A History of the Federal Reserve, Volume 2 (100 page)

Feldstein (2003, 376) concluded that “the models are far too limited. . . . to be an operational guide to policy. The models inevitably give inadequate attention to financial conditions, to changing institutions, to international markets, and to many other things.”

Lucas (2007, 168) concluded in his usual succinct way that neglect of money was a mistake. “Events since 1999 have not tested the importance of the [ECB’s] second monetary pillar. . . . I am concerned that this encouraging but brief period of success will foster the opinion, already widely held, that the monetary pillar is superfluous and lead monetary policy analysis back to the kind of muddled eclecticisms that brought us the 1970s inflation.”

This rejects the use of models with only one interest rate and no role for money. It suggests a role for asset markets including credit and money, and it supports the distinction between price level changes and maintained inflation (Brunner and Meltzer 1989, 1993). Svensson (2002–3, 9) accepts part of this view. “Any realistic model of the economy requires more variables than just inflation and the output gap to describe the state of the economy.”

Mistaken models of the economy contributed to policy mistakes.
¹²
It is an unfortunate fact, nonetheless a fact, that the Federal Reserve produced better results for the economy in the atheoretical 1950s and the eclectic 1980s and 1990s. I believe that part of the problem in the 1960s and 1970s was that there was too much emphasis on quarterly forecasts and
too little attention to medium- and long-term policy implications. Economics is not the science that gives reliable quarterly forecasts. Currently, there is no such science. Federal Reserve policy will do better at achieving stable growth and low inflation if it directs more attention to medium- or longerterm results.

12. A recent costly error based on faulty judgment was the concern with deflation in 2003. An economy with a very large budget deficit and a depreciating currency is extremely unlikely to experience deflation. The Federal Reserve did not accept this argument. Its concern for deflation delayed the increase in the federal funds rate, contributing to the subsequent housing price increase and substantial expansion of housing credit at low introductory rates. Federal Reserve history shows that concerns about a zero bound for a single short-term rate are misplaced. There are many non-zero interest rates and relative prices. Sellon (2003) supports the analyses in Brunner and Meltzer (1968) rejecting the standard liquidity trap and zero bound.

International monetary policy varied from the classical gold standard at the start in 1913 to fluctuating exchange rates after 1973. Efforts to coordinate international policy in the 1920s under the gold exchange standard reflected the strong public belief in the gold standard at that time. In the 1930s, Britain, France, and the United States attempted limited coordination under the Tripartite Agreement. In the postwar period from 1945 to 1973, most countries adopted the Bretton Woods system. Later, the 1978 and 1985–86 agreements to coordinate broke down. All such efforts failed.

Two related reasons dominate. First, the public and policy typically give greater weight to avoiding recession and perhaps inflation than to maintaining fixed exchange rates. Second, governments take responsibility for social problems, including but not limited to unemployment, and use budget expenditure or tax changes that produce budget deficits. Third, governments have little interest in adjusting policies for the benefit of other countries. Given these conditions, international coordination or fixed exchange rates are unlikely to return to the United States.

In nearly a century of experience with financial failures, the Federal Reserve never developed and announced a lender-of-last-resort policy. Sometimes it lets the institution fail; sometimes it lends to keep it solvent. Failure to announce and follow an explicit strategy increases uncertainty and encourages troubled institutions to press for bailouts at taxpayers’ expense. The credit crisis after 2007 is the latest example.

Many of the faults and errors arise for three principal reasons. First, the FOMC gives excessive weight to current and near-term events over which it has little control. Longer-term consequences that could be prevented or achieved receive little attention. Much of the discussion at FOMC meetings is about whether to change the federal funds rate by 0.25 percentage points. Forecasts that look ahead a year or more have little observable effect on current or future actions. The Federal Reserve has not developed procedures that adjust its actions to achieve its medium- or longer-term objectives.

Second, economic data are subject to permanent and temporary changes. Oil price changes are examples of permanent or persistent changes that are usually unforeseen. Bank failures, especially failure of a large bank or financial firm, can occur without prior warning. Most changes in productivity growth are of this kind. Wars, major political events, and currency devaluations or revaluations are other examples. Permanent or persistent
changes alter wealth and income. Adjustment to persistent changes in the environment can cause temporary changes in consumption investment, employment, and measured rates of price change. Most of these changes are real, not monetary. The Federal Reserve has to learn to make the distinction.

Third, the Federal Reserve frequently confuses private and public interest. This occurs especially in its response to banking and financial problems. Preventing financial failures protects stockholders often at the expense of taxpayers. The Federal Reserve’s public responsibility requires maintenance of the payments system. Depositors are insured.

The Federal Reserve makes mistakes. No readers of these volumes should have any doubt about that. Many of the mistaken actions result from errors, but not all. During the Great Inflation, Board members and the FOMC often failed to distinguish between nominal and real values. Some errors reflect uncertainty about the future. Also, the Federal Reserve is the agent of Congress. Too many of its actions respond to actual or perceived congressional pressure. To protect its independence from congressional legislation, it accedes to political pressure.

