Speech

Thinking Like a Central Banker MarketNewsInternational NewYork,NewYork September28,2007 PublishedintheFederalReserveBankofSt.LouisReview,January/February2008,90(1),pp.1-7 Everyone looks at the world through ASSESSING THE ECONOMY lenses colored by his or her own expe- AnareawhereFedpracticeandmarketpracriences and background. Over my nine ticeareessentiallyidenticalisinassessingthe plusyearsattheFed,Ihavebeenstruck stateoftheeconomyandtheoutlook.Private by misunderstandings of why the Fed acts as it sectorandFedforecastersusesimilarmethods does—misunderstandings from vantage points andrelyonthesamestatisticalinformation. thatarequitedifferentfromthatofaFedofficial. Obviously,thereareprofessionaldifferencesof Those with Fed experience do know things that opinionandofapproaches,butthesedonotcreate others do not. Some of what we know is confi- adividebetweenFedandprivateforecasts.AsI dential, but such information is in most cases haveoftenputit,economistsinsideandoutside disclosed with a lag. There are few permanent theFedstudiedatthesameuniversitiesunder secrets. Still, there is a central-banker way of thesameprofessorsandreadthesamejournal thinking that can be described and analyzed; articles.Thereissubstantialmovementofeconodoing so may help others to avoid mistakes in mistsintoandoutoftheFederalReserveSystem. assessing Fed policy. That is my topic in these Fedeconomistsattendmanyuniversityseminars, remarks. andacademiceconomistsattendFedseminars. Disagreementsaboutforecastsaresimilarinside Obviously,allIcandoistodescribehow andoutsideoftheFed. oneparticularcentralbankerwiththeinitials Thereisadifferenceintheinformaloranec- W.P.thinksaboutwhathedoes.Andmyperspecdotalinformationavailableinsideandoutside tiveisthatfromaparticularcentralbank,the theFed.TheFedhasalargenetworkofbusiness FederalReserve.MyFedcolleaguesmightput contactsandreliesonthemtoaugmenttheforethingsdifferentlyandmightbelievethatIamoff castingeffort.However,someprivateforecasters basewithsomeofmycomments.Nevertheless,I haveaccesstodataandinformationtheFeddoes thinktheeffortisworthwhile,forthedegreeof not.Largefinancialfirmsinparticularhaveaccess successofmonetarypolicyispositivelycorretodata,suchascreditcardactivityandprospeclatedwithhowcompletelythemarketundertiveborrowingbymajorclients,thattheFeddoes standstheFed.MydisclaimeristhattheviewsI nothave.Retailfirmshaveextremelycurrent expressherearemine.Theseviewsnotonlydo informationonsalesandorders.Ofcourse,the notnecessarilyreflectofficialpositionsofthe Fedmayobtainsomeofthisinformationthrough FederalReserveSystembutalsomaynotreflect itsbusinesscontacts,butprivatecompaniesoften theviewsofanyoneelseattheFed,pastorpres- makemuchmoresystematicuseoftheirown ent.IthankmycolleaguesattheFederalReserve internalbusinessinformationthantheFeddoes. BankofSt.Louisfortheircomments,butIretain Forecasterscontinuallyprovideupdatesbased fullresponsibilityforerrors. ontheflowofcurrentinformation,bothstatisti- 1

MONETARYPOLICYANDINFLATION calandinformal.Inthisregard,Fedandmarket economist,riskisatwo-sidedconcept.Outcomes practiceisessentiallyidentical. maybeaboveorbelowpriorexpectations.The Thereis,however,adifferencebetweenthe possibilityofanoutcomefarbelowexpectation Fedandthemarketintheuseofforecastinforma- deservesspecialattention,forsuchanoutcome tion.Tradersandportfoliomanagersbasetheir mayforceafirmintobankruptcy.Afinancialfirm tradesonthecurrentflowofinformation,which