
existence of too little unemployment, will cause inflation to accelerate. Thus,
just as there is some ‘neutral’ rate of interest that will stabilize inflation
expectations, there is an implied level of unemployment (the NAIRU) that is
‘neutral’ with respect to the price level (i.e. neither inflationary nor
short, the Fed’s philosophy regarding policymaking in the 1990s reflected a
belief in the notion that inflation is “fundamentally a monetary phenomenon”
(Greenspan, Transcript, February 1999, p. 78) and that with the appropriate
degree of restraint in the FFR the Fed can achieve price stability.
Tilt, the Markets and the Frustration of the Fed
It is clear
from the transcripts that the Fed believes that monetary policy works not only
through setting the current FFR but also through its impact on
expectations regarding the futuredirection of its policy rate:
Beyond the action you choose
today, there are three mechanisms
convey your message to financial markets: the wording
accompanying announcement, the tilt to the directive, and
the tone of
Chairman Greenspan’s Humphrey-Hawkins testimony in
(Kohn, Transcript, June, p. 71).
It is also
clear that “Fed watchers” will do whatever they can to extract information from
policymakers’ speeches, testimony, statements, etc. as they prognosticate about
the direction of future policy moves. Indeed, as Governor Gramlich noted, only
half tongue-in-cheek, Greenspan could “change long-term interest rates by 25
basis points, if he wanted to, by just frowning in a certain way!” (Transcript,
March, 1999, p. 45). Of course, if financial markets read the signals
incorrectly, the policy decision becomes complicated, as the Fed must decide
whether to deliver the move that markets anticipate or run the risk of
disrupting markets by surprising them, an action that can be particularly
undesirable when financial markets are already wary.
An understanding of this dilemma led to the notion that
policy effectiveness depends crucially on the central bank’s ability to
accurately communicate its policy goals and its outlook regarding the likelihood
of future rate moves. In 1999, the Fed decided to immediately inform markets
when it changed its view regarding prospective developments. The information was
conveyed in a statement, released by the FOMC, in which the Committee indicated
its “policy tilt” or “policy bias.” The “tilt” was intended to prepare markets
for future moves by indicating the Fed’s estimation of the relative chance
of an increase (decrease) in the FFR in the period ahead. If, for example, the
Fed believed that its next move was more likely to be a rate hike than a rate
cut, it would announce an asymmetrical tilt (or bias) toward tightening.
If, in contrast, conditions were such that the Fed did not perceive the
probability of a future move – in either direction – as relatively more likely,
it would announce a symmetrical posture.
In sum, the Fed theorized that policy effectiveness was
dependent on the degree to which the FOMC successfully communicated its outlook
regarding the likelihood of future rate moves. In the late 1990s policymaking
was guided by the belief that policy effectiveness could be improved by
immediately announcing any change in the Committee’s ‘bias.’
3. WHEN THEORY AND REALITY COLLIDE: THE
‘NEW CONSENSUS’ AND
THE ‘NEW ECONOMY’
Recent developments in mainstream economic theory have
embraced the short-run non-neutrality of money, with a consensus forming around
the idea that central banks can directly manage the economy by manipulating the
rate of interest (Clarida et al. 1999; Svensson 1999). This intellectual
convergence regarding both the goals (price stability) and methods (using the
short-term interest rate as the main instrument of policy) of monetary policy
has been dubbed the ‘new consensus’ by monetary economists. According
to this ‘new consensus’ view, inflation results when aggregate demand growth
outpaces aggregate supply growth, something that can be prevented through
adjustments in the short-term rate of interest. Thus, higher (lower) interest
rates lead to less (more) borrowing and spending, which reduces (increases) the
rate of inflation through the ‘demand channel.’ But inflation can also be
propagated via the ‘expectations channel,’ as an accommodative stance fuels
rising inflation expectations, which intensifies the demand for higher wages.
The purpose of this section is to examine the way in which the Fed actually
crafted policy during the so-called ‘new economy’ era.
3A. Taylor Rules and the Fed’s
Assessment of their Usefulness
With much of
the intellectual community rallying around the ‘new consensus’ view, economists
began searching for new rules to guide the implementation of monetary policy.
The most influential of these has been the Taylor rule, which calls for changes
in the short-term interest rate in response to changes of the price level or
real income. Specifically, the Taylor rule holds that the nominal interest rate
should be set in accordance with the following formula:
r = r*
r = the short term
nominal interest rate (the FFR)
r* = the
“equilibrium” rate (assumed to be close to the steady-state growth rate)
= the rate of inflation over the past four quarters (considered a proxy for
αy and αp
are the policy reaction coefficients
y = current
= trend level of output (or maximum sustainable output)
= the target rate of inflation
weights assigned to both αy
the Taylor rule calls for an increase in the FFR whenever inflation increases
above its target rate or real GDP rises above potential.
