Speech

The Critical Role of Economic Education in the Conduct of Monetary Policy HawaiiCouncilonEconomicEducationAnnualMeeting Honolulu,Hawaii April25,2000 Iam delighted to be here today to speak true.Mysecondsubjectwillbethatwemustkeep before the Hawaii Council on Economic ourfocusonthelongrun.JohnMaynardKeynes Education. I have spent most of my life isoftenquotedtotheeffectthatinthelongrun in higher education and now, as a policy wearealldead,butthatisaterriblymisleading official in the Federal Reserve System, I am still thingtosay.Ifwedonotlookatthelong-run intimately involved in education issues. My consequencesofpolicyactions,weareboundto audiences may be different, but the issues are getourselvesintoalotoftrouble. thesame.Imustsay,however,thatitisconsider- Thirdly,I’llemphasizethatpricestability,or ablyeasiertospeaktoyoutodaythantofreshmen lowandstableinflation,isafarmoreimportant at nine in the morning. goalthanmanymaythink.Whenthepricelevelis Iwillproceedbydiscussing,first,whyevery- stableforanextendedperiod,peopletendtotake oneneedstounderstandthebasicsofmonetary pricestabilityforgrantedandfailtounderstand thatmanyothergoodfeaturesoftheeconomy policy.Lotsofpeople,especiallyyoungpeople, dependcriticallyonitscontinuedmaintenance. seemtobelievethatthosepeskysupplyand Bythesametoken,whentheeconomysuffers demanddiagramsaretoodifficultanduninterestfrompriceinstability,manythingsgowrongthat ingtobeworthspendingmuchtimeon.Most shouldbe,butoftenarenotappreciatedtobe, people,though,eventuallyfindthattheycannot linkedtothelossofpricestability. escapeknowingsomethingaboutmortgageinterest Beforeproceeding,Iwanttoemphasizethat ratesandothermundanemattersthatturnoutto theviewsIexpressherearemineanddonot besoterriblyimportantfortheireconomicwelfare. necessarilyreflectofficialpositionsoftheFederal Speakingintheabstractabouttheimportance ReserveSystem.Ithankmycolleaguesatthe ofunderstandingmonetarypolicytakesusonly FederalReserveBankofSt.Louisfortheircomsofar,however.Togettotherealmeatofthearguments,butIretainfullcreditforerrors. mentrequiresthatweentangleourselvesinalive issueortwo,andspendenoughtimeontheissue tounderstandwhyeveryoneoughttoknowsome- SOME BACKGROUND ON FED thingaboutit.Forthisreason,I’lltacklethree POLICY PROCEDURES issuesthatstrikemeasparticularlyrelevantin today’seconomy.ThefirstissueisthattheFederal Beforediggingintothesubstanceofpolicy,I Reservereallyhasonlyonepolicyinstrument, needtobesurewe’reonthesamewavelengthin orpolicylever.Ifthereisonlyoneinstrument, ourunderstandingofFedpolicyprocedures. thentherecanbe,orshouldbe,onlyonepolicy ThekeyinterestrateforFedpolicyisthefederal goal.I’llexplainwhybothofthesestatements— fundsrate.Thefundsrate,tousemarketlingo,is thattheFedhasonlyonepolicyinstrumentand simplytheinterestratebankschargeeachotheron thatoneinstrumentrequiresonlyonegoal—are loansofthefundstheyholdinreserveaccounts 1

ECONOMICEDUCATION atFederalReserveBanks.Commercialbanksand WHY EVERYONE NEEDS TO otherdepositoryinstitutionsmaintainthese UNDERSTAND MONETARY reservesondepositattheFedinordertomeet POLICY BASICS theirrequiredreservesandtomakepaymentsas checksclearthebankingsystem.Depositoryinsti- Businessenterprisesoftenborrowlarge tutions—or“banks”asIwillcallthemfromnow amountsoffunds,andsotheprobabledirection on—sometimeshavesurplusfundsthattheylend ofinterestratesandthemonetarypolicyconsidouttootherbanksthathaveadeficiencyoffunds. erationsbehindfutureinterestratesareofdirect