modelsriskquantitatively,totheextentpossible, needstobeupdatedthroughoutthetradingday. andthenexamineswithgreatcaretheextentto Fedpolicymakers,ontheotherhand,donotcon- whichformalmodelsmaymisskeyrisks,perhaps tinuouslyadjustthestanceofpolicyinthesame becausetheywerenotobservedduringthesamwaymanagersadjustportfolioholdings.Forthis pleperiodusedtofitamodelorbecausetheecoreason,myownpracticeisnottoworrymuchas nomicenvironmentmaybechanging.Acentral towhetherIhavecorrectlyabsorbedtheimport bankhasasimilartask.Quantificationofrisksto ofeachday’s,oreachhour’s,data.Iknowthat theeconomyshouldbetakenasfaraspossible someinformationwillbeirrelevanttomypolicy andthencarefulthoughtappliedtorisksbeyond positionbecauseitwillbesupersededbynew thosethatcanbecapturedinmodels. informationbythetimeofthenextFOMCmeet- Oneimportantdifferencebetweenafinancial ing.Forexample,Idonotneedhour-by-hour firmandthecentralbankisthatafirmhasamuch informationonsecurityprices.WhenIgetto widerarrayofstrategiesavailabletomitigaterisk thenextFOMCmeeting,I’llhavethelatestdata, thandoesacentralbank.Afinancialfirmcan chartsofhowsecuritypriceshavebehaved makecarefulcalculationsoftheextentofduration sincethepreviousmeeting,andanalysesofprice mismatchbetweenassetsandliabilitiesandcan behavioroveramuchlongerperiod—indeed,for adjustitspositionscontinuouslytocontrolthe extentofmismatch.Afinancialfirmcandealin asfarbackintimeasIfindhelpful.Giventhat manyderivativesmarketstocontrolrisk.AfinantheFOMCdoesnotadjustpolicycontinuously, cialfirmhaswidelatitudeinchoosinghowmuch updatingmyforecastwitheverydatarelease risktoaccept. wouldnotbeanefficientuseofmytime. Acentralbankprettymuchhastoaccept AconsequenceofthefactthatFOMCmeetpolicyriskstotheeconomyarisingfromthe ingsoccuratsix-weekintervals,onaverage,is economy’sinstitutionalstructureandmarket thatwhenIgiveaspeechandtakequestionsImay environment.Marketsentiment,bullishorbearnotbecompletelyuptodateontheimplications ish,canchangequickly.Analytically,thecentral ofthelatestdata.Inmyspeechesanddiscussions bankcanexploreimplicationsofvariouspossible ofpolicywithvariousaudiences,Itrytoconcenscenariosandcanengageinspecialinformation trateonlonger-runissuesandgeneralprinciples. collectiontotrytounderstandasquicklyaspos- IemphasizethatIwillbestudyingallthedata siblewhatishappeningintheeconomy.Beyond andanecdotalinformationinthedaysleading that,whatacentralbankcandoistoadoptfrom uptoanFOMCmeeting.Thus,Iordinarilydo timetotimeasomewhatasymmetricpolicy notgivedetailedanswerstoquestionsonthe stanceinanefforttocontrolrisk,especiallyby preciseimplicationsofthelatestdataforthe guardingagainstparticularlycostlypossibleouteconomicoutlook.Inmanycases,Ijusthaven’t comes.Wheninflationriskisthedominantconstudiedtheimplicationsthoroughly,althoughI cern,policyshouldleanontherestrictiveside certainlydosobythetimetheFOMCnextmeets. andpolicymakersshouldbemorereadytotighten thantoeasepolicy.Conversely,whendeflation and/orrecessionriskpredominates,policyshould DEALING WITH RISK beasymmetrictowardpolicyease.However, Aprivatefirm,especiallyafinancialfirm, thereisalwaysthedangerofleaninginone musthaverobustpoliciestoaddressrisk.Toan directiontoofarortoolong;policymakersmust 2