When the output and inflation gaps are nil, the Taylor rule asserts that the
FOMC should set the FFR equal to the “equilibrium” real rate, which approximates
the economy’s steady-state growth rate.
Although the FOMC does not allow the Taylor rule to dictate the course of its
policy actions, the rule is routinely used by the Fed staff, which presents the
Committee with forecasts that are based on the presumption that monetary policy
responds to changing economic conditions according to the Taylor rule. The staff
– the group of economists that presents an assessment/outlook at the beginning
of each meeting of the FOMC – then informs the Committee how its recent interest
rate decisions compare with the policy rule. In February 1999, the staff
informed the Committee that based on the versions of the Taylor rule it
calculates, the Fed’s stance had become too accommodative (Transcript, February,1999). While several members of the Committee sympathized with the staff’s
most remained skeptical about raising the FFR, given that the output gap had
been narrowing for several years without any evidence of rising inflationary
Those skeptical of the rule point to the experience of the
late 1990s, when technological efficiencies brought surprising increases in the
productivity trend and gave rise to the belief that the emergence of a ‘new
economy’ was fundamentally altering many key economic relationships. For
example, during the period 1996-1998, the U.S. experienced economic growth that
was faster than most economists considered potential even as the unemployment
rate remained below most economist’s estimates of NAIRU. With the rules of the
game apparently changing, Governor Ferguson asked and answered the following
fundamental question: “What is [the economy’s] maximum sustainable growth? We
aren’t really sure” (Transcript, March, p. 64).
The problem with the Taylor rule (and the Fed’s own
philosophy) was that it required policymakers to have a clear sense of the
economy’s potential so that demand growth could be kept at supply’s capacity,
which was considered fixed. But the sharp increases in productivity that
took place during the 1990s called into question the concept of ‘trend’ (or
fixed) supply capacity. Without a clear idea of the economy’s supply potential
(i.e. no real confidence in the value of y*), many members of the
FOMC expressed misgivings about the Taylor rule, arguing that it had become a
causality of reality. Governor Gramlich had this to say:
precise point estimates of the inflation and unemployment
targets. If the
estimates are off, the advice is off. . . The Taylor rule
. . . does not
work well when it is difficult to define operating targets
or unemployment. As we have discussed often in this
difficulty may now be showing up particularly with respect
unemployment term, given the problems in identifying the
could make the case that the NAIRU is 6, 5, or 4 percent
May, p. 45).
raised a similar concern, noting that “the existence of a supply shock makes it
hard to judge inflationary risk by looking at real output growth, since such
shocks tend to change the output/inflation mix in the economy” (Transcript, May,
p. 28). If sustained increases in productivity were indeed altering the
economy’s underlying trend rate of growth, the Taylor rule would offer bad
And this is exactly what happened in the late 1990s, when the
Fed staff presented its forecasts using estimates of the inflation and
unemployment targets that did not account for the full effect of the supply
shocks the U.S. economy had experienced. Based on the estimates the staff had
chosen, their models called for sharp increases in the FFR. But President Boehne
cautioned his colleagues against following the Taylor rule’s advice:
Credibly resisting inflation
also means being a credible evaluator
of the inflation threat. . .
we need to be able to tell the difference
between a wolf and the
family dog. Let’s be honest with ourselves:
current and pipeline
indicators of inflation look more like the family
dog than a wolf, and our
forecasting models have for several years
cried wolf when there has
been no wolf (Transcript, June 1999, p. 44).
President Boehne argued, the Fed must be a judicious arbiter, weighing its own
evaluation of economic reality against the prescriptions offered by economic
theory, adding, “when reality tells us something different from the models … we
ought to take a new look at the models” (Boehne, Transcript, February 1999, p.
Thus, despite the fact that a handful of members were amenable to the
implementation of policy following (some version of) the Taylor rule,
the majority insisted that flexibility was essential and that rules must not be
permitted to displace judgment.
Indeed, several members of the Committee argued that if policy had been
implemented in accordance with the Taylor rule, the longest expansion in recent
history may well have been compromised.
3.B. The High-Growth, Low-Inflation
Dilemma: The Elves vs. the Wolves
the Taylor rule was dispensing the wrong policy advice, the FOMC embarked on a
campaign of rate reductions that resulted in a total drop of 75 basis
points during the fall of 1998.
