Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. I also want to thank the staff for preparing these memos. They are very stimulating, a great discussion of a very difficult topic, and I know it was a lot of work. I also want to agree with the Chairman that all comments in this arena are in the spirit of optimal monetary policy, which is the only way I would make any comments here at the table. What is the best policy? What will get the economy back on track soonest? That is always what we are trying to think about here. The truth is that there are lots of ways that you might think about what the optimal policy is, so that is what the debate is about.

Let me begin with the first part of the memo asking for comments saying whether we should go quickly or gradually to zero. I think the most important element is somehow to switch away from nominal interest rate targeting once the target approaches zero because at that point the target just ceases to make any sense and you leave the private sector in the dark about any signals that they might be receiving about where the Committee intends inflation and monetary policy more generally to be going forward. To go quickly to zero is effectively what we have already done with respect to the federal funds rate, at least in terms of the actual federal funds rate, and if I am reading the Greenbook appropriately, according to the staff Greenbook forecast, it is evidently not going to help very much going forward. I think we did go to zero fairly quickly here.

I do not find the Reifschneider–Williams paper, which I know carries some weight around here, very compelling, so let me give the brief reasons behind that. For one thing, you are taking a model and you are extrapolating far outside the experience on which the model is based. That might be a first pass, but that is probably not a good way to make policy, and I wouldn’t base policy on something like that. There are also important nonlinearities. This whole debate is about nonlinearities as you get to the zero bound, and in my view, they are not taken into account appropriately in this analysis. You have households and businesses that are going to understand very well that there is a zero bound. It has been widely discussed for the past year. They are going to take this into account when they are making their decisions, so you have to incorporate that into the analysis. That is a tall order—there are papers around that try to do that, and many other assumptions have to go into that.

The third thing I think is important is that, in other contexts, gradualism or policy inertia is actually celebrated as an important part of a successful, optimal monetary policy. Mike Woodford, in particular, has papers on optimal monetary policy inertia, and many others have worked on it. In those papers, it is all about making your actions gradual and making sure that they convey some benefit to the equilibrium that you will get. All of a sudden, in this particular analysis, when you are facing a zero bound, that goes out the window, and I don’t think that it is taken into account appropriately in the analysis. Also, it is thrown out the window exactly at a time when you might think that the inertia and the gradualism are most important, which would be in time of crisis when you want to steer the ship in a steady way. So I think that we have a long way to go to understand exactly how to behave near a zero bound, and I would not make policy based on that particular analysis or the subsequent work. But as I stated at the beginning, I think it is a moot point anyway because the effective fed funds rate is trading near zero. We are there. We have arrived.

Does the zero bound impose significant costs on financial institutions? In general, to this I would say “no,” as the markets can adjust. More important, markets should be expected to adjust to the optimal monetary policy that we set. We are not in the business of keeping particular markets working in the particular ways that they have worked in the past. I don’t want to disrupt things so rapidly that we upset the apple cart. On the other hand, I think the attitude should be that, given enough time, we should expect markets to adjust appropriately. I guess that is what I think about that issue of going quickly or not.

We talked for a minute about communication strategies. Three were mentioned in the memo. The first was to hold the federal funds rate at zero until specified conditions obtain. The second one was the FOMC will act to counter inflation below target, and the third one was to accept higher inflation later. In general, I think that the communication idea is important and valuable to think about in this situation. This is because it plays to the rational expectations, forward-looking aspect of the behavior of households and businesses. My sense is that the benchmark forecasting models embodied in the Greenbook or in a prominent private-sector forecast such as Macroeconomic Advisers may understate these kinds of effects because they don’t completely incorporate the forward-looking elements probably as much as we would like. That is because it is very difficult to do.

So I think that the communication thing is the right idea. But I do not think that communicating that we intend to hold the federal funds rate at zero until specified conditions obtain will have much effect because the market already expects that we will maintain the rate at zero until conditions improve. That strikes me as a way of saying that we have hit our constraint, we are bound by our constraint, and so we are effectively doing nothing further. I wouldn’t want to get into that kind of message in the communication game, and the communication game is a tricky one. If we went that route, I think deflation would develop. The economy would become mired in a deflationary trap similar to Japan’s, which I illustrated last time. In general, my feeling is that understanding the Japanese situation as something like a steady state is more how we need to think of it. In a steady state, the markets are clearing, the expectations are consistent with outcomes, and there is no pretense of returning to the previous situation unless you eliminate that steady state or somehow shock the system out of that steady state. In Japan the policy rate has not been above 1 percent for fourteen years. Fourteen years! That starts to sound to me as though the best way to think about this is that there may be multiple steady states out there, and you may be at risk that the dynamics will send you to the deflationary trap.

Our understanding about the dynamics of those—I know because I have worked on them myself—is very poor. Exactly how they would work and how you would get coordination on one versus the other is a very difficult question. That research is in its infancy. But the concept that you might think about the possibilities in the situation as being multiple steady states should perhaps be entertained more seriously around the table here.

