Speech

Milton and Money Stock Control MiltonFriedmanLuncheon Co-sponsoredbytheDepartmentofEconomics,UniversityofMissouri, theEconomicandPolicyAnalysisResearchCenter,andtheShow-MeInstitute UniversityofMissouri–Columbia Columbia,Missouri July31,2007 We are here today on Milton Beforeproceeding,Iwanttoemphasizethat Friedman’s birthday to remember theviewsIexpressherearemineanddonot him and his enormous contribu- necessarilyreflectofficialpositionsoftheFederal tions. Those of us who studied ReserveSystem.Ithankmycolleaguesatthe under him are extraordinarily fortunate. Most of FederalReserveBankofSt.Louisfortheircomus were able to maintain contact with him for ments,butIretainfullresponsibilityforerrors. the years between our studies and his death. IfMiltonwereheretodaythereisnothinghe wouldenjoymorethanalivelyseminaronsome THE CASE FOR MONEY STOCK aspectofeconomics.AlivelyseminariswhatI CONTROL intendtooffer.I’mprettysurethatwhatI’mgoing Asacard-carryingmonetarist,Iarguedthe tosaywouldhaveprovokedhimandthatIwould steadymoneygrowthcasevigorouslyinyears havelearnedalotfromhearinghimcommenton past,anditisstillmyconvictionthatacentral myanalysis. bankignoresmoneygrowthatitsperil.Milton OfthemonetaryeconomicsbattlesMilton andhisco-authors,especiallyAnnaSchwartz, foughtinthe1960sand1970s,hispolicyprescripprovidedampleevidencethatvariationsinmoney tionforsteadymoneygrowthatalowrateisthe growthwerehighlycorrelatedwiththebusiness onlyimportantissuewherehefailedtocarrythe cycle,andhearguedthatsteadymoneygrowth profession.Mainstreammacroeconomicsaccepts wouldreducetheamplitudeandfrequencyof hisviewthatthelong-runPhillipscurveisvertirecessions.Healsoarguedthatsustainedinflacal,thatweneedtofocusonreal,ratherthan tionwouldbeimpossiblewithoutsustained nominal,interestrates,thatlowinflationiscentral moneygrowthinexcessoftheeconomy’slongtoeconomicstabilityandthatfiscalpolicyhas runrealrateofgrowth. littletodowithshort-runfluctuationsinemploy- Miltonfavoredsteadymoneygrowthbecause mentandoutput.Butfeweconomistsstillsupport hedidnotbelievethatcentralbankerswerewise moneygrowthtargeting. enoughtoimproveontheoutcomesthatwould AlthoughMilton’smoney-growthpolicy flowfromsteadymoneygrowth.Withevidence prescriptiondidnotwinout,Ibelievethathis fromtheGreenspanera,Miltonchangedhisview analysisjustifyingthisprescriptionhashadmuch abit,butwasnotconvincedthatGreenspan’s moreinfluencethanmanyrealize.I’llreviewhis successinadjustingthestanceofmonetarypolicy caseforthisrecommendationandthendiscuss waslikelytobereplicatedbyfutureFedchairmen. howthiscaserelatestocurrentcentralbank Thecaseforcontrollingthemoneystockalso practice. restedonthedangersofcontrollinginterestrates. 1

MONETARYPOLICYANDINFLATION Apolicyinterestrateheldtoolowsetinmotion bankallowsexpectationstobecomeunanchored, acumulativeprocessoflargerandlargerinfla- theninterest-ratecontrolbecomesadangerous tionarydisequilibrium;withapeggednominal andpotentiallydestabilizingpolicy.Butshould rateofinterest,risinginflationandinflation thepracticeofmonetarypolicydependonhow expectationswouldlowertherealrateofinterest. wellinflationexpectationsareanchored?Ido Thatwastheoppositeofwhatwouldbeneeded notrecallMiltondiscussingthisquestion,pertoquellinflationaryfires.Theprocesswassym- hapsbecausehebelievedthatthebestwayto metrical;withongoingdeflation,amonetary maintainwell-anchoredexpectationsovertime policyholdinganominalinterestratesteady wasforthecentralbanktocommittosteadyand wouldpromotedeflationandarisingrealrateof lowmoneygrowthunderallcircumstances. interest.Anadjustableinterest-ratepegdoesnot Howdoesacentralbankanchorinflation changetheanalysisinanyfundamentalway; expectations?Oneapproachwouldbeforthe giventhatinflationexpectationsmaybechanging, centralbanktocommittolowandsteadymoney