When the Committee convened for its first meeting in 1999, it considered its
policy stance to be accommodative, and several members believed that the Fed’s
task was to determine “whether, when and how fast the policy actions of last
fall should be unwound” (Hoenig, Transcript, February, p. 59). The key issue was
to determine whether there had been a structural change, as suggested by the
combination of declining inflation together with a declining unemployment rate,
or whether the favorable supply shocks would soon dissipate and inflationary
pressures would emerge. The FOMC debated these questions at its February and
During this time, members generally fell into one of two
categories: the ‘optimistic elves’ or the ‘pessimistic wolves.’ The former, who
were open to the possibility that the U.S. economy might indeed have undergone a
structural change, preferred to let the experiment unfold, refusing to assume
that the future course of inflationary pressure must be upward. Though they were
not inflation “doves,” they preferred to adopt a wait-and-see approach, giving
the economy the chance to surprise them, but indicating their willingness to
pounce at the first sign of inflation. In contrast, some members expressed a
penchant for preemptive action, preferring to begin the unwinding process before
the “inevitable” occurred. Below, we examine the arguments presented by members
from each camp.
Governor Rivlin recognized the difficulty of setting policy
in a high-growth, low-inflation environment, referring to a set of “cheerful
little elves who run the U.S. economy and get their kicks out of proving the
cautious forecasters wrong” (Transcript,February 1999, p. 61). While she
considered their work impressive – she credited the elves with controlling the
weather, keeping productivity growth increasing, and maintaining unemployment
below what even the most optimistic NAIRU enthusiast considered possible, all
the while containing inflation and decreasing wage pressure – she recognized the
dilemma this posed for the Committee, asking the following question of her
colleagues: “Have the elves run out of tricks or can they beat the game one more
time?” (ibid., p. 62).
President Boehne seemed willing to see
what the elves could do:
If one goes back, for
example, to the 1960s there was a lot of talk that
we could have
price stability and unemployment rates of 3 ½ percent or
percent. . . I believe if any of us had been asked two or three
years ago if we
thought we could have a 4 ½ percent unemployment rate
falling, we would have said that was a pretty nutty idea.
How do we know
the string has run out? How do we know that we
can’t have a
still better world? (Transcript, February 1999, p. 101).
apparently convinced that the good times would not continue to roll, Greenspan
agreed that a better understanding of the underlying relations was needed before
any action should be taken:
[W]e are at the tail end of
a series of years in which, by all our
measures, growth has been above trend. Price pressures
mounting at this stage, but instead they are going in the
direction. This involves, in my judgment, a major issue that
we need to
understand before we move forward with a policy shift
Presidents Boehne and Gramlich
I think we need to see
something in the pipeline, even very preliminarily,
that suggests that the
economy is beginning to experience a buildup in
inflationary pressures that
puts sustainable economic growth in jeopardy.
Or we need to see something,
even if it is very preliminary, that suggests
that we have the beginning
of boom conditions. Neither strong growth
alone nor a low unemployment
rate alone is a reason to tighten monetary
policy (Boehne, Transcript,
March 1999, p. 60).
We have to move
quickly. But we don’t have to move in advance of real
inflation which, as I said, is not available yet (Gramlich,
February 1999, p. 70)
Chairman McDonough stressed that a rate hike was both unjustified and damaging
to the Fed’s public image:
I think an
announcement of a tightening in policy at the present time
would make us
seem oblivious of what it going on in the world. But
more seriously, with a complete absence of inflation,
it would put
the Committee on record as being opposed to economic
(Transcript, March 1999, p. 59).
Thus, in the
absence of any evidence of a detrimental shift in the inflation-output mix, the
elves opposed a preemptive rate hike, preferring instead to see just how long
the good times might continue to roll.
worried that the favorable supply shocks that had prevented inflation from
rising would soon dissipate expressed a desire to move sooner rather than later:
I think the
balance of risks is on the upside. I would illustrate that
comparing the following two options: One option is to raise rates
now and have it
turn out ex post not to have been necessary; the other
option is to
hold rates steady now and have it turn out after the fact that
we should have
tightened. I would much rather deal with the former
the latter because I believe it would be much easier to
tightening than to have to catch up if it turns out that we are
Transcript, March 1999, p. 59).
Minehan also expressed a desire to act preemptively, maintaining:
Arguably, monetary policy is
stimulative, given the available
liquidity in markets and the
reduction in real interest rates brought
about by the 75 basis points
of easing in the fall. The question we
have to ask is whether we
really want to stimulate the economy
right now or whether it
might be prudent to bring policy closer to
neutral . . . stimulative
policy right now seems to run a greater
risk of making things worse
later on … (Transcript, February 1999, pp.
President Jordan echoed her call for
action, arguing that:
The longer we wait to start
to rein in some of the nominal aggregate
income growth and spending
growth, the longer we are subsequently
going to have to endure a
period of very weak growth in output and
employment in order to lean
against the rise in inflation. So, at some
point we have to contemplate
an adverse transitory tradeoff, and I
think the sooner the better
(Transcript, February 1999, p. 53).
also believed it might be necessary to make some short-run sacrifices in order
to reap the longer-run benefits of price stability:
developments have been exceptional. It has been
a wonderful ride, and we
have all enjoyed it. But we will ultimately
be graded – and indeed we
will grade ourselves – on the effect of
current policy on the
inflation trend in coming years. Might we not
achieve a higher grade on
the final exam by accepting a less except-
ional growth performance in
the near term? (Transcript, February 1999).
