July

6, 1995

Long-run Ranges Donald L. Kohn

I will section tive

begin

with

a few points These exercises

from the long-run are, at best.

scenario only indica-

of the bluebook.

of the potential tendencies First.

outcomes.

but they may be useful as you think about

in illustrating alternatives. simularedein

general

and results

policy

judging level

from the staff of the federal more

projections funds rate years in.

and model is slightly

tions,

the

current and will

strictive, creases

become

so in coming kicks

as inflation This

and additional gap that

fiscal

restraint

is evident output funds

the small year

opens

up between

potential

and actual in the

this rate in

in the baseline years of past large.

strategy,

and in the decline

subsequent standards

required

to keep the gap from in the federal the easier

getting rate,

wider.

By the

variations Even under

funds

the adjustment eliminates rate

is not that monetary moves levels fiscal federal might

strategy, policy, well

which

restraint

and also

offsets

fiscal

the funds the

down

only to 4-314 in the were rate

percent,

remaining

above

lowest Even if

reached policy funds

recent

period less

of sluggish

expansion. reductions though

somewhat probably would

restrictive,

in the when they

still would

be needed,

have

to start as Mr.

depend

importantly

on the behavior

of the

bond market,

Simpson

illustrated. of price-stability goals for

Second. monetary policy

with again

the discussion coming

to the fore,

it may be useful with that endeavor.

to review The

the output bluebook

losses

that may be associated of course, embody

simulations, curve

the conventional like these

accelerationwill be

ist Phillips

model,

and calculations

probably

-2

used

in any public

debate

about

changing simulation after

the goals that

of the Federal

Reserve. hood

In sum, the bluebook stability years shortly

gets to the neighbor2000 requires 3 perin

of price point

the year

centage

of more that

unemployment inflation

than the path at around

of output

the easier To be sure, announcing sacrifice in fact,

strategy

holds

its current effect

level. of

the model

does

not allow publicly

for a credibility

and committing ratio does

to such a goal--that followed.

is, the But it is. for

not depend

on the strategy

difficult States

to find or other

such a credibility countries.

effect

empirically

the United

The model inflation

also does

not allow or trend

for favorable

feedbacks Using

of declining the very

on the level

in productivity. Wilcox flation paper.

generous

estimate gains

of the Rudebuschas the disinlosses virtual from price but less onefrom

and phasing

in the productivity value

occurs,

the present

of the net output after

disinflation stability extreme tenth

is recovered

by only a few years Others have

is reached results

in 2000.

found

favorable,

for productivity

gains:

if the effect take Some about

is about 19 years of

the Rudebusch-Wilcox the cumulative been unable

result,

it would

now to recoup course. have

lost output.

researchers,

to pinpoint

the size of any effect. the baseline risks forecast to a to

Third, supply nominal

the exercises shocks

subjecting us of the

and demand federal

remind

inherent

in using holding

funds funds

rate as the policy rate path

instrument. of such

When shocks, force

a predetermined ties begin

in the face gather

instabiliin

small,

but ultimately feed back

increasing

as changes back

inflation economy

expectations and inflation.

on real rates. real

which

feed

on the by a

The equilibrium

rate may not change in the bluebook

lot in response

to a shock:

the two illustrations

require adjustments of only 114 to l/2 percentage point.

Nonethe-

less, in the face of such a shock, to get the same inflation outcome by a given time, the lags in the effects of monetary policy mean that a much larger funds rate adjustment is needed initially than ultimately. MOreOVCZr* recognizing that the state of the world has changed

will take a while, and the longer the needed adjustment is delayed, the larger is the required initial rate movement. This is the lesson

from the United States in the late-1970s. and apparently from Japan in the mid-1990s. At this meeting, you are faced with the task of reconsidering the annual ranges for money and debt for 1995 and setting provisional ranges for 1996. Staff projections and alternative ranges for 1995

are given in a table on page 12 of the bluebook.

Overall credit flows

have been a little stronger than anticipated early in the year, reflecting importantly the financing of inventory investment.
a

MOreOVer,

remarkably high proportion of credit flows has gone through depos-

itories, as borrowers continued to favor debt that was short-term or repriced frequently until the recent sharp decline in bond yields. As a consequence, although debt growth is only a little above the

middle of its range. M3 is appreciably over the upper end of its range. With market rates coming down. and yields on M2 assets re-

sponding sluggishly as usual, savers have favored M2 assets, in effect helping to fund the re-intermediation of credit. M2, as a c~nse-

quence, is running in the upper portion of its range. Over the balance of this year. we see credit growth slowing some--bringing this mea.sure to around the middle of its current range As a conse-

--and more of it being financed in longer-term markets.