theissueremainswhetherinterest-rateadjust- growthcomewhatmay.Aproblemwiththis mentsareadequatetomovetherealrateofinter- approachisthatitmaynotappearcredibleto estintheappropriatedirection.Steadymoney themarketswhenfinancialinstabilityand/or growth,ontheotherhand,wasinherentlystabi- recessionoccurs.Ifapolicyofsteadymoney lizingastherealrateofinterestwouldtendtorise growthhasexceptions,cantheexceptionsbe duringaninflationandfallduringadeflation. definedinsuchawaytoretainanchoredinfla- Miltonalsoarguedforsteadymoneygrowth tionexpectations? onpoliticalgrounds.Acommitmenttosteady Anecessaryandsufficientconditionfor moneygrowthwouldreflectaruleoflawrather anchoringisthatthecentralbankactvigorously thanofmen.Hedidnottrustthelegislatureto toresistinflationordeflationwheneveritbecomes runmonetarypolicyinanonpoliticalway,nor evidentandparticularlywheninflationexpectadidhetrust“unaccountablebureaucrats,”ashe tionschange,upordown,inanunwelcomeway. mightputit,appointedforlongtermstoconduct Ifthecentralbankiswillingtopushashardasit adiscretionarymonetarypolicy.Hisviewwas takes,regardlessofshort-runconsequencesto shapedbytheFed’spoorperformanceintheearly unemploymentandespeciallytothebondand yearsoftheGreatDepressionandbythefactthat stockmarkets,thenmarketparticipantswill atthattimepressurefromCongress,whenitwas developfirmviewsonthelikelyrateofinflation insession,didpushtheFedabitinthecorrect inthefuture.TheFedmustconvincemarket direction. participantswhobetagainstitthattheywill Thisbackgroundisallfamiliarground;I regrettheirbets. reviewittointroducemycommentsoncurrent Itishighlydesirablethatthecentralbank centralbankpractice. behaveinarule-likeway,bothforthepolitical objectiveoftheruleoflawratherthantheruleof menandbecausepredictablepolicypromotes CONSEQUENCES OF moreefficientdecisionsintheprivatesector.To themaximumpossibleextent,wedesireanequi- CONTROLLING THE FEDERAL libriuminwhichthemarketsbehaveasthecentral FUNDS RATE bankexpectsandthecentralbankbehavesasthe EverythingMiltonarguedaboutmoneystock marketsexpect.Centralbankbehaviortoanchor controlistrue,buttheeffectofinflationexpecta- expectationsoflowandstableinflationisthe tionsonthepracticeofmonetarypolicyitself singlemostimportantaspectofpolicypredictabilwas,Ibelieve,amissingelementintheanalysis. ity.IbelievethattheFedhascomealongwayin Theeconomyfunctionsdifferentlywheninflation thatdirectionthough,obviously,therearecerexpectationsarefirmlyanchored.Ifacentral tainlyopportunitiesfortheFedtorefineitspolicy 2

MiltonandMoneyStockControl rule.Inthiscontext,by“rule”Isimplymeanthat thoseinterestrateswereheldfixedbymonetary theFed’spolicyactionsaresystematicandhighly policy.IftheFedhadbeenpegginglongrates,the predictableresponsestonewinformation. flighttoqualitylastweekwouldhaverequired Steadymoneygrowthwouldalsobehighly theFedtotakefundsoutofthemarket.That predictable,butIbelievethattheFed’sactual wouldhavebeenadestabilizingresponseto adjustmentsofitsfederalfundsratetargethave marketfearsconcerninghousingandthesubyieldedsuperioroutcomessince1982towhat primemortgagemarket.NorwouldtheFedhave wewouldhaveobservedundersteadymoney beeninagoodplaceifithadtomakeadecision growth.Ialsobelievethatadvancesinknowledge astojusthowfaritshouldadjustapeggedlong permitustosaywithsomeconfidencethatthese interestrate.Thisisthekindofjudgmentbest gainsarenotjustanaccidentofAlanGreenspan’s lefttothemarket. specialskillsandintuition. Whatouranalysismissedagenerationago So,theFedhaspushedhardatcertaintimes, wasthatthetypicalmodelwithonlyoneinterandkeptitsfederalfundstargetunchangedat estratecouldnotpossiblyallowforstabilizing othertimes,withtheresultthatinflationexpec- marketresponsesinlongrateswhenthecentral tationsarenowquitewellanchoredandpolicy banksettheshortrate.Ofcourse,macroeconoadjustmentsarenotthemselvesdisturbancesto