Theseloansaretypicallyforonedayatatime,or andimmediateinteresttoeverycorporation. “overnight”inmarketparlance.TheFederalOpen Everyfirmmustalsobeconcernedaboutfuture MarketCommittee(FOMC)conductsmonetary wageandpricedevelopments,whichmeansthat policybydetermininganintended,ortarget, anunderstandingoftheFed’sobjectiveofprice interestrateforfederalfunds.Attheendofeach stabilityanditssuccessinachievingthatobjective ofitsmeetings,theFOMCdirectstheFed’sOperat- isimportantforbusinessmanagers. ingDeskattheFederalReserveBankofNew Eachofusasamemberofaconsuminghouse- Yorktomaintainthefederalfundsratenearits holdalsoneedstounderstandthebasicsofmoneintendedlevel.TheDeskachievesthisobjective tarypolicy.Fromtimetotime,almostevery byplacingadditionalfundsinthemarketwhen householdisfacedwithadecisionaboutpurchasthefundsratethreatenstoexceedtheintended ingahouseandmustunderstandthebasicsof rate,orwithdrawingfundsfromthemarketwhen mortgagefinance.Thesebasicstodayrequiresome therateisfallingshortoftheintendedlevel. knowledgeoftherelativeadvantagesanddisadvan- Marketparticipantsspendalotoftimeformtagesoffixed-rateandadjustable-ratemortgages. ingexpectationsaboutthelikelycourseofthe Tounderstandtheconsequencesofchoosingone federalfundsrateinthefuture.Therateona1ofthesealternativesovertheother,households weekTreasurybill,forexample,reflectsthemarneedtoknowsomethingaboutthebasicsofmoneket’sbestguessastotheaverageforthefederal tarypolicyandthelikelysuccessoftheFederal fundsrateoverthenextsevendays.Theinterest Reserveinkeepinginflationlowonasustained rateona1-monthobligationreflectsexpectations basis.Inaddition,householdsneedtounderstand aboutthe1-weekrateforthenext4weeks,and whytheFedisdoingwhatitisdoingsothat the1-yearratereflectsexpectationsoverthenext familyfinancialdecisionswillnotbemadeon 52weeks.Continuingthislineofargument,the thebasisofmisinformationaboutmonetarypolicy. 30-yearbondratereflectsexpectationsaboutthe Finally,justasbusinessesneedtoknowsomenext30one-yearrates. thingaboutprices,becausebusinessesbuyand Thispicture,ofcourse,iscomplicatedby sellgoods,andaboutwages,becausebusinesses interestdifferentialsofvariouskinds,butforour hirelabor,soalsohouseholdsmustknowsomepurposesthebigpictureiswhatweneed.Let’s thingaboutthesesameissues.Households,after focusontwokeyelements:First,theFOMCsets all,areontheoppositesideoftheseeconomic theovernightrate,whichquitenaturallyhasa transactionsfrombusinesses.Householdspay significantinfluenceovershort-termrates.Second, thepricesthatbusinesseschargeandreceivethe longer-termratesdependonthemarkets’underwagesthatbusinessespay. standingthedirectionofmonetarypolicyandall oftheeconomicforcesthatinteracttoyieldthat long-rundirection.Thus,averyimportantrespon- THREE ILLUSTRATIVE ISSUES sibilityfortheFOMCistocommunicateasclearly THAT REALLY MATTER aspossiblethelonger-rundirectionofmonetary policyandtheconsiderationsthatunderliepolicy Theimportanceofunderstandingmonetary decisions. policybasicsreallycomesalivewhenwecon- 2