But Governor Ferguson spelled out the
risks most candidly:
The risks seem to be mainly
to the upside. It is easy to determine
what those risks are and
what may drive economic growth above
the forecast: plentiful
jobs, accommodative credit conditions, and
(Transcript, February, p. 70).
Thus, there were a range of opinions about the prospects for
continued growth and the risks associated with delaying an increase in the FFR.
But, in the end, the Committee supported the recommendation of its Chairman,
Alan Greenspan, who argued that it was appropriate to refrain from moving until
there was something concrete to justify a move. With that, the gap was bridged
and the Committee voted – at the conclusion of both its February and March
meetings – to maintain the FFR at 4 ¾ percent.
3.C. The April CPI Report: The Wolves
Begin to Circle
After many months of prolonged weakness in the various
measures of U.S. inflation, April’s core CPI jumped four-tenths of a percentage
point, a rise that garnered much attention during the FOMC’s May deliberations.
Although the jump provided the Committee with evidence of only a single month of
heightened inflationary pressure, some members began to worry that the day of
reckoning had finally arrived. President Hoenig, for example, confessed, “I have
become … increasingly worried about the current stance of policy and our ability
to maintain low inflation going forward” (Transcript, May 1999, p. 34).
President McTeeter’s confidence was also shaken by the news, adding, “[t]he
blockbuster, of course, was Friday’s CPI report. I will have to concede that it
was only one month’s data; however, the risks have shifted upward” (ibid., p.
35). However, not everyone agreed that the inflation-output mix was beginning to
move in the old familiar way.
If the Fed were following the Taylor rule, the proper
response would be straightforward – the FOMC should vote for a sharp increase in
the FFR. But the Fed did not follow a Taylor rule (or any other rule, for that
matter), so their May deliberations relied “less on a future as predicted by
models and more on inferences, both quantitative and qualitative” (Ferguson,
Transcript, February 1999, p. 71). And, as usual, this resulted in a range of
differing assessments and policy preferences. Some believed that the increase in
the core CPI necessitated an immediate policy response, articulating their
positions using tactics ranging from carefully crafted forecasts to anecdotal
evidence and impassioned commentary. Others continued their pleas for restraint,
preferring to wait for further evidence that the good times were indeed coming
to an end. The following excerpts provide a sense of these deliberations.
President Broaddus, relying on instinct, was the first to cry wolf:
I know I have
been crying wolf around this table for a long time and
my fears have
not been realized, but we have to take each day as it
comes, I guess.
So wolf! (Transcript, May 1999, p. 26).
on their own economic analyses and the forecasts prepared by the Fed staff to
bolster their arguments that the output-inflation mix was indeed shifting in a
way that required a policy response. Vice Chairman McDonough focused on the
April increase in the core CPI, suggesting that it may be an indication of
coming inflationary pressure:
[W]e’ve tried to take apart
the data statistically . . . and we’ve come
conclusion that the statistical probability is sufficiently high
increase actually is telling us something important that I
definitely have to take it into consideration in our
policy (Transcript, May, p. 44).
Moskow also suggested that inflation might be on the verge of accelerating,
pointing to the likelihood of a slowdown in productivity growth:
productivity growth remains as rapid as it has been for the past
then this projected real growth rule would be sustainable.
But if, as my
somewhat pessimistic staff keeps telling me, trend
growth has not picked up as much as the Greenbook
could face a substantial increase in inflation by the end of
Thus, I think the risks have become tilted decidedly to the
upside, and I
think the time has come to reevaluate our policy stance
1999, p. 27).
Presidents Broaddus, Jordan, and Hoenig offered a variety of anecdotes to
justify their support for policy action:
hearing from experienced bankers, anecdotally at least,
competition for loans is very, very strong – probably excessive
– which may be
laying the foundation for problems down the road
Transcript, May 1999, p. 24).
Pittsburgh say the city is in the early stages of a major
boom that will last five years . . . people from western
had been saying that they were lagging considerably
behind Ohio and
Kentucky but now they claim that they have closed
the gap. . . A
contact from one of the community banks in southwest
said that a significant employer for their community
decided to go
out of business and laid off 200 workers . . . and . . .
we still hear
references to, in one person’s words, ‘outrageous prices’
being paid for
farmland (Jordan, Transcript, May 1999, p. 30-31).
talking with business people in our region, . . . there is a hint
of a different
attitude toward price increases” (Hoenig, Transcript, May
1999, p. 33)
In contrast, Governor Rivlin remained optimistic about the
prospects for non-inflationary growth ahead, opposing any adjustment in the FFR.