ThinkingLikeaCentralBanker bepreparedtoreversecourseandshouldtrynot reexaminemyinterpretation,andifIstillbelieve toallowthestanceofpolicytodrifttoofarfrom IamcorrectImightcommentduringtheQ&A abaselineapproach. sessionafteraspeechthatmyownpersonaltake Itisworthemphasizingthatthecentralbank, onthedatadiffersfromthemarketview.My asthedominantplayerinthemoneymarket,is aimwouldbetopromptmarketparticipantsto inadifferentsituationthanisacompetitivefirm. reexaminetheirinterpretationofthedata. Thecentralbank’sstrategyinmitigatingrisk Consideranotherexampleoftheimportance mustworkthroughthemarketsandbyshaping oftrackingmarketexpectations.WhenIexamine accuratemarketexpectationsaboutfuturecentral thefederalfundsfuturesmarket,alargediscrepbankbehavior. ancybetweenmarketexpectationsandmy“best Thelistofpossiblerisksfacingprivatefirms guess”oftheFOMC’sfutureactionsmightsuggest andcentralbanksisalongone.Ariskthatis tomethepossibilityofaFedcommunications oftenincompletelyunderstoodbythoseoutside failure.Theidealsituationisoneinwhichthe managementisreputationalrisk.Theissueis marketandtheFedhavereadavailableinformamuchmorethansimpleembarrassment.Trustis tionthesameway.Iamonlyoneparticipantin anessentialcapitalassetforafinancialfirm,and theFOMCprocess,butItrynottocontributeto foracentralbank.Adamagedreputationcansend marketmisunderstandingofmonetarypolicy. customersfleeingtocompetitors.Foracentral ThemarketiscollatinginformationfromallFOMC bank,adamagedreputationcanleadmarket participants,payingespeciallycloseattention, participantstoquestionthebank’spolicyconsis- ofcourse,totheChairman’sviews. tency,itsmotivations,andevenitsveracity.For Ialsofollowmarketdatacarefullyaspartof thesereasons,successfulprivatesectorfirmsand ongoingresearchonhowmarketexpectations centralbanksbothinvestheavilyinprograms areformed.Thisresearch,conductedwitheconandprocedurestoensurefairdealingandhigh omistsintheSt.LouisFed’sResearchDivision, ethicalstandards.Withregardtoreputationalrisk, helpsmetounderstandmonetarypolicyata theissuesinsideandoutsidethecentralbank deeperlevel.Myperspectiveinthisresearchis areessentiallyidentical.Financialfirmsand essentiallythesameassimilarresearchconducted centralbanksunderstandeachotherverywell inuniversitiesandbyactivemarketparticipants. onthisdimensionofmanagingrisk. OBJECTIVES ASSESSING ODDS ON FED Privatefirmshavethegoalofprofitmaximiza- POLICY ACTION tion,whereasthecentralbankispursuingthe Marketparticipantsareconstantlyassessing macroeconomicgoalsofpricestability,employtheoddsonFedpolicyactionsatupcoming mentstabilityatahighlevel,andfinancialmarket FOMCmeetings.Theseassessmentsregister stability.Theprivatesectorandmonetarypolicy directlyinmarketprices,especiallyinthefederal goalsarequitedifferent,butthatfactdoesnot,in fundsfuturesandoptionsmarketsandthesimilar myview,defineanimportantdifferencein marketsineurodollars.Thereisanimportant approach. policypurposefortheFedtostudythesemarket Policymakersthinkintermsofalossfunction expectations.Understandinghowtheflowofnew thatdependsondeparturesofoutcomesfrom informationaffectsmarketexpectationscanbe desiredoutcomes.Policygoalsarequantifiable usefultopolicymakers.Forexample,supposeI and,aswithprofits,comewithshortandlong interpretasurprisechangeinemploymenttobe horizons.Asalreadydiscussed,privatefirms ananomalyinthedatabutIobservealargemarket andcentralbanksmustunderstandandcontrol reactiontothedatarelease.Inthatcase,Iwould riskstotheextentpossible. 3