quence, M3 growth should slow substantially, but not enough to put it within its current range. M2 growth on average over the second half

-4

should

look much

like

the first half,

leaving

this

aggregate surge

within

its range. taper more off, into

We are projecting partly as rates

that the very funds

recent

in M2 will come

on money market

and other Still,

M2 assets

line with

the lower

rates.

the possibility eases

that M2 could the stance

run above

its range.

especially can't

if the Committee be ruled out.

of policy

in coming

months,

Even tion leave bank year. credit Until grown

so. only the M3 range would adjustment

seem to require

consideracould surge range in

of a possible the range "as

at this meeting. state that growth

The Committee a temporary above the

unchanged expected the staff

and simply

lending

to push actual believes

this

However,

that the weakness four years

in depository outlier. had

and M3 growth the thrift at least

over the previous crises

"as the

and bank

of the late

198Os,

M3 generally

as fast

as M2, and with depository relative to income

institutions

no" a

healthier, reasonable adjusting

faster

M3 growth

and to M2 no" seems should

expectation. its M3 range

In this upward:

case,

the Committee

consider points--to with to

an increase

of 2 percentage

2 to 6 percent--would the M2 range encompass

seem to represent a reasonable

a reasonable of being

relationship high enough

and to have

chance

M3 growth

for the year.

Such a decision

could

be explained to more normal

as a technical patterns

adjustment

to take account and M3 velocity. policy. for these

of the return without

of intermediation of monetary warned prove that

any implications Humphreyin the 1995

for the thrust Hawkins M3 range Report might Staff given on page

Indeed,

the February an increase

reasons,

necessary. and alternative Under sets of ranges the interest expect half for 1996 are and nomi-

projections

17 of the bluebook.

rates

nal income cally

of the Greenbook

forecast,

we would

in 1996 basiof this year.

a continuation

of the trends

of the second

~2 in

growth part: by

would

come

in

a little in while by the

higher

in income

1996 and

than the
slow

in

1995.

buoyed drop M3 as in

a strengthenilig next year. strong to

nominal debt

assumed

interest would

rates

and

113 would of

further: in the of total has

still

remain

standards

earlier share

1990s

depositories In simply as to

contj~nue Julys of

capture years.

a substantial the Committee

lending. chosen year

recent whatever

generally for the

carryover ranges

ranges nexr about were to

it has year-. evolving already

chosen This has

current

provisional of and to the

folk the

been

attractive relation-

because ships, no scope

uncertainties the ranges

money-income low enough about the

because lower

that the

there

was

theI;! further srability would M3

send

a message Given for

Committee's projecif you

intent tions. chose

to

seek

price

over

time. work for the

staff

this to

strategy the

certainly higher that

1996.

especially

adjust you may

rang: noticed was

1995. staff more is. discussion and forecast than in

have

of broad most of

money

and over

credit recent in

a litfle -that

straightforward there were fewer

bluebooks

years-

mentions This Eve11 of the

persistent two

shif~ts

asset

demands targeting is still

and

special

factors. more

raises if

questions: on target conveying

Is the ranges any

exercise dubious.

meaningful? behavior

relying

is the about the

aggregates economic

useful

information

underlying

si~tuatioli'? TO be sure the gryti of M2 has come oft its funds Led much more in line the backup wit!1 last in

results tw" years

from as

tradirional the last lure year. of

specifications bond mutual rhe

demand with

bver the

faled of

market well the

rates below

However. by these

this

aggregare and ~2

remair:s in of the

that

predicted was

specif~ications. in excess of the

growth

second

quartetmodel.

appreciably latter miss

prediction unusual

standard

This

likely

reflects

the

behavior-

-6

of intermediatereturns

and long-term assets

rates: with

the standard

model

proxies bill

the

on alternative choice when

a three-month rates

Treasury

rate-in their

not a good traditional

long-and These fragile.

short-term

fail to move

alignment. is still

results

suggest

that

our understanding may suggest a

of M2 demand greater changes early

The recent

experience rates.

sensitivity

of M2 demand

to long-term

and associated it seems too and useful the monetary only demand ag-

in its cyclical whether

performance. back

In other words,

to tell Even
even

we're

on a well-specified to remember that

cUlZ"e. gregates,

if we are, in their

it is well well-behaved

episodes--provided

rough of a

guideposts broad tee's ranges array

for policy, of other

and had to be interpreted in the economy. sense

in the context

information trying

It was the Conunitgrowth

frustration for M2 that

with

to make

out of annual which looked

led to the P* exercise, trends in M2.

to signals

from the longer-term Nonetheless. private and total easing

the turnaround growth

in broad money

and the pickup of the this

in

debt

this year may be indicative conditions interest that have rates.