TheCriticalRoleofEconomicEducationintheConductofMonetaryPolicy sidersomeexamples.I’veselectedthreespecific primarymissionofachievingpricestabilityto examplesthataresimpleandeasytoexplainand bedeflectedbyattemptingtopursueothergoals. yetextremelyimportant. TheissueIwanttoemphasizeisnotthat othergoalsareunimportant.Allofuswantthe One Policy Instrument Means One unemploymentratetosettleataslowalevelas Policy Goal possible,andwewantthestockmarkettobe pricedcorrectly,andwewanttheforeignexchange I’llstartthistopicbymakingastatementthat ratetosettleatanappropriatelevel.ButtheFed soundstechnicalandcomplicated,butreallyisn’t: simplydoesnothavepolicyinstrumentstoachieve Inengineeringcontroltheory,weknowthatto allofthesegoalsandmustinsteadconcentrate achieveNgoalsrequiresatleastNinstruments. onthegoalthatisitsdirectresponsibility.To Forexample,ifwehavethreegoalslikecontrolrepeat,thatgoalismaintaininglowandstable linganairplane’sspeed,altitudeanddirection, inflation. theplanemusthaveatleastthreecontrolinstru- Nowthisbasicviewcanandshouldbemodiments.Thethrottleinstrumentcontrolsspeed, fiedjustabit.ItispossiblefortheFedfromtime therudderincombinationwithsomeothersurtotimetoadjustmonetarypolicytocounterprobfacescontrolsdirection,andtheelevatorsonthe lemsinachievingothergoals,butonlytothe horizontalstabilizercontroltheplane’saltitude extentthatsuchpolicyadjustmentsdonotdamage bydirectingitupordown. thelong-runcauseoflowandstableinflation.For Consideranothersimpleexample.Withtwo example,inthefallof1998,theFOMCreduced objectives,suchascontrollingacar’sspeedand theintendedfederalfundsratetorespondto direction,thedriverneedstwocontrolinstrufinancialdisturbancesthatarosefollowingthe ments—asteeringwheelandanaccelerator. Russianbonddefault.Easingmonetarypolicy Whatistherelevanceofallthisformonetary temporarilydidassisttheeconomyinworking policy?TheFederalReservehasonlyonemain throughthesefinancialdisturbances,withouta policyinstrumentatitsdisposal.Thatinstrument long-runconsequenceforthegoaloflowand istherateofcreationofmoney,ormoregenerally, liquidity.TheFedexercisescontrolovermoney stableinflation.Byrespondingtothedisturbance, creationonaday-by-daybasisbyadjustingthe theFedwasabletokeepthoseproblemsfrom intendedfederalfundsrate.Withonlyonepolicy havinganimpactonemploymentandeconomic instrument,theFedcanpursuesuccessfullyonly activity.Theprincipleinvolvedhereiswellunderonepolicygoal.Thatgoalislowandstableinfla- stoodincontroltheory.Theapplicationofapartion,orpricestability,dependingontheexact ticularinstrumentmayhavesimultaneouseffects phraseused. onseveralgoals.Forexample,applyingmore ThissimplefactthattheFedhasonepolicy powertoanairplanewillincreaseitsrateofclimb. instrumentandmust,therefore,decidewhich Butthepointisthattofullyachievegoalsforboth singlegoalitwillpursueisoftremendousconse- altitudeandspeed,theaircraftmusthavemore quence.PeopleofteninsistthattheFedoughtto thanathrottle. pursueotherobjectives,suchasreducingthe Iinviteyoutokeepyoureyesandearsopen unemploymentrate,stabilizingtheforeign forexamplesofpeopleurgingtheFedtopursue exchangerate,ornudgingthestockmarketupor multipleobjectives.Isuspectthatyouwillfind down.TheFederalReservecannotinfactpursue manysuchexamplesandthatalittlethoughtwill multipleobjectivesandhopetoachievethemall. indicatejusthowuninformedthesepolicypro- Giventhatthemainconsequenceofexcessiveor posalsare.ItisimportantfortheFedtomaintain deficientliquiditycreationisinflationordeflation, itsfocusonwhatitcanreasonablyaccomplish, eitherofwhichcreatesawholehostofother andnottopermitotherissuestodeflectitfrom problems,theFederalReservemustnotallowits itsprincipalresponsibility. 3