MONETARYPOLICYANDINFLATION Privatefirmandcentralbankgoverningand ofpolicygoals,suchaspricestability.Thereare discipliningprocessesare,ofcourse,quitediffer- manydimensionstopolicydesign.Asimple ent.Nevertheless,analyticalapproachestoachiev- exampleisthattheFederalReservenowadjusts inggoalsarequitesimilar.Idonotbelievethat itstargetforthefederalfundsrateinmultiplesof differencesofobjectivesandgoverningprocesses 25basispoints.Thatmayseematrivialexample, defineanessentialdifferencebetweenthetwo butinthepasttheFedsometimesadjustedits typesoforganizations.Thus,inthisrespectthose fundsratetargetbysmalleramounts.Another intheprivatesectorandinthecentralbank exampleisdisclosureofthepolicydecision understandandrelatetoeachothereasily. promptlyafterthedecision.Thatpracticestarted onlyin1994andeversincetheFOMChasalmost constantlygrappledwithdisclosureissues. PRICE MAKERS VERSUS PRICE Icouldpointtomanyotherdimensionsof definingapolicyrule,orresponsefunction TAKERS (Poole,2005).Mypointisnottoelaborateonthe Whatisacriticallyimportantdifference natureofthepolicyrulebutinsteadtoemphasize betweenacentralbankandaprivatefinancial howdifferentthatresponsibilityisfromthatofa firmisthatthecentralbank,intheshortrun portfoliomanager.Policymakersshouldshape anyway,setsapolicyinterestrateandimpor- theirpolicyactionsbyconsciousdecisionsabout tantlyinfluenceslonger-terminterestrates howtoguidemarketthinkingnotjustintheconthrougheffectsonmarketexpectations.Thecen- textofaparticularpolicyactionbutalsointhe tralbankisapricemakerintheinterbankfunds futureforpolicyactionsingeneral.Putanother market.Privatefinancialfirmsareessentially way,wheneconomicconditionsrecur,policy pricetakersinthatmarketandinthegovern- responsestothesamesetofconditionsshould mentsecuritiesmarket. alsorecur.Ifthatwerenotthecase,thenpolicy Atypicaltraderorportfoliomanagercan actionscouldbeinterpretedonlyasrandom, plansecuritypurchasesandsaleswithlittleor unpredictableresponsestochangesineconomic noregardtoanyeffectsonmarketpricesorthe conditions.Itsimplycannotbegoodpolicyfor behaviorofotherfirms.Ofcourse,thisstatement policyactionstobeessentiallyrandom. isnotpreciselytrueforverylargeportfolios,but Themarketinterpretseverypolicyaction thedifferenceinmarketimpactbetweenacentral andeverypolicystatementinthecontextofpast bankandalargeprivateportfolioisenormous. actionsandstatements.Whatisasurpriseand Thefactthatacentralbankisapricemaker whatisexpecteddependsonpastpractice.The makesitsstrategyfundamentallydifferentfrom implicationofthisobviouspointisthatevery thatofaportfoliomanager.Toachievepolicy policyactionneedstobebasedonanunderstandgoals,thecentralbankmustthinkofitspolicy ingofhowtheactionwillberegardedinthe actionsasfollowingapredictablepolicyrulethat future.Policyactionssetprecedents,andpolicytheprivatesectorcanobserve.Aportfolioman- makersmustbecarefulaboutthoseprecedents. agerrespondstotheflowofnewinformation Otherwise,whatappearstobeapolicysuccess partlyasitaffectsprobabilitiesoffuturecentral todaycouldbetheseedofapolicyproblemin bankaction. thefuture. Ipointedoutearlierthatbothmarketpartici- Modernmacroeconomicsemphasizesthe pantsandpolicymakerstrytounderstandthe importanceofpolicypredictabilityforgoodpolicy implicationsoftheflowofinformationforpolicy outcomes(Taylor,1984).Thedifferenceinperactions.NowIwanttoemphasizetheimportant spectivefromstandardpractice30yearsagois pointthatpolicymakershavethetaskofdesign- profoundandincompletelyrecognizedbymany ingsystematicpolicyresponsestonewinforma- journalistsandcommentators.Evenintheearly tion.Thedesignshouldadvanceachievement Greenspanyears,manythoughtthatmonetary 4