substantial year through freely

of financial in market assets

occurred

movements liquid

Credit

is flowing These

and the

of the public

are rising or severe

rapidly. financial

circumstances constraints

do not seem to suggest on spending. to this

unusual

The exceptions are Ml. reserves,

picture base.

of relative

strength

in flows having

and the monetary to keep a result sweeps

It is true that it is.

we're

to withdraw month this

reserves has been

the funds

rate where

In the last who have tax.

of the bookkeeping to reduce earlier the

of banks,

instituted But we were

NOW account draining

reserve

requirement At the

reserves

this year flows

as well.

configuration

of interest

rates

and income

in the first

half,

.

.

-

-7.

people

don't

want

to hold

as much of

Ml. the

This

has been

largely

a

function

of the

lagged

effects

rise in

interest

rates last
see some very

year.

We expect these effects
growth

to abate;

without

sweeps

we would

in Ml and reserves

last month

and going

forward--but

slow.

More technologies nontransaction rate

fundamentally. have eroded

deregulation

and changes between more

in payment and

the differences Ml demand

transactions

assets.

making

dependent of this more

on interest aggregate than now for

relationships. over a wider

As a consequence. range

growth

swings

and its velocity interest

varies

before you

the same changes can't growth judge

in short-term financial

rates:

in other

words.

underlying from the

conditions

using

standards

for Ml rapid to go to,

derived

1960s and 1970s.

The extraordinarily with a decision

expansion

of Ml in 1992 and 1993 went what seemed

along

and stay with. policy--less judged

by other measures than in many

a moderately

expansionary the FOMC

expansionary

recessions--that Slow growth with

appropriate

to the circumstances. appear

and contraction to modest-

of Ml in 1994 and 1995 does ly restrictive is appropriate quickly ing. remind stance

consistent The question

the move

of policy.

is whether

that stance will

to the current me that that's

circumstances--but the subject

the Chairman part

of another

of the meet-

July Short-run Policy Donald L. Kohn

6.

1995

As well can be be

noted

in the a bit in with

discussion to the its the

of

long-run side staff to

scenarios. at this

policy point. and but

may This

positioned seen not

restrictive of the tilt rate

only

results downward funds

forecast

model also in

baseline the level

simulation of the

inflation. to rules" its

real read

federal outs

relative "policy to

historical to output

averages. and

in the or

from

various tend

keyed

inflation below

nominal

GDP--which even the along and

produce

federal of if

funds the mone-

rates tary

6 percent--and least unfolds in

perhaps

in the ones. like

behavior Especially the path would the price

aggregates--at reduction a decrease at intent some

narrower anything real few

federal by to be the

deficit staff, needed were

assumed seem

nominal over the

funds years,

rates

point

next

unless toward

Committee stability. scenarios

on making in

considerable the funds staff rate

progress and 112 is

Implied is that point fine seem the

forecast is about

the to

alternative 3/4 of

current its on

a percentage putting estimatle Those this size be asis too does

above a point to be

natural an

rate--though measure. readings

this

undoubtedly this

ambiguous with an

Nonetheless, from financial

consistent built Judging in

markets. like this

markets magnitude. seen as

have

easing the

by year-end market.

of something a decline growth that As of

from to

stock the

sufficient with do see

foster good

earnings

would Peter

sociated markets could be

continued some

economic of

expansion. at this up in

noted. no action

possibility with a modest

ease edging

meeting, rates.

and Over

associated

a longer

stretch, term

a failure to back

to ratify up more.

the expected at least

decline

would

cause

longersome.

rates

in real terms.

reversing movement

but by no means since

a large

portion.

of the downward

registered

last winter. But that backing up helps to keep the disinflation expectations term process are

going

in the staff difficult

forecast. to read.

Market

for inflation structure outside

at best rates

but the overall upward tilt.

of interest forecasts for

retains

an appreciable results

and many widespread

as well

as survey

seem to suggest inflation stance

expectations years. be that

flat or even

slightly

higher

over coming would

An argument in building

for maintaining in rate declines. tion; keeping

the current the market

of policy your

has misread

intentions

for inflathe odds that the

the funds

rate unchanged

at this time signal

increases to markets

on some disinflation Federal toward Reserve price takes

and would seriously

send another its stated

goal of making

progress

stability policy

over time. unchanged odds might also be preferred if the Comforecast. say

Keeping mittee

saw appreciable in market

on upside

risk to the staff

from the drop decline

interest

rates this year.