ECONOMICEDUCATION It’s the Long Run That Matters Policymakersoftenfindthemselvesconfronted byapublicclamortodosomethinginresponse Oneofmyfavoriteformatsforastudentterm toashort-runproblem.Onoccasion,ashort-run paperwastoaskthestudenttoreviewaparticular policyresponsecanbeconstructive,aswasthe economicepisodebygoingbacktonewsmagacaseintheRussianbonddefaultin1998.But zinesandnewspapers.Askingastudenttoread moreoftentheappropriateadviceis,“Don’tjust thenewspapersforafewweeksoneithersideof dosomething,standthere!” thestockmarketcrashesof1929and1987,orover Oneargumentforkeepingpolicyonasteady, afewmonthsduringtherecessionof1982,ora evencourseisthatpolicyactionsinresponseto fewmonthsasinflationrosesharplystartingin short-rundisturbancesareseldomsuccessful.But thefallof1973,isanexcellentwaytogetthe theargumentisreallydeeperthanthat.Producstudenttodevelopasenseoftheseevents. tivitygrowthandjobcreationinamarketeconomy Economichistorianswritingaboutsuch aredrivenbythousandsuponthousandsofdeciepisodesdistillthedetailedrecordintothekey sionsintheprivatesector.Animportantresponeventsandpolicydecisions.Thejobofthehistosibilityofgovernment,includingtheFederal rian,ofcourse,istoputeventsintoalonger-run perspectivebyexaminingthekeymilestones, Reserve’sresponsibilityformonetarypolicy,is policydecisions,andcausalmechanisms.Butat tosetastableandpredictablecoursewithinwhich anygiventime,peoplegetcaughtupintheevents privatedecisionscanbemadeefficiently.Onthe ofthedayandfinditdifficulttoputtheseevents whole,householdsandfirms,interactingthrough intotheappropriateperspective. markets,domakeefficientdecisionsaboutprices AsIreflectonhoweventsunfold,Iamalways andquantitiesofgoodsandservices.Excessive struckbytheenormousamountofattentionpaid governmentactivismcaninterferewiththeeffitoinformationthatwill,tothehistorian,beat ciencyofthosedecisions. mostrandomnoise.Perhapsyouhavehadthe Ifyouhaveanydoubtsabouttheoverriding strangesensation,asIhavehadmoretimesthan importanceofthelongrun,trytothinkbackto Iliketoadmit,ofpickingupanewspaperand thedetailedeventsofayearortwoago.Ifyou afterreadingforafewminutesdevelopinga startreadingnewspapersseveralyearsold,you strangesensethatyoumusthavereadthispaper willfindyourmemoryrefreshedbutyouwillbe before.Ilookatthedate,anddiscoverthatI’ve impressedbyhowtrivialinthelightofsubsequent pickedupanewspaperseveralweeksold.I’ve developmentsmostofthoseday-to-dayevents alreadyreadthepaperandhavediscardedfrom were. memoryalmosteverysinglebitofinformationin it.Yet,alltoomanypolicypositionsaredriven Price Stability Is More Important Than bythetrivialinformationthathappenstohitthe You May Think headlines. TheultimategoalofFederalReservepolicy Thelongrunis,ofcourse,thesumofaseries ofshortruns.Oneyearisthesumof12months, istopromotemaximumsustainableeconomic andonedecadethesumof10years.Oureconomic growth.Weemphasizetheimportanceofprice well-beingdependsmostlyonaveragesovera stabilitybecausethatisthesinglemostimportant decade,andonlytoarelativelysmallextenton contributionthatmonetarypolicycanmake fluctuationsaroundthoseaverages.Policymakers towardachievingthedeeperobjectiveofmaxiusuallyprefertominimizefluctuationsaround mumsustainableeconomicgrowth.TheFederal thelong-runtrends,butthegovernment’spower Reservealsocontributestosociety’sgrowthgoals todosoisoftenverylimited.Thus,akeyobjective bysupervisingandregulatingbankstomaintain forpolicyistopreventshort-runfluctuations asoundbankingsystemandbyprovidingefficient fromaffectingpolicyinsuchawayastodrive paymentservicessuchascheckprocessingand theeconomyoffthedesiredlong-runtrack. electronicpaymentmechanisms. 4