While Vice Chairman McDonough agreed that a rate hike was unwarranted, arguing
that “[s]uch a move would be taken as a knee-jerk reaction to the CPI number
regarding which all of us have some questions,” he did believe that the Fed
should adopt an asymmetric directive toward tightening in order to demonstrate
to markets that the Fed wasn’t asleep at the wheel (Transcript, May 1999, p.
58). Governor Rivlin opposed the announcement of a tilt, asserting, “I do not
see strong economic reasons for not waiting another month before making your
proposed change even though only a tilt is involved. After all, the only really
disturbing economic news is the core CPI for one month” (ibid., p. 59). Finally,
President Broaddus, who did not believe Vice Chairman McDonough’s recommendation
went far enough, argued that the Fed needed to “show the flag, get back in the
ballgame . . . and to do so more decisively than by just moving to a tilt”
(ibid., p. 60).
At the close of the meeting, Chairman Greenspan put the three
recommendations – stay the course, issue an asymmetric tilt toward tightening
but leave the FFR unchanged, or raise the FFR and issue an asymmetric tilt
toward tightening – before the Committee. In the end, the FOMC voted to maintain
the FFR at 4 ¾ percent but included the following statement in its directive:
[T]he Committee believes
that the prospective developments are more
likely to warrant an
increase than a decrease in the federal funds rate
operating objective during
the intermeeting period (Transcript, May,
And with that
the Fed initiated its first experiment with the asymmetric tilt.
3.D. Crying “Wolf!” Forces the Fed to
At its May
meeting, the Fed prepared markets for a rate hike that it never intended to
result in an inevitable move when it announced the bias toward tightening. But
the FOMC did end up raising the FFR in June, despite the fact that April’s jump
in the core CPI appeared to be a one-off event rather than an indication that
inflation had begun to accelerate. So why did the Fed act?
As the transcripts reveal, the Fed’s new instrument failed to
affect markets in the way the Fed anticipated:
I was startled by the
extraordinary market talk after we announced
an asymmetrical directive
following the May meeting. . . We might
as well have raised rates at
that point as far as I am concerned. . . .
Indeed, what we are looking
at is a long-term interest rate that is
moving up because market
participants think the Fed is going to move
June, p. 88).
markets were anticipating a rate hike, some saw the increase as preordained,
arguing that raising the federal funds rate was “largely a foregone conclusion”
(Boehne, Transcript, June, p. 44). Others, such as President McTeeter and Vice
Chairman McDonough believed that conditions did not merit an increase and that
the Fed should show restraint until such time as inflation appeared to
and markets everywhere are waiting for us to pounce
on growth and job creation
and stifle them. Since I do not believe we
should do that, I believe
that our challenge is to clarify out
strategy – first to
ourselves, then to the public and the markets. . . .
we should not be in a
tactical position of being constantly poised to
attack an enemy that does
not appear visible to me. We need to find
a way to tactical symmetry –
to a position where we, the public, and
the markets think we are
watchfully waiting but not looking for
knock down (McDonough, Transcript, June, p. 48).
some felt compelled to validate the market’s expectations in order to maintain
credibility, others believed that a rate hike was unwarranted in the absence of
troublesome news on the inflation front. After much deliberation, the FOMC felt
compelled to move, voting to raise the FFR 25 basis points at the close of its
To justify the June increase, members argued that despite a
drop in the core CPI, there were reasons to believe that inflationary pressures
were mounting. Some truly strange anecdotes were offered as “evidence” of these
pressures. For example, President Broaddus relayed the following story:
One of our
economists [from the First District] has a close friend who
has a house in
the Boston area. The friend got an estimate last year for
an addition to
his house but didn’t have the work done. He got an
just recently, a year later, and it’s up about 30 percent.
extraordinary!” (Transcript, June 1999, p. 40).
And President Minehan shared the
The job market
for summer teenage employment is strikingly good
if my 17-year
old and his friends are any indication of that market”
June 1999, p. 37).
No one offered
any tangible evidence of pipeline inflation. Yet the majority – many of whom
felt ‘boxed in’ by the May directive – clearly wanted to raise the FFR.
Ultimately, they justified their move for the record by offering anecdotal
evidence and impassioned commentary about the importance of credibility and the
need to fulfill market expectations.
When the Committee reconvened in August, it was presented with a Greenbook
analysis that forecasted heightened inflation risks and recommended further
increases in the fed funds rate. As its authors noted, the recommendation seemed
counterintuitive, given that “real GDP growth was surprisingly weak in the
second quarter, and the core CPI increased only a tenth-and-a-half per month on
average in June and July” (Transcript, August 1999, p. 36).