To be sure.

that

can be seen as largely economy.

an endogenous

response

to to a weakerespecially includ-

than-expected since

But markets encouraged and other

may have over-reacted, by some exogenous

they may have been testimonies
as

factors,

ing various Federal

public

pronouncements-from of further unlikely the most

the fiscal to rerecent

Reserve.

well

as by firmer

expecrations

consolidation spond data strongly perhaps

that

is not yet assured. funds

With markets

to an unchanged

rate, and with

ameliorating

concerns

about the extent

of the downward

-3

impetus tively

to the economy. small of awaiting

the Committee additional slowdown

might

view

the co.sts as relathe depth and

information and the

to judge

persistence demand place.

of the current

response market

of aggregate now in

to the more

accommodative

financial

conditions

Nonetheless, track in the eyes than

although

inflation

may not be on a downward it also is much less likely to

of outside

observers,

strengthen this

it seemed

to be when

the Committee may argue

last tightened--and for a near-term the tightening against buildin the

improvement

in the inflation

outlook

adjustment

in the stance perhaps

of policy.

In retrospect.

last February ing inflation economy pated, since

can viewed which

as an insurance

policy

pressures.

is less needed more

now.

The slowing

then has been as well

considerably as many

pronounced revised

than anticidown expected funds for unof

and the staff while

others

have

inflation rate.

also lowering members

the expected have

path for the federal projected

Committee

themselves point.

reduced

growth

1995 by almost employment the natural accelerating the Committee restraint actual

a percentage

and increased

the anticipated

rate at the end of the year to somewhere rate. With pressures would on resources

in the vicinity the risk of reduced. and

lessened,

inflation might

seem to have been greatly the degree adverse

be able to decrease a little inflation. in This regard without

of monetary movements in

at least

risking

or expected

An inclination extent the Committee reduction

would

be reinforced

to the a A

did not place in inflation

a high priority rates

on fostering future. for a

continuing number

in the immediate over the years

of you have expressed

a preference

strategy ticularly levels

that hard

would

attain

price

stability

over time by leaning to cap the

par-

against cyclical

upticks

in inflation

rate at lower reaction

in each

expansion--that strategy

is. an asymmetrical

function. deliberately tion had

Inherent

in this

is not necessarily output

seeking once inflawere to folits

to impose

a persistent

gap, especially

stabilized strategy. it would Such

around with

low levels.

If the Committee into

low this potential. policy.

the economy

now moving

line with

seem at this time to call for a more adjustment in 1996. to be sure. would again later increase would better assure

neutral the economy

a policy

that

grew along

its potential

Easing needing tee

at this time, course once

the odds

on

to reverse

this year.

If the Commitis. if you

saw the chances think

of this

occurring

as quite

large--that

didn't

the federal

funds

rate was fundamentally

too high--easing seem to risk and your you thought later to

and then

tightening

just to react TO incoming the markets situation. too high. about your

data would intentions because prepared your

unnecessarily assessment rates were reverse would

confusing

of the current

But easing and being

in fact basically

should

data come in to cause appropriate and.

you to revise in the event.

assessment, explainable

seem

entirely

readily

in the context concerned economy, shocks. stances that that

of that new information. the balance it might

In particular. toward

if you were a weaker adverse circum-

of risks was tilted

take time to recognize adjustments to policy now might

developing might

and that timely be difficult. fixed

in these

some easing funds

help to avoid

the pitfalls in

of holding supply

the nominal

rate in the face

of shifts

or demand.

If a forward-looking the amplitude "mid-course common. tion But of cycles corrections"

monetary

policy

is successful and in interest size may become to move

in damping rates. more

in business

activity small

of relatively policy

so far monetary long

has tended

in one direcmarkets are

in relatively to project reactions

sequences. rate

and. as a consequence. following

likely Market explain Hawkins likely basis

further

reductions

any easing

action. and

may be shaped today's

by the words announcement

you use to describe and in the HumphreyInstead In that markets regard.

the action--in testimony--but

only to a limited itself

extent.

are a 50

to read the action point

quite closely.

cut in the funds

rate might

be seen as connoting expansion

that the and curThe

Federal

Reserve

saw significant rates

risks to economic above

rent short-term resulting sirable

as appreciably reduction indeed

appropriate rates

levels. would

significant

in real interest saw the situation leave

be de-

if the Committee A 25 basis point

in that

light. impression speculamight

cut would

also a distinct promoting

that more tion well

was coming, immediately

perhaps

even more Still.

promptly,

almost

on when. 50 basis

the market Unlike

reaction

be smaller reversal

than with

points.

Februar-y 1994, a in the context changes in

policy

at this meeting

would

not be occurring

of public rates were

statements likely

and analysis

that appreciable to achieve

further

to be necessary

the System's

objectives.