In his speech on May 20, 2004, a Fed Governor, Ben Bernanke, argued in favor of a gradual approach to interest rate policy settings. According to Bernanke, because policy makers do not have precise knowledge of how the economy will respond to a given change in interest rates it is logical that policy makers should proceed cautiously.
In other words, inadequate knowledge regarding how the economy works makes it appropriate for policy makers to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions.
Furthermore, Bernanke holds that the gradual approach allows central bank policy makers to have greater influence over long-term interest rates. This in turn permits the Fed to have more direct influence over the future course of the economy. In other words, he holds that long-term interest rates are driven by the expectations of financial markets participants about the likely future course of short-term interest rates, which are in turn closely linked to expectations regarding the federal funds rate.
Consequently, according to Bernanke,
In a gradualist regime, an increase in the federal funds rate not only raises current short-term rates but also signals to the market that rates are likely to continue to rise for some time. Because they reflect the whole path of expected future short-term rates, under a gradualist regime long-term rates such as mortgage rates tend to be relatively sensitive to changes in the federal funds rate. Thus, gradualism helps to ensure that the FOMC will have an effective lever over economic activity and inflation.1
It would seem, therefore, that the formula for making the economy healthy is to make the central bank’s policies transparent and predictable. According to Governor Bernanke, it would appear that transparent policies are good for the health of the economy because this doesn’t disrupt the fluctuations of relative prices of goods and services. Consequently it is held that this allows the economy to move along the path of stable economic growth.
Although Bernanke believes in a market economy, he doesn’t trust the notion that the economy can look after itself. There are always various shocks that can throw it off the stable growth path and pose a threat to the economy’s well being. He believes that it is the role of the central bank to put the economy back on the right path because without the Fed’s intervention the economy could even fall into a black hole.
Thus if the economy falls below the path of stable economic growth it is the role of the Fed to put it back on this path by means of monetary pumping and the lowering of interest rates. If, however, the economy exceeds the stable growth path the central bank must push the economy back onto the path by slowing monetary pumping and lifting interest rates.
In order to enable the Fed’s policy makers to guard the economy against various shocks, economists have devised various formulas for the efficient conduct of monetary policy.
One of the most highly regarded formulations as to how policy makers should conduct their policies was devised by John Taylor2 , currently the under secretary of the Treasury and a former Stanford professor of economics. According to Taylor’s formulation, also known as the Taylor rule, the Federal Funds rate should be increased or decreased in response to changes in real GDP and inflation. Thus if real GDP rises above the potential GDP by one percent the Federal Funds rate should be raised by 0.5 percent. If inflation rises by one percent above its target of 2 percent, then the Federal Funds rate should be raised by 0.5 percent. Hence
R=P+0.5*Y+0.5*(P-2)+2
Where
R is the federal funds rate
P is the yearly rate of growth in price inflation
Y is the percent deviation of real GDP from its potential
This rule supposedly allows policy makers to navigate the economy onto the stable growth path, which is reached once real GDP is equal to potential GDP and inflation is equal to its target of 2 percent. The Federal Funds rate, within these conditions, according to Taylor should be at 4 percent. In short, the 4 percent Federal Funds rate becomes neutral once the economy is on the growth path of stability since it neither stimulates nor holds back economic growth.
Now, observe that this formula is a framework for manipulating the entire economy, i.e., to target the pace of economic growth and the pace of price inflation. Also, note that the target for inflation is set at 2 percent. Why is that so? It is held that 2 percent inflation is a good thing since it provides a buffer that prevents the economy from falling into a deflationary black hole.
The fact that the Taylor rule accurately depicts movements in the Federal Funds rate is the manifestation of the interventionist mindset of the Fed.
By influencing financial markets players’ expectations through transparent policies, the Fed presents itself as a market servant. The Fed, it would appear, only validates what the market has already decided. Thus the rise in long-term interest rates runs ahead of the Federal Funds rate, i.e., the Fed is always seen as being behind the curve—it does what the market has decided. Hence the Fed, i.e., Greenspan, is simply exercising the market’s wishes, or so it would appear to be the case.
