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FEDERAL RESERVE BANK OF ST
.
LOUIS
REVIEW 
JANUARY
/
FEBRUARY
2007
3
Understanding the Fed
William Poole
This article was originally presented as a speech at the Dyer County Chamber of CommerceAnnual Membership Luncheon, Dyersburg, Tennessee, August 31, 2006.Federal Reserve Bank of St. Louis
Review 
, January/February 2007,
89
(1), pp. 3-13.
to recognize that economists have developed aformal theory of monetary policy over the past60 years or so and that this theory really doesguide our thinking. The theory has two logicalparts. The first is a clear set of objectives. Thesecond is a specification of how policy, in pursuitof these objectives, affects the economy.The model of how the economy works iscomplicated, and I could not possibly begin topresent it here. But I will say that our understand-ing of how the economy works is based on eco-nomic theory and an enormous body of empiricalresearch that tests the theory. Our understandingis often qualitative, and we know that we mustattach standard errors to our numerical predic-tions. An active research program within theFederal Reserve and by academic and businesseconomists continuously refines the theory andour empirical understanding.Let me use an analogy: Hurricane forecastinghas come a long way, but, as anyone who watchesthe weather news knows, the forecasts are notperfectly reliable. Ship captains have to makepolicy decisions on what courses to set, takinginto account the forecasts and what is knownabout forecast accuracy. Economic policymakershave to make the same sorts of decisions basedon incomplete knowledge.
P
eople often ask me questions aboutthe Fed, sometimes out of simplecuriosity and sometimes out of a realneed to know for business reasons.Portfolio managers, for example, have a real needto know. My remarks reflect my effort to providerather systematically some answers to commonquestions. And I will also answer questions thatought to be put to me, but usually are not. Thereis no reason why the Federal Reserve should bea mysterious organization—we ought to beresponsive to your concerns.Obviously, I want to emphasize that the viewsI express here are mine and do not necessarilyreflect official positions of the Federal ReserveSystem. I suspect that each of us involved inFederal Reserve policy would answer the ques-tions somewhat differently and emphasize differ-ent things. In any event, I’ll offer my answers. IthankmycolleaguesattheFederalReserveBankof St. Louis for their comments, especially Robert H.Rasche, senior vice president and director of research, who provided special assistance.
THE ROLE OF ECONOMICSCIENCE IN MONETARY POLICY
A very general question concerns the basis onwhich policy decisions are made. It is important
William Poole is the president of the Federal Reserve Bank of St. Louis. The author appreciates comments provided by colleagues at theFederal Reserve Bank of St. Louis. Robert H. Rasche, senior vice president and director of research, provided special assistance. The viewsexpressed are the author’s and do not necessarily reflect official positions of the Federal Reserve System.
©
2007, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.
 
So, given policy objectives, and given a viewabout how policy decisions affect the economy,the central bank can in principle specify a policyrule, or response function, that guides policy. Toachieve a good result, the general public and mar-ket participants need to understand the objectivesand the response function so that the privateeconomy can determine its activities with fullknowledge of how the central bank will act. Of course, uncertainty is an inherent characteristicof the economic world. What should be predict-able are the central bank’s responses to the never-ending sequence of surprises that characterizethe economic environment.
 Monetary Policy Objectives
Congress sets the mission of the FederalReserveintheconductofmonetarypolicy.Origin-ally,theFed’smissionwasspecifiedintheFederalReserveActsignedintolawbyPresidentWoodrowWilsoninDecember1913.TheFed’scurrentman-date, set formally in an amendment to the FederalReserve Act in 1977 and reaffirmed in 2000,requirestheFederalReservetopursuethreeobjec-tivesthroughitsconductofmonetarypolicy.Theyare “maximum employment, stable prices andmoderate long-term interest rates” (Bernanke,2006a). Economists recognize that long-terminterest rates incorporate a premium for expectedinflation. Thus, the objectives of price stabilityand low long-term interest rates are essentiallythe same objective.This “dual mandate,” so-called because of itsemphasis on both employment and price stabilityobjectives,differsfromthatofothercentralbanks,especially the “inflation targeting” central banks.Inflation targeters, including the Bank of Canada,the Bank of England, and the Reserve Bank of New Zealand, among others, operate under anagreement with their respective governments thatdefines price stability as the single objective andspecifies a quantitative definition of the inflationobjective. In a similar fashion, the EuropeanCentral Bank (ECB) is given a price stability man-dateundertheMaastrichtTreaty,thoughthetreatydoesnotgiveanumericvalueorrangetotheECB.The ECB has interpreted its mandate as prevent-ing the inflation rate from exceeding 2 percentper annum over a “medium term” horizon.Today, there is general agreement amongprofessional economists and central bankersaround the world that, in the long run, monetarypolicycannotachieveatradeoffbetweeninflationand employment. Successive Fed chairmen haveemphasized that price stability is not only a man-dated objective of monetary policy but also themeans by which monetary policy contributes toachieving the other two objectives. The view goes back at least to Chairman William McChesneyMartin:“Myinterestinamonetarypolicydirectedtoward a dollar of stable value is not based on thefeeling that price stability is a more importantnational objective than either maximum sustain-able growth or a high level of employment, butrather on the reasoned conclusion that the objec-tive of price stability is an essential prerequisitefor their