metricmodelsdidhavebothshortandlong themarket.Withinflationexpectationsanchored, rates,butthestructureofthemodelsdidnotperchangesinthenominalfederalfundsratereliably mitanalysisofthesortIamdiscussingbecause movetherealfederalfundsrateinthesamedirec- thetypicaltermstructureequationmadethe tionandbyroughlythesameamount.Datafrom longrateadistributedlagontheshortrate.The tradinginindexedTreasurybonds,andfrom model’sshortrate,inturn,wasdeterminedby surveys,allowtheFedtomonitorchangesin monetarypolicymakerssettingitdirectlyorby inflationexpectationscontinuously.Suchmonithemoneymarketunderapolicydetermining toringhelpstremendouslytoprovideassurance moneygrowth. thattheFedisnotfallingbehindinitspolicy Onceweallowexpectationstouncouplethe adjustments. currentlongratefromthecurrentshortrate,the Inotedthatanattractivepartofthecasefor situationchangesdramatically.Themarketcan steadymoneygrowthwasthatmarket-driven respondtoincominginformationinastabilizing changesininterestrateswouldbeinherently waywithoutthecentralbankhavingtorespond. stabilizing.Interestingly,andIthinksurprisingly, Longbondratescanchange,andchangesubstanwenowseethesameprocessatworkwithlongertially,whilethefederalfundsratetargetremains termbondyields.TheFedadjustsitsfederal constant. fundsratetargetinadiscretionary,thoughhighly Eventually,ofcourse,ifchangedconditions predictable,fashion,butsignificantchangesin persist,thecentralbankwillhavetoadjustthe longratesdooccur.Thoseofyouwhofollowthe policyrateinthedirectionrequiredbythenew marketscloselycouldpointtomanycasesin information.Intheabsenceofsucheventual recentyearsinwhichlongrateshavehelpedto policyadjustment,thedestabilizingeffectsofa stabilizetheeconomywhiletheFedremained constantinterestrateemphasizedintheearlier onthesidelines,holdingthefederalfundsrate literaturewillappear. targetunchanged. Wearewitnessingthisphenomenoncurrently. Puttingasidewhatishappeningtothemarkets THE BOTTOM LINE asIspeak—somethingIobviouslycouldnot incorporateinmywrittentext—thedeclinein Considerwherethisanalysisleavesus. longTreasuryrateslastweeksurelyhelpedto Assumeinflationexpectationsarewellanchored. stabilizemarketsrelativetoasituationinwhich Thecentralbankcanholditspolicyraterelatively 3

MONETARYPOLICYANDINFLATION steadyandrelyonmarketadjustmentsinlong rightquestiontoaskisnotwhetherFedactionin ratestodomuchofthestabilizationwork.When responsetoanycurrentmarketupsetwouldbe newinformationarrives,mostofthetimethe desirablebutratherwhetheritispossibleto centralbankcanwaitformarketresponsesand defineasystematicresponsetomarketupsetsin thepassageoftimetoclarifywhatishappening. generalthatwouldbehelpful.TheanswerIgive Thecurrentsituationisaperfectillustration. isthateffectsontheeconomycanrarelybeunder- TheFeddoesn’tknowandmarketparticipants stoodwithoutpassageoftimeandmoreinformadonotknoweither,thefullimplicationsoflast tion.Occasionally,thereiscontemporaneous week’sstockmarketdeclinesandincreasesin evidenceofdamagetomarketmechanismsthat riskspreads.Marketreactionslastweekmaybe mightjustifyquickFedaction. overdone,orperhapsnot.Wejustdonotknow. Thekeypointisthat,inthesesituations,the Inasituationliketheterroristattacksof9/11, marketismakingjudgmentsonsecurityprices, theFedknewenoughtobelievethataquickpol- stabilizingtheeconomywithouttheFedhaving icyresponsewouldbehelpfulandunlikelyto toleadtheway.Thisisexactlytheprocessenviitselfbedestabilizing. sionedagenerationagobythemonetaristadvo- Atypicalmarketupset,suchaslastweek’s, catesofsteadymoneygrowth.ThisiswhatMilton isnotatalllike9/11.Mostoftheseupsetsstabi- taughtusaboutmarkets,andhewasright. lizeontheirown,butsomedonot.I’mnotsaying Wheninflationexpectationsarefirmly thattheFedshouldignorewhathappenedlast anchored,animportantreasonfortheFedtolet