Has transparency produced more real economic growth?
In comparison to previous Federal Reserve regimes it seems that Alan Greenspan’s Fed is the most transparent. Thus our examination of the data shows that it is only during the reign of Alan Greenspan that market players were able to correctly anticipate the Fed’s monetary policies.
Our analysis shows that during the period September 1987 to present on average the yield on the 10 year T-Note has led the Federal Funds rate by 3 months (see chart). No lead, however, was found during the reigns of previous Fed chairmen Arthur Burns and Paul Volcker.
Has the greater transparency made economic growth stronger? A conventional way of thinking would suggest that all that is required in order to answer this question is to compare average real economic growth in terms of real GDP during various Fed regimes.
Average real GDP rate of growth
A.Burns 70.Q1-78.Q1 | P.Volcker 79.Q3 - 87.Q2 | A.Greenspan 87.Q3 - |
3% | 2.8% | 3.1% |
According to the table, Greenspan’s transparent Fed policies did not create better economic growth in terms of real GDP in comparison with the Burns and Volcker regimes. In short, the fact that market players can anticipate the Fed’s actions doesn’t mean that more economic growth will emerge as a result.
Furthermore, one would expect that transparent policies would lead to more stable economic growth and would not cause severe fluctuations, i.e., boom-bust cycles. Examinations of trend-adjusted real GDP doesn’t support this either. Sharp fluctuations in economic activity also remained intact during Greenspan’s transparent regime (see chart).
Why any policy of intervention can only make things much worse
The entire idea that policies of intervention can somehow bring the economy onto a path of stability is untenable. A policy of intervention always benefits some individuals at the expense of other individuals. It always leads to a redistribution of real wealth and weakens the process of wealth formation. The fact that individuals can correctly anticipate the future course of the monetary policy of the Fed cannot undo the damage that such future policies will inflict on the economy.
When new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients, with more money at their disposal, can now acquire a greater amount of goods while the prices of these goods are still unchanged. As money starts to move around, the prices of goods begin to rise. Consequently a late receiver benefits to a lesser extent from monetary injections, or may even find that most prices have risen so much that they can now afford less goods. In short, increases in money supply lead to a redistribution of real wealth from later recipients, or nonrecipients of money to the earlier recipients.
Likewise once new money is injected, irrespective of whether it was expected or not, it will set in motion the diversion of real resources from wealth generating activities to activities that sprang up on the back of newly pumped money (the first recipients of money). This monetary pumping, which is associated with the lowering of interest rates, sets in motion the so-called economic boom.
Now, whenever the Fed reverses the loose stance by slowing down monetary pumping and lifting interest rates it arrests the diversion of real resources and weakens various activities that emerged on account of the previous loose monetary policy, i.e., an economic bust ensues.
Pursuing more transparent and predictable monetary pumping cannot stop the damage that this pumping inflicts on the last recipients of money and on the process of wealth generation. What matters here is not expectations but rather real actions. Hence the only way to avoid the damage is to stop monetary pumping altogether and the resulting manipulation of interest rates.
Furthermore, to present the economy as some kind of object that follows a growth path is an absurdity. The so-called economy is just a metaphor—in reality there is no such thing as an ‘economy,’ there are only various individuals who are producing various goods and services and exchanging with each other. There are no means or ways available to measure and quantify the totality of these activities since various heterogeneous goods cannot be added up into a meaningful total. So if we cannot tell what the total product is obviously there is no way or means to know what the so-called economy is doing. Consequently, any policy which attempts to navigate the imaginary “economy” only disrupts the process of wealth generation and undermines the well being of individuals.
- 1Remarks by Governor Ben S. Bernanke at an economics luncheon co-sponsored by the Federal Reserve Bank of San Francisco and the University of Washington, Seattle, Washington, May 20, 2004.
- 2John B. Taylor Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference on Public Policy 39 (1993) pp. 195–214 North-Holland