ThinkingLikeaCentralBanker policyworkedbycreatingsurprises.Thatperspec- Iwouldbedoingmyjobiffearofprovidingmistivewasnaturalbecausepolicysurpriseshad informationledmetoprovidenoinformation. visibleeffectsonsecurityprices. Forthisreason,Ihavemaintainedanactivespeak- Theoreticaldevelopmentsinmacroeconomics ingschedule. inthe1970semphasizedthatpolicysurprises Idofollowsomegeneralpracticesdesigned wereundesirable.Efficientplanningintheprivate toreducemissteps.Itrytoschedulespeeches, sectorrequiresthatexpectationsaboutgovernandcertainlypressinterviews,fortimeswhen mentpoliciesbeaccurate,orasaccurateasthe themarketsareclosed.Thatallowsthemarketto inherentuncertaintyoftheeconomicenvirondigestwhatIsayovernight.Anotherpracticeis mentpermits.Policymakersoughtnottoaddto thatIneverpredicttheoutcomeoffutureFOMC inherenteconomicuncertainty.Itisdesirablethat, meetings.GiventhatIamonlyoneparticipantin tothemaximumpossibleextent,theeconomy thosemeetingsandthattheChairman’sopinion becharacterizedbyanexpectationalequilibrium carriesgreatweight,predictingtheoutcome inwhichthemarketbehavesaspolicymakers wouldbefoolish.Thatisobvious,butwhatis expectandthecentralbankbehavesasthemarket expects.Therearecertainlytimes,however,when lessobviousisthatIdomybesttoavoidbeing policysurprisesareunavoidable. committaleveninmyownmindaboutthepolicy So,muchofmyownthinkingisdrivenbyan implicationsofrecentdata.Clearly,Icoulddraw efforttohelpdefineapolicythatwillincrease conclusionsfromavailabledatathatwouldcreate policypredictabilityovertime.Inmyspeeches acertainpresumptionaboutthepolicydecision andensuingQ&A,Itrytoemphasizegeneral oratleastaboutmypolicyposition.Iamvery policyprinciplesratherthanthecurrentpolicy cautiousaboutdrawingfirmimplicationsabout situation.Whatisimportantisnotthepolicy policyfromthedata. actionatthenextFOMCmeeting,whichistypi- Iemphasizethatmypolicypositionwill callywhatpeoplewanttoknow,butthepolicy dependonalltheinformationavailableatthe regularitythatwillextendacrossmanyFOMC timeoftheFOMCmeeting,onthestaffanalysis, meetings,whichiswhatpeopleshouldwantto andonthedebateduringthemeeting.That know. descriptionofmyattitudeisliterallycorrect.I notedearlierthatIoftendonotfocusonthedata arrivingdaybydaybecauseIknowthatnewdata AVOIDINGPOLICYDISTURBANCES willsupersedeexistingdataandthatIwillbenefit Animportantcorollarytothetaskofdefining frommyownintensivepreparationbeforeeach apolicyruleisthatthecentralbankoughtnotto meeting.Irelyontheexpertstaffanalysisprebeasourceofrandomdisturbances.Allofusare paredforeachFOMCmeeting.Giventhecomwellawareofthepotentialforsayingthings plexityanddynamicnatureoftheissues,Ifind inadvertentlythatwillcreatemarketmisunderitbestnottoformasettledpolicypositionwell standingoflikelyfutureFedpolicyactions.Or, inadvanceofthemeeting. moreprecisely,whatneedstobeunderstoodis Moreover,whatpolicypurposewouldbe howandwhyvariouspossibleeconomiccondiservedbymydiscussingpubliclyeverytwistand tionswouldjustifyparticularappropriatepolicy turnofmyanalysisbetweenFOMCmeetings? responses.Onewaytoavoidmisinformationis toavoidprovidinganyinformation.Putanother Marketeffectsfromdoingsowouldnotservea way,ifmymouthisnotopen,Icannotputmy constructivepolicypurpose—indeed,theywould footintoit. violateoneoftheimportantfindingsinmacro- Inmyview,however,itisimportanttotryto economicsthatpolicyshouldnotcreaterandom conveycorrectinformation.Idonotbelievethat disturbances. 5