TheCriticalRoleofEconomicEducationintheConductofMonetaryPolicy Withregardtomonetarypolicy,toofewpeople economyarerelatedtothepricestabilitythe seemtounderstandhowgreatlypricestability economyhasenjoyedinrecentyears.Pricestacontributestotheeconomy’sgeneralwelfare. bilityisanabstractgoalandisnotmuchworth Pricestabilitywillnotbyitselfguaranteesuccess, pursuingforitsownsake.Butsomanyaspects fortherearemanyothercooperatingconditions ofoureconomicwelfarearedirectlyandindirectly necessary.Butpriceinstabilitywithoutquestion connectedtopricestabilitythatitisimportant canguaranteesignificantproblemsinanyecon- nottounderestimatetheimportanceofachieving omy.Thepublicoftenattributestheseproblems thatgoal. tonon-monetaryconditionswhentheyinfact IsaidamomentagothatIwasnotgoingto stemfrommonetaryinstability. extendthelistofillsfrompriceinstability,and TheU.S.economytoday,andforthepast thevirtuesofpricestability,butIwillbreakthat severalyears,hasbeenenjoyingextraordinarily promisejustbrieflytocommentontheeconomics lowunemploymentandrapidjobgrowth.Ibelieve oftheeducationsector.Ourcurrentprosperity thatstablemonetaryconditionsyieldingalow hasgeneratedlargeamountsoftaxrevenueatall andstablerateofinflationandsolidexpectations levelsofgovernment.Theseresourcesareavailofcontinuingstabilityhaveplayedasubstantial ableforagreatvarietyofpublicresponsibilities, roleintheeconomy’ssuccessinthelabormarkets. includingeducation.Withuniversitybudgets U.S.inflationinthe1970scertainlycontributed growing,Iknowthattheuniversitydemandfor substantiallytotheemploymentvolatilityofthat economistsishigh;thatdemandmakesitdifficult period.Therecessionsof1973-75and1981-82 forustohiretheyoungeconomistsweneedfor werethemostseriousdownturnssincetheGreat ourstaffattheSt.LouisFed.Incontrast,during Depression,andthesedownturnsaroseonthe the1970s,manystatebudgetswereundersubbacksofacceleratinginflationandexpectational stantialpressurebecauserisingpriceswereouterrorscausedbyunanticipatedchangesinmone- runningtheavailabletaxrevenues.Someofyou mayrecalltheperiodsofstringencyduringthose tarypolicy.Today,despiteaneconomicexpansion years. ofrecordlength,weseenosignsthattheexpan- Moreover,therelativestabilityofwagesand sionisclosinginonoldage.Ifinflationgetsaway priceshasmadethejobofeducationalbudget fromtheFedtoanysignificantdegreeintheyears planningaloteasier.Allofusmayhavetoscramahead—andIampushingwitheveryboneinmy bletofindthetalentweneed,butwedoour bodytodowhatIcantomakesurethatcircumscramblingwithinanenvironmentinwhichwe stancedoesnotfaceus—thenthedangersof canreasonablyplanourbudgetoutlays.Theend recessionwillsurelyrise. resultisgreaterefficiencyinmatchingtalentand Monetaryinstabilityandinflationdamage resources.Clearly,also,withthejobmarketso stabilitynotonlyinthelabormarketbutalsoon strong,thereareampleemploymentopportunities ahostofotherfronts.Someofyoumayrecallthe forourstudentsastheyfinishtheirdegrees. difficultypeoplehadinbuyinghomeswhenmortgageratesaveragedmorethan15percentin1982. Duringmuchofthedecadeofthe1970s,falling CONCLUDING OBSERVATIONS stockandbondpricesdamagedincomesecurity forolderAmericans.Publicconcernoverinflation Bynow,I’msureyouhaveagoodideaofthe ledtotheunwisepoliticalresponseofwageand thrustofmythinking.Iwill,however,pointout pricecontrolsin1971,andthosecontrolscreated thatIhavediscussedtheseandothermonetary avastarrayofotherproblems. policyissuesthatreallymatteratgreaterlength Icouldextendthislisttogreatlength,butwill inanumberofspeechesoverthelasttwoyears notdoso.Mypointisthatmanyfeaturesofthe thatIhavebeenattheSt.LouisFed,andI’llput 1970swererelatedtotheinflationaryenviron- inaplugforourwebsitethatcontainsthose ment,andmanyfavorablefeaturesoftoday’s speeches. 5