President McTeeter was opposed to a further rate increase, noting that “[w]ith
inflation low and with the economy strong, I am concerned that any tightening
today would be interpreted as a vote against prosperity (McTeeter, Transcript,
August, p. 61). When Chairman Greenspan began his remarks to the Committee, it
appeared as though he, too, was making a case against a further increase
in the FFR:
I agree with the Vice Chair
in that I believe we have arrived at price
any measure we can employ . . . we don’t have any real
inflation has risen (Transcript, August, pp. 74-76).
But he went on to argue for an
additional increase of 25 basis points:
The truth of the matter is
that we have a very strong economy with
very marginal indications of
any slowing. But the question that is
still up in the air is
whether, in fact, it is an overheating economy.
An important element of
that, obviously, is what is going on in the
supply and demand for labor.
There is no question that the pool of
people seeking jobs is
continuing to erode. . . My bottom line is that
I think we have
to tighten by 25 basis points. (ibid., p. 77)
McDonough was the first to support Chairman Greenspan’s recommendation,
Since I believe that we are
enjoying price stability and since I believe
very firmly in the rather
brilliant analysis that you have just presented,
one might ask: Why are we
tightening at all? In my view, the reason is
that the domestic economy
can certainly bear it.
also spoke out in favor of the increase, suggesting, “the market expects it and
not to move at this point would confuse the market” (Transcript, August, p. 80).
Thus, despite the fact that the Chairman and Vice Chairman of the Fed agreed
that price stability had already been achieved, the FOMC voted 9-to-1 in
favor of a 25 basis point increase in the FFR.
Fed resisted the temptation to raise rates at its October meeting, in part due
to the strongly-worded remarks offered by Vice Chairman McDonough. Since an
admonishment of this sort is rare, it is worth quoting at length:
It seems to me that some
people look at the current situation and say:
We are experiencing the
soon-to-be longest economic expansion ever,
we have a 4.2 percent
unemployment rate, we have the unemployable
being employed, and isn’t
that terrible! I don’t think its terrible at all.
I think it’s great and
wonderful, especially if we remember that our
goal in monetary policy is
to promote sustainable economic growth
and that the tool we are
supposed to use is price stability. With a year-
over-year rate of 1.9
percent in the core CPI at the end of August, I
think we surely have price
models of all the Reserve Banks and of the
Board’s staff have been
consistently wrong in that they have forecast
inflation increases. The
same models predict that there will be inflation
increases in the future. . .
Perhaps we should realize that these forecasts
. . . are likely to stay
wrong and that, therefore, the inflation we are
concerned about is rather
like Don Quixote’s windmills – a fiction of
our own minds.
We’ve also been
very worried about tight labor markets and yet
tight labor markets have not
in fact been resulting in inflation, even
though we continue to worry
about them. . . If we continue to talk
labor markets as if that is a truly evil phenomenon, we
are going to
convince the American people that what we believe in
is not price
stability, which is for the good of everybody, but a
in income distribution that goes against the working
. . . In my view we should declare victory on what has been a
very good piece
of work and stop worrying ourselves into believing
that we have to
stand in the way of something that I think is very positive (McDonough,
Transcript, August, pp. 35-36).
Fed left the FFR unchanged in October, it raised rates another 25 basis points
at the conclusion of its November meeting, arguing that a final increase was
necessary before the end of the year.
sum, the FOMC went from playing a highly inactive role – it moved the FFR just
five times from January 1995 through November 1998 – to playing a highly active
role – announcing an asymmetric tilt toward tightening in May 1999 and then
raising the FFR three times before the end of 1999. The Fed announced the ‘tilt’
on the heels of the jump in the April core CPI figure, but it never intended to
prepare markets for a series of imminent policy actions. And yet it became clear
that markets interpreted the ‘tilt’ in this way, betting that the Fed was
preparing to embark on a series of gradual rate hikes. Ultimately, the FOMC
fulfilled these expectations, even though virtually everyone on the Committee
agreed that price stability had been achieved by June.
Federal Reserve was posed with a unique dilemma in the late 1990s – one in which
growth was robust, the stock market was booming, unemployment was low and
inflation was nowhere to be found. The Fed struggled to make sense of the
changing economic environment and to fit what was happening in the U.S. into
some kind of theoretical framework. It had long given up any attempt to control
monetary aggregates and was using the overnight lending rate as its primary
means of managing the economy. But the Fed wasn’t convinced that tighter labor
markets and sharp increases in aggregate demand necessitated an increase in the
FFR, as recommended by conventional theory (e.g. the Taylor rule). Instead, the
FOMC decided that the U.S. was experiencing a technology-driven productivity
boom that was allowing that economy to grow faster than anyone thought possible
without setting off inflation. The rules of the game appeared to be changing,
and the Fed responded by changing some rules of its own.
changes were designed to align policy with the new reality, but they were also
intended to make the Fed’s actions and intentions more transparent to markets.