MONETARYPOLICYANDINFLATION BASICS OF POLICY STRATEGY employmentstability.Asoftoday,wejustdonot knowwhattheconsequencesmaybe.Mybest Ihaveemphasizedtheimportanceofthe guessisthattheinherentresilienceoftheU.S. centralbankerperspectiveinconveyingapolicy economyalongwithfuturepolicyactions,should strategy.Iwillconcludebysketchingtheapprotheybedesirable,willkeeptheeconomyona priatestrategyasIseeit. trackofmoderateaveragegrowthandgradually First,thecentralbankshouldbeclearasto declininginflationoverthenextfewyears. itsgoals.Themostfundamentalgoalismaximum Similarboutsoffinancialmarketinstability possiblesustainableeconomicgrowth,whichin inthenineteenthcenturyonuptothefinancial mymindmotivatesthedualmandateinthelaw panicof1907ledCongresstopasstheFederal fortheFederalReservetostriveforpricestability ReserveActin1912.Afundamentalresponsibility andhighemployment.Pricestability,whichis ofthecentralbankistocontributetoorderlyand uniquelyacentralbankresponsibility,contributes efficientfunctioningoffinancialmarkets.The greatlytothegoalofmaximumsustainablegrowth. financialmarketupsetof2007willjointhehis- Pricestabilityisnotinconflictwithhighemploymentbutcontributestoit. toryofupsetsincludingthosein1970,1984,1987, Ipersonallybelieve,andhavesostatedon and1998.Eachupsethasdifferentspecificsbut numerousoccasions,thattheinflationgoalshould allofthemhavecommoncharacteristics,includbequantified.Iknowthatmanydisagreeonthis ingespeciallyaflighttosafeassets. point.Intoday’seconomy,Ibelievethataquan- Ibelievethatpartofthepolicystrategyought tifiedinflationgoalisnotcriticallyimportantbut tobetoconveyasclearlyaspossibletothemarket quantificationmightbeofgreatimportancein whatthecentralbankisdoingandwhy.Apolicy thefuture.Iaskthisquestion:IftheFedhadhad strategythatisamysterytothemarketswillnot aspecificinflationgoalin1965,wouldthatcom- servethecentralbankwell.Ofcourse,themarket mitmenthavehelpedtoavoidtheGreatInflation? willobservewhatthecentralbankdoesandinfer Ithinktheanswertothequestionis“yes.”Ifthat manyaspectsofthestrategyfromthoseobservaisthecorrectanswer,thentheUnitedStatesmight tions.Nevertheless,centralbankstrategyalways haveavoidedaverycostly15-yearperiodofinfla- reliesinpartonjudgmentsaboutincominginfortion,ortheperiodmighthavebeenshorter. mation,suchaswhetheraparticulardatarelease Acentralbankcannotfixthelevelof hasanomalousfeaturesandshouldbediscounted. employmentoritsrateofgrowth,ortheaverage Thestrategyofacentralbankshouldbeinstiturateofunemployment.However,thecentralbank tionalizedandenduring.Thestrategyshouldnot cancontributetoemploymentstability.Avoiding, changejustbecausetheofficialrosterchanges.The oratleastcushioning,recessionsisanimportant strategyshouldevolveaseconomicknowledge goal.Thisgoalshouldnotbeviewedasinconflict improvesandaseconomicconditionschange. withpricestability.Themostseriousemployment Ihopetheseremarksareuseful.Theydo,in disasterinU.S.historywastheGreatDepression, anyevent,explainsomethingabouthowIhave whichwasaconsequenceofmonetarypolicymisapproachedmyresponsibilities. takesthatledtoongoingseriousdeflation.Similarly,theperiodoftheGreatInflationsawfour recessionsin14years.Pricestabilityisanessen- REFERENCES tialpreconditionforoveralleconomicstability. Wehavetentativesignsthatthefinancial Poole,William.“TheFed’sMonetaryPolicyRule.” marketsarebeginningtorecoverfromtherecent FederalReserveBankofSt.LouisReview, upset,butfinancialfragilityisobviouslystillan January/February2006,88(1),pp.1-12; issue.Iftheupsetweretodeepeninasustained http://research.stlouisfed.org/publications/review/ way,itmighthaveseriousconsequencesfor 06/01/Poole.pdf. 6

ThinkingLikeaCentralBanker Taylor,JohnB.“AnAppealforRationalityinthe PolicyActivismDebate.”FederalReserveBankof St.LouisReview,December1984,66(10),pp.151-63; http://research.stlouisfed.org/publications/review/ 84/conf/taylor.pdf. 7