Not all chairmen are intimidated. In August 1982 Paul Volcker refused to commit to reduce interest rates if Congress voted to reduce the budget. His decision came despite his efforts to reduce interest rates at the time. This was unusual.

Offsetting some of the errors are some notable achievements. These include developing the payments system, maintaining a reputation for integrity and the absence of corruption, abetting development of an efficient financial system, managing a complex domestic and international monetary system under changing external conditions, and recognizing that it is lender of last resort to the entire financial system.

A strong, independent chairman can overcome the emphasis on the short term. The Federal Reserve, and its then chairman, deserve praise and respect for reducing inflation after fifteen years of increasing inflation amid widespread skepticism. This remarkable period in Federal Reserve history brought in the period known as “the great moderation.” The next chairman maintained low inflation and relatively stable growth. Success of this kind increases public confidence and reduces congressional and administration pressures. The country experienced three of the longest periods of growth punctuated with mild recessions.

TOWARD BETTER RESULTS

In more than twenty countries, central banks have now (2009) adopted some type of inflation target as the policy goal. Usually the goal is a dual
mandate—stable growth and low inflation. The European Central Bank has a legally stated objective to maintain price stability. But it does not ignore unemployment. A principal benefit of a stated objective for inflation is that it directs attention toward a medium-term objective and away from the excessive concentration on current and near-term changes. The Federal Reserve greatly needs to give more attention to the medium-term consequences of its action.

The earlier chapters show that some FOMC members recognized at times the need to direct more attention to the medium term. Proposals of this kind had no effect on policy action or decisions. Although it has not adopted an explicit inflation target, the FOMC has encouraged the belief that it has a 1 to 2 percent target. There is, as yet, little evidence that the possible target consistently affects FOMC decisions.

Four reasons bolster the case for directing more attention to the medium term. First, quarterly values of several of the variables FOMC members watch can be described as near random walks. Output or real GDP is one of those variables. Short-term movements are dominated by random movements that cannot be predicted reliably or controlled effectively.

Second, Federal Reserve quarterly forecasts have smaller errors in the recent more stable years than the errors that I summarized in my presidential address to the Western Economic Association (Meltzer, 1987). Forecast errors are still large. McNees (1995, table 7) reported mean absolute forecast errors by private and FOMC forecasters for the years 1983 to 1994. Table 10.1 shows these errors.
¹³
The table shows that most FOMC forecasts are about as accurate as the average of private forecasts. Inflation forecasts for eighteen months ahead were better than other forecasts.

One striking conclusion is that short-term forecasts are not substantially more accurate than forecasts one-and-a-half years ahead. Also, forecast errors for near-term real GDP growth of about 1 percent are a large fraction of average growth—2.5 to 3 percent. This suggests that aiming at a longer term would not greatly reduce accuracy. And by concentrating on longer-term results, accuracy might improve.

Chart 10.2 shows the difference between forecast and reported values of real output from 1971 through 1999.
¹⁴
There seems little benefit to be gained from continued reliance on short-term forecasts. The Federal Reserve should not ignore current data. It should reduce the weight given to
these data using the method explained in Muth (1960) that extracts the persistent component in the data. Muth showed that the weights attached to transitory and permanent changes should reflect the relative variances of the two types of change.

13. Blue chip forecasts are the median value of a large number of professional forecasters. FOMC forecasts were made semiannually by members of FOMC. The data show the range and central tendency for these forecasts. Many other summaries of forecast errors yield similar results. In 2008, the FOMC members started to publish quarterly forecasts.

14. SPF forecasts are similar to Board of Governors staff forecasts.

Third, data revisions are a second source of error. Although data revisions are large at times and capable of misleading policymakers, revisions are less troublesome than forecast errors. Chart 10.3 shows the size of data revisions. In the relatively stable 1990s, data revisions became less trouble
some.
¹⁵
However, the July 2005 revision of national income accounts (not shown on Chart 10.3) raised the 2004 inflation rate from 1.6 to 2.2 percent.

Fourth, central banks make their judgments under considerable uncertainty about the evolution of the economy, the public’s behavior, financial innovation, and a host of other events, including errors in reported data. One source of uncertainty is the persistence of observed changes and failure to separate persistent and temporary changes. Some of the latter reverse promptly.

To reduce the influence of temporary or one-time changes the Federal Reserve relies on a measure of inflation that excludes volatile food and energy prices. This moves in the right direction. As noted above, Muth (1960) proposed a better alternative. If the transitory variance is relatively large, the reported change is considered transitory, so the best response is to do nothing. If the permanent variance is relatively large, the change is likely to
persist, so policy should respond. In intermediate cases, the proper size of the response depends on the degree to which it appears to be persistent.

15. Here is an example: The Bureau of Labor Statistics (BLS) reports payroll employment and unemployment on the first Friday of the next month. Employment is close to 140 million. BLS tries to hold its estimate within 1 percent of total employment. It fails frequently. Small changes in the seasonal factor can produce large errors (Furchgott-Roth, 2007). The Federal Reserve pays considerable attention to the announced unemployment rate despite frequent large revisions.