The Fed began announcing its precise FFR target and also announcing any policy
shifts at FOMC meetings immediately upon changing their bias regarding future
rate moves. The Fed also changed its philosophy regarding the use of preemptive
rate adjustments, moving the FFR just five times in forty-six months (January
1995 – October 1998).
In May 1999, the Fed resisted a rate hike but issued a policy
tilt toward tightening when a jump in April’s core CPI shook its confidence in
the ‘new economy.’ Markets reacted strongly to the announcement, believing that
the Fed was preparing them for a series of gradual rate hikes. When the
subsequent months’ CPI figures showed no sign of an upward shift in the
inflation trend, many members of the FOMC spoke out against the need for an
actual increase in the FFR. But a majority of its members argued that the Fed
needed act in order to validate market expectations, and the FOMC voted to raise
the FFR three times during the last half of 1999. The transcripts of the FOMC
meetings reveal a strong deference to the will of its Chairman, who oversees the
fairly ad-hoc process of prescribing policy under a dual mandate without formal
rule(s) to constrain its actions.
Arestis, Philip and Malcolm Sawyer.
2003. “On the Effectiveness of Monetary Policy
and Fiscal Policy.” Working
Paper No. 369, Levy Economics Institute of Bard
Arestis, Philip and John McCombie. 2005.
“Is Federal Reserve Policy Working?”
Challenge, March-April, Vol.
48, No. 2, pp. 48-66.
Clarida, R., J. Gali and M. Gertler.
1999. “The Science of Monetary Policy: A New
Journal of Economic Literature, Vol. 37, No. 4, pp.
Dalziel, Paul. 2002. “The Triumph of
Keynes: What now for Monetary Policy
Journal of Post Keynesian Economics, Vol. 24, No. 4, pp. 511-
Fontana, Giuseppe and Alfonso
Palacio-Vera. 2003. “Is There an Active Role for
Monetary Policy in the
Endogenous Money Approach?” Journal of Economic
Vol. 37, No. 2, pp. 511-XXX
Greenspan, A. 2001. “Transparency in
Monetary Policy.” Remarks by Chairman A.
Greenspan, October 11.
Lawlor, Michael S. 2000. “Modern
Macroeconomics: Theory, Policy and Events.”
Journal of Post Keynesian
Economics, Vol. 22, No. 4, pp. XX-XX.
LeHeron, Edwin and Emmanuel Carre. 2004.
“Credibility Versus Confidence in
Meyer, Laurence H. 2001. Remarks before
the National Association of Business
Seminar on Monetary Policy and the Markets, Washington, D.C.,
Mosler, Warren. 2004. “Channel Surfing
with the Fed.” http:///www.mosler.org
Svensson, L.E.O. 1999. “Inflation
Targeting as a Monetary Policy Rule.” Journal of
Monetary Economics, Vol. 43,
No. 2, pp. 607-654.
Taylor, John B. 1993. “Discretion versus
Policy Rules in Practice.” Carnegie-
Rochester Conference on
Public Policy 39, pp. 195-214. North-Holland:
Science Publishers B.V.
Thornton, Daniel L. and David C.
Wheelock. 2000. “A History of the Asymmetric Policy
September/October, Federal Reserve Bank of St. Louis, pp. 1-16.
Transcript of Federal Open Market
Committee Meeting of February 2-3, 1999.
Transcript of Federal Open Market
Committee Meeting of March 30, 1999.
Transcript of Federal Open Market
Committee Meeting of May 18, 1999.
Transcript of Federal Open Market
Committee Meeting of June 29-30, 1999.
Weller, Christian E. 2002. “What Drives
the Fed to Act?” Journal of Post Keynesian
Vol. 24, No. 3, pp. 391-417.
Wray, L. Randall. 2004. “The Fed and the
New Monetary Consensus: The Case for Rate
Two.” Public Policy Brief, Highlights, No. 80A. The Levy Economics
Bard College. www.levy.org.
central banks – e.g. the Bank of Canada, the Bank of England and the ECB
– have hierarchical mandates, which single out price stability as the
principal objective and allow other objectives to be pursued only once
price stability has been achieved. Many countries pursue price stability
through a framework characterized as inflation targeting (IT). See
Fontanta and Palacio-Vera (2002) or Le Heron and Carre (2004) for more
on the (IT) framework.
Fed releases these transcripts with a five-year lag.
(2004) argues that the Fed implemented at least one of these changes in
response to pressure by legislators – especially from Representative
Henry Gonzalez – who thought the Fed’s operations had become too
FOMC, the Federal Reserve System’s (FRS) principal monetary
policy-making body, consists of the seven members of the Board of
Governors of the FRS and all twelve Federal Reserve Bank (FRB)
presidents. The chairman of the Fed serves as chairman of the FOMC, and
the president of the New York Fed serves as its vice chairman. The vice
chairman is a permanent voting member, while the voting rights of the
other Bank presidents rotate among them on a fixed schedule – only four
of the remaining 11 Bank presidents have voting status at any time.