ECONOMICEDUCATION Finally,then,letmecirclebacktomymain expectationthattheinterestratereceivedwillbe themeabouttheimportanceofpublicunderstand- higherinthefuture.Tomakethesedecisionsintelingofthesemonetarypolicyissuesforthejobof ligently,borrowersandlendersneedtoundertheFederalReserveSystem.Somepeoplemay standthebasicsofmonetarypolicy.Otherwise, taketheviewthatthepublicshouldsimplyput theywillmakemistakendecisionsthatwillultigoodpeopleinofficeandthenallowtheseexperts matelydamagetheeconomy’slong-rungrowth. todothejobrightwithoutfurtherpublicinter- Thus,inpursuingthegoalofmaximumsustainference.Ifthatviewwerecorrect,thentherewould ableeconomicgrowth,theFedmustbeconcerned benoneedforthepublictounderstandmuch withmuchmorethansettingtheintendedfederal aboutwhatwedo. fundsrateatthenextFOMCmeeting.Weneed Irejectthisviewfortworeasons.First,my todothebestjobwecaninconveyingtothe observationofAmericanpoliticstellsmethat,in marketthereasoningandoutlookformonetary avigorousdemocracy,peoplewillnotsitback policyandtheeconomymoregenerally.Wecanandlettheexpertsdotheirownthing.Infact,I not,ofcourse,forecasttheunforecastable,but thinkthevotersarerighttopayattentiontowhat wecanmakeclearourconvictionthatmaintaining wedo,forexpertsinpowerdonotalwaysmake lowandstableinflationisourprimaryresponsitheproperdecisions.Whereveryoucomeouton bility.Wecanalsoprovideasenseofhowwego thisissue,thefactisthatvotersdonotignorewhat aboutrespondingtoandanalyzingtheflowof wedo,andthereforeitisintheinterestofthe incominginformation. nationthatvotersunderstandwhatgoodpolicy Lookingatthisargumentfromabusiness isallabout.Otherwise,theyandtheirrepresenta- perspective,weknowthatefficientbusiness tivesmaydemandtheFederalReservetomovein managementrequiresfirmstomakecorrectdecidirectionsthatwillnotturnouttobeconstructive. sionsinhiringlabor,buildingplantandequip- ThereisanotherreasonfortheFederalReserve ment,designingandpricinggoodsandservices, tobeconcernedaboutpublicunderstandingof andsoforth.Thesedecisionsincludeefficient monetarypolicyissues.Inmybriefdescription financialdecisions.Andthosedecisionsinturn ofmonetarypolicyatthebeginningofthisspeech, requiresomeknowledgeofmonetarypolicyissues. IpointedoutthattheFeddirectlysetsanintended I’msurethatmostofyouinthisaudienceare ratefortheovernightfederalfundsratewhilethe convincedoftheimportanceofeconomicedumarketsetslonger-terminterestratesonthebasis cation.Weneedtoconvincethosewhoteach ofexpectationsaboutthefuture.Howcanthe English,foreignlanguages,history,andother marketsetthe10-yearbondrateorthe20-year non-economicssubjectsthatatleastatasteof mortgageratewithoutknowingsomethingabout economicsisgoodforeverystudent.Everyone monetarypolicy?Theinteractionofborrowers needstounderstandthebasicstomakesound andlendersinthemarketplacedeterminesthose decisionsinhouseholdfinancialmanagement. longer-termrates.Mortgageborrowers,forexam- Understandingthebasicsofmonetarypolicy ple,needtomakejudgmentsaboutwhetherthe willpaydividends,bothforindividualsasciticurrentrateislikelytoreflectagoodbuyor zensandforthemasmembersofhouseholds whetherthemortgageratemightbelowerinthe andintheircapacityasproductiveemployees comingmonths.Similarly,lendersneedtodecide ofbusinesses. whentolendandwhentohangontofundsinthe 6