week—weneedtounderstandwhatishappening. marketstaketheleadisthatoveractiveFed However,itisimportantthattheFednotpermit responsestomarketdevelopmentssetprecedents uncertaintyoverpolicytoaddtotheexisting thattendtodestabilizemarketsinthefuture.If uncertainty.Themarketunderstands,Ibelieve, themarketbelievesthattheFedisalwaysprimed thattheFedwillactinduetime,ifandwhen toadjustpolicy,thenmarketparticipantswill evidenceaccumulatesthatactionwouldbeappro- spendmoretimetryingtosecond-guesstheFed priate.Thatiswhytradinginthefederalfunds thantryingtounderstandwhatishappeningto futuresmarketreflectschangedoddsfromtwo businessandhouseholdbehavior.AsIemphaweeksagoonapolicyadjustmentlaterthisyear. sizedearlier,agoodmarketequilibriumrequires Iflastweek’seventsdonotturnouttochange thattheFedbehaveasthemarketexpects.When theprobablecourseofeconomicgrowthand therearewidelyvaryinginterpretationsinthe inflation,thenthefedfundsfuturesmarketwill marketaboutwhatishappening,itisimpossible reversecourseandtheexpectedpolicyeasing fortheFedtobehaveasthemarketexpects willdisappear.Or,ifevidenceaccumulatesthat becausethereisnounifiedviewinthemarket theinflationpictureremainsbenignbuttheout- aboutwhatishappening.Atanygiventime,it lookfortheeconomynextyearappearslikelyto maybeimpossibleforthemarkettocometoa besignificantlyweakerthanthecurrentbest unifiedviewaboutwhatishappening,simply guess,thenthemarketwilldeepenitsconviction becauseofincompleteknowledgeanddifferent thattheFedwillbecuttingitsfedfundstarget. professionaljudgmentsbythosebestinformed. TheregularityofFedbehaviorIespouseis Still,thereneedbelittleornouncertainlyabout thattheFedshouldrespondtomarketupsets FedbehaviorthedaybeforeanFOMCmeeting. onlywhenithasbecomeclearthattheythreaten Fedactionsatfuturemeetingsmonthsahead toundermineachievementoffundamentalobjec- willremainuncertain,toboththemarketand tivesofpricestabilityandhighemployment,or theFOMCitself,becausethefutureinformation whenfinancial-marketdevelopmentsthreaten setisuncertain. marketprocessesthemselves.TheFedshouldnot Inthemeantime,thecentraltendencyof trytosubstituteitsjudgmentsforthemarket’s marketviewsonwhatishappeningwillcontrol judgmentonappropriatesecurityprices.The thelongbondrateandsecuritypricesmoregen- 4

MiltonandMoneyStockControl erally.Differencesinmarketviewsastowhatis happeningwilldeterminewhoislongandwho isshortinthemarket.Eventually,asnewinformationclarifiesthesituation,thevarianceof viewsaroundthecentraltendencywillfalland morenormalmarketconditionswillreemerge. Asforthepoliticsofmonetarypolicy,I believethereisextremelywidesupportfora totallyapoliticalFed.Thereisaconsensuson thedesirabilityoflowinflationandthattheFed shoulddowhatitcantostabilizetheunemploymentrateatthelowestrateconsistentwithsustainednon-inflationaryeconomicgrowth.The marketandmostpoliticalleadersbelievethat theFedisapolitical.Themarkettrustsus,and we,inturn,workhardtoretainthistrust.When Isay“we”IreallymeantheFedasaninstitution. Fedofficials,staffandReservebankdirectors haveadeepunderstandingoftheimportanceof apoliticalmonetarypolicy.Thisunderstanding goesfartowardmakingFedactionsreflectarule oflawratherthanaruleoftheindividualsmaking thedecisions.Theclosestanalogy,perhaps,is thatweworkasfiduciaries.Idonotdenythatit wouldbedesirablefortheFederalReserveAct tobeclearerabouttheobjectivestheFedshould pursue.Still,theFedasaninstitutionhasgonea longwaytomakeitspolicyactionsrule-likein theirregularity.Iftheinstitutionisstrongand incorruptible,asIbelieveitis,thenweprobably haveasmuchassuranceinademocraticsociety aswearelikelytoget. AlthoughMiltondidnotprevailinhisquest tohavetheFedmaintainaconstantmoneygrowth rate,hedidprevailinhisinsistencethatpolicy beapoliticalandrelytothemaximumpossible extentonmarketjudgments.Helostabattlebut trulydidwinthewar. 5