Fed insists on delaying the release of these transcripts for five years
so that it is not possible to discern, for example, exactly how the FOMC
arrived at its most recent policy decision(s). The Fed insists that the
lagged release is necessary to prevent markets from overreacting to any
particular line of discussion, thereby interfering with current policy
 In the
fall of 1998, the Fed established a pattern of adjusting rates during
the intermeeting period (i.e. the period between regularly scheduled
meetings of the FOMC). When the Committee adopted the “bias” language in
1999, the objective was to convey to markets the relative chance
of rate change during the forthcoming intermeeting period.
 In the United States, the
legislature defines no precise target for inflation or (un)employment.
This gives the Fed greater flexibility than banks that operate under a
sole mandate (e.g. the Bank of England and the Bank of Japan) with a
precise inflation target, but it also complicates the policymakers’ job
because multiple objectives often carry trade-offs, particularly in the
output gap measures the difference between potential GDP and actual GDP.
The output gap is often considered a proxy for the degree of ‘slack’ in
 According to Dalziel, “central
banks around the world are self-consciously engaged in aggregate demand
fine-tuning to a degree that was previously unimaginable, even during
the golden age of Keynesian macroeconomics in the 1950s and 1960s”
(2002, p. 519).
Fed believes that a negative real rate (i.e. the FFR minus the core CPI)
is always accommodative, though it offers no precise definition for the
‘neutral’ rate of interest, arguing that it varies across time and
 One critic of the Fed’s
‘neutral rate’ strategy recently quipped, “[t]he Fed offers as
justification for rate hikes an unknown neutral rate that is supposedly
above the FFR, along with the promise that once the FFR gets to the
neutral rate, the Fed will be able to recognize this achievement. Can
policymaking become more convoluted than that?” (Wray, 2004, p. 3).
more on the use of the asymmetric directive, see Thornton and Wheelock
 The Fed used its new
instrument twice in 1999 and, each time, markets overreacted to the
announcement of a change in the “bias,” causing long-term interest rates
to move up in anticipation of an imminent Fed move. Confused and
frustrated by the market’s reactions, the Fed changed its announcement
procedure in January 2000, extending its time horizon and offering a
slightly more ambiguous assessment of “the balance of risks” with
respect to the attainment of its dual mandate. With this change, the Fed
hoped to retain the image of transparency without causing markets to
overreact by attaching a high degree of immediacy and certainty to
Taylor (1993) argued that the interest rate reaction function yielded
better results when some weight was attached to real output (i.e. when a
pure price rule was not followed).
Dalziel (2002) uses UK data to argue against the use of the “output gap”
in predicting inflationary pressures.
 Governor Meyer, for example,
said, “I pay a lot of attention to the policy prescriptions from the
Taylor rule . . . So, I ask myself: How have we ended up departing so
aggressively from the Taylor rule prescriptions?” (Transcript, February
2-3, p. 65).
 Governor Meyer has suggested
an “incremental asymmetric Taylor rule,” which would call for an
increase in the FFR when unemployment fell below the NAIRU but held off
on reducing the FFR in the face of modest increases in the unemployment
rate (Transcript, February 1999, p. 66). Similarly, he proposed that the
Fed respond to increases in the core CPI with “more than proportionate
increases in the nominal funds rate,” while modest reductions in
inflation should be passively accepted (ibid.).
 President Broaddus voiced
concerns about the rigidity of the Taylor rule, since it requires the
Fed to move the funds rate only in response to the emergence of
an inflation gap or an output gap. In the absence of such gaps, it
requires the Fed to show restraint – a requirement that does not appeal
to the more activist members of the Committee, who believe that the
Committee’s “main policy successes in the 1980s and 1990s have come when
we have acted more preemptively” (Broaddus, June 29-30, p. 99).
FOMC made three moves in 1998, cutting the FFR by 25 basis points in
September, October and November. After the November move, the FFR stood
at 4 ¾ percent.
was also the central question in March, when the Committee again faced
unexpected strength in output and weakness in inflation.
Fed was particularly interested in discovering why, in an environment in
which labor markets were considered exceedingly tight, wage increases
had actually decelerated.
kind of “evidence” is truly dumbfounding, as anyone who has ever
solicited bids for construction or repair work knows. Indeed, this kind
of variation is common when even when several contractors are bidding
the same job on the same day!
 This is an on-going problem
for the Fed, which “now realizes that adoption of transparency and
gradualism means that it surrenders a degree of discretion to market
expectations. Policymakers must continually take the pulse of the market
to ensure that these expectations are not disappointed” (Wray, 2004, 4).
Greenbook contains the staffs' summary of recent economic information, a
baseline economic forecast and scenarios based on possible alternative