It is much better to say, as far as a communication strategy, that we are constrained on interest rates and therefore we are switching to something else. I think a monetary base, reserves, or some kind of quantity measure would be fine. The reason you want to do this is that you want to remind the private sector that we control inflation and that we intend to keep inflation close to our target. This is a way to tell a story about how you are going to do that—a way to signal to the private sector. So to get the intended effect in the minds of the private sector, you eliminate references to the federal funds target and force them to rethink their views of monetary policy and rethink what we are doing. Of course, this has to be done in a reasonable way. It can’t be done in a willy-nilly way. Also, all the issues that have ever come up around this table about monetary targeting and reserves and all the difficulties with that would come up again. But I think it is a great way to make the switch, much as Volcker did in 1979, and get the private sector to reorient to the new reality.

So, yes, it is very important to stress that we will counter inflation below target—I guess that is the second part of this question—and the idea of, well, you could say we are going to accept higher inflation later, perhaps much later. Although being a theory guy I like that because you are playing on rational expectations, it doesn’t seem as credible to me with the private sector. The way we are looking at it now, you would be talking far into the future, promising some more inflation—you know, in 2013 we will do 5 percent or something like that. It just seems too far away to have a lot of effect on our situation right now.

Let me talk briefly about purchases of agencies and longer-term Treasuries. In general, I think this is okay, but I do not think we should expect a lot of impact from this. I think the effect will be marginal. I might remind the Committee that the famous Operation Twist from the 1960s was generally judged to be ineffective, and that is why I think the central banks did not, generally speaking, play games on the yield curve in the past. I guess I would prefer agencies to the longer-term Treasuries because of the more direct correlation with the mortgage markets. I think that might help our case a little in this current situation, but I wouldn’t expect a lot out of that policy.

Expansion of 13(3) credit backstops—I see this as likely, the way policy is going. I think it is helpful in some circumstances. I would like to see us work harder, maybe much harder, on the metrics for success of these facilities and perhaps rework or discontinue facilities that may not be meeting expectations. We saw some justification here earlier in the report by Bill Dudley, which I interpret as saying that the goal is to reduce risk premiums from what markets say they should otherwise be. Frankly, I am not sure in all cases what the purpose of the programs is. We have a lot of them out there. We have ideas. We should quantify that. We should be assessing, and then we should turn around and say, “This one is working. This one is not working.” I would like to see a lot more in that direction. I understand that we haven’t done it so far because, obviously, we are running on all cylinders. We are fighting very hard here. But going forward, that is something we should be thinking about.

Our other nonstandard tools are useful. Again, I think we need to reestablish with the private sector that the central bank controls the medium-term inflation rate, even in environments where the nominal interest rate is zero. A simple way to communicate this is to start talking more about reserves, the monetary base, and the monetary aggregates. Again, this has to be done in a reasonable way. We understand that taking out a program is going to change things, and we need to communicate that effectively. We understand that the links between money growth and inflation may not be exactly what we would like them to be, but this is the situation we are in because our interest rate channel has turned off. So in normal times, I would prefer to communicate in terms of interest rates, but that is not the situation that we are in right now.

Let me talk a bit about the directive to the Desk. In my opinion, the directive should be in terms of the quantity of reserves, letting the level of the federal funds rate trade as necessary— again, not unlike the Volcker situation. Presumably, the federal funds rate would trade close to zero on average. The prescription to express the directive in terms of reserve quantities has a long tradition here on the Committee. That language was used at least through 1994, if I have it correct. I remember when I was first in the Federal Reserve System we would talk about the degree of pressure on reserve positions, and so there is ample precedent inside the System to work this way. I think that would keep everything working smoothly in terms of governance. I see no reason not to go in that direction.

The introduction of new programs that are intended to have a minimal effect on the level of reserves, as occurred before September of this year, would not interfere with the reserves objective of the Committee. Others do interfere with that objective, and in that case they would need to be approved here. But my sense of the Committee here, though I can’t speak for everybody, is that I don’t think we would have any pushback on that, and we would keep the governance thing very clear if we did it that way. So that would be my preference. I agree with the Chairman that we want the best policy. We want to work in a cooperative manner, and I think that is one way to do it here.

When the market turmoil abates, then we should begin setting target ranges for reserves or monetary base growth. Once the crisis is past, then we can begin setting a federal funds target again, maybe coming back with a range initially for the federal funds rate and then gradually moving back into the targeting regime, which I agree in normal times is a much better way to communicate policy.

Let me talk just for thirty seconds on the communication of alternative tools. Above all, we have to communicate that we control medium-term inflation even when nominal interest rates are zero and that we intend to keep inflation near target. That is the overriding objective in this situation. Otherwise, you are going to let inflation probably drift far below target, and the market will be scratching its head about, well, what are you going to do about it? Okay. Thanks very much.

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