achievement” (McChesney Martin, 1959,p. 5). In his 1979 confirmation hearing, ChairmanPaulVolcker(U.S.Congress,1979)madethisstate-ment: “I believe that ultimately the only soundfoundation for continuing growth and prosperityof the American economy is much greater pricestability.” Early in his tenure, Chairman AlanGreenspan (1988) concurred in this view: “TheCommittee continued to focus on maintainingthe economic expansion and on progress towardpricestability,whichwasseenasanecessarycon-dition for long-term sustained economic growth.”In July 2006, Chairman Ben S. Bernanke (2006b)acknowledged the following: “The achievementof price stability is one of the objectives that makeup the Congress’s mandate to the Federal Reserve.Moreover,inthelongrun,pricestabilityiscriticalto achieving maximum employment and moder-ate long-term interest rates, the other parts of thecongressional mandate.”I believe that we can go a step beyond thesestatements. In my view, the goal of price stabilitymust be the primary goal for three reasons. First,inthelongrun,employmentandeconomicgrowtharemaximizedinanenvironmentofpricestability.Second, only in an environment of price stabilityand market confidence that the central bank willcontinuetomaintainpricestabilitywillthecentral bank be in a position to act deliberately to offset
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2007
FEDERAL RESERVE BANK OF ST
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LOUIS
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many types of disturbances that would otherwisecreate fluctuations in employment and output.The Federal Reserve does not have the power tocompletely offset all such disturbances, but itcan cushion their effects and thereby improveeconomic stability. Finally, price stability is agoal in its own right simply because price insta- bility creates arbitrary and unfair redistributionsof income and wealth.I have often noted that my own personalpreference is to define “price stability” as a con-dition in which the rate of inflation, properlymeasured, is on average zero. I insert the qualifier“properlymeasured”topointoutthatactualpriceindices may have statistical problems such thatzeromeasuredinflationonaparticularpriceindexmight not in fact reflect a true state of zero infla-tion.Althoughmyownpreferenceisforzeroinfla-tion properly measured, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important thanthe exact number chosen. Thus, I find that recentdiscussion of a “comfort zone” of 1 to 2 percentinflationmeasuredbythepriceindexforpersonalconsumption expenditures (PCE), excluding thevolatile food and energy components, is perfectlyconsistent with my own thinking.Note that the congressional mandate to theFederalReservedoesnotincludeanyofnumerousobjectives that from time to time have been advo-cated by supporters of various interests: for exam-ple, stable exchange rates, stable asset prices, orhousing investment. Clarity of objectives is animportant attribute of monetary policy today andcontributes greatly to its success.
Systematic Policy 
The dual nature of the Fed mandate is wellsummarizedinthe“Taylorrule.”In1993,Stanfordeconomist John Taylor proposed a simple formularelating the federal funds rate to (i) a long-runinflation target and (ii) short-run deviations of inflation from that target and short-run deviationsofrealgrossdomesticproduct(GDP)(Taylor,1993)from a measure of “potential real GDP.”
1
Taylorsuggested that his simple relationship character-ized in broad outline the actual behavior of thefederal funds rate in the early years of theGreenspanFOMC.Theessenceofthisrelationshipis that, in the long-run, the FOMC seeks to keepthe federal funds rate roughly consistent with alevel that is believed to produce a target level of inflation. Taylor assumed a target rate of inflationof 2 percent per year measured by the total con-sumer price index (CPI). In the short run, therelationship implies that the FOMC adjusts thetarget federal funds rate up as either the observedinflationrateexceedsthetargetlevelofinflationorreal GDP exceeds potential real GDP. Conversely,undertheTaylorrule,theFOMCreducesthetargetfederal funds rate when inflation falls below itstarget and/or real GDP falls short of potential realGDP. Thus the relationship incorporates the pri-macyofalong-runinflationobjectivewhileincor-porating short-run stabilization efforts.Figure 1 shows the actual value of the federalfunds rate target on FOMC meeting dates startingin 1987 as well as a computed value based onTaylor’s original formula and the informationavailable to the FOMC at the time of each meet-ing.
2
The inflation rate in the figure is the totalCPI. Through 2000, the gap between real GDPand potential real GDP is the value measured bythe staff of the Board of Governors at the time of each FOMC meeting.After 2000, the staff assumptions about theGDP gap are not yet publicly available, so thedotted line in the graph for this period is com-puted with the GDP gap as constructed by theCongressional Budget Office. Also beginning in2000, the FOMC changed its inflation objectivein two ways. First, the Committee emphasizedthe inflation rate as measured by changes in thePCE inflation rate rather than the CPI inflationrate. Second, the Committee emphasized the corePCE index, which excludes the volatile food andenergy components. Hence, it is likely that after
Poole
FEDERAL RESERVE BANK OF ST
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LOUIS
REVIEW 
JANUARY
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FEBRUARY
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1
Taylor compared the values of his formula against the observedhistory of the funds rate from 1987 through 1992.
2
In the figure, the Taylor formula is evaluated on the basis of “realtime” information that could have been used in reaching a policydecision. Since May 17, 1989, all changes in the intended fundsrate have been 25 basis points or multiples thereof. Since April18, 1994, all changes in the intended funds rate have been votedon by the FOMC either at a regularly scheduled meeting or on anintermeeting conference call.
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