Geithner: Some Perspectives on U.S. Monetary Policy

Remarks by President Geithner: Some Perspectives on U.S. Monetary Policy. - FEDERAL RESERVE BANK of NEW YORK

Speech

Remarks by President Geithner: Some Perspectives on U.S. Monetary Policy.

January 11, 2006

Timothy F. Geithner

, President and Chief Executive Officer

Remarks at the New York Association for Business Economics in New York City

Thank you for giving me the opportunity to speak to you today.

The craft and the discipline of the business economist have

long had a special place in the Federal Reserve System. And

I am pleased to have the chance to meet with this distinguished

group in the profession.

My remarks are my personal views and do not attempt to represent

the views of the FOMC.

The U.S. economy has entered its 17th quarter of economic

expansion. As has been the case throughout history, this expansion

has features that distinguish it from past expansions, and

I’ll begin my talk today with a review of some of these

features.

Growth in real GDP has been remarkably stable over the past

two years, even when compared with the moderation in growth

that has occurred over the previous two decades relative to

the earlier part of the post-war period. These steady growth

rates have hovered in the vicinity of 3.5 percent, which is

close to most estimates of the rate of potential growth in

the U.S. The robustness of growth is a testament to the resiliency

and flexibility of the U.S. economy in responding to adverse

shocks.

A key feature of this expansion is the continued strength

in productivity growth. The 3.7 percent annual rate of productivity

growth the U.S. economy has averaged since the end of 2002

is well above most estimates of the underlying or structural

rate of growth in productivity, which tend to be between 2.5

and 2.75 percent, estimates themselves that are much higher

than those of a decade earlier and reflect the outstanding

productivity performance of the U.S. economy in the last 10

years. Much of the source of the recent productivity growth

seems to be in multi factor or total factor productivity—in

other words, in increases in the efficiency of business processes

and the use of technology.

These developments in productivity growth are important,

of course, because of their potentially favorable implications

for inflation dynamics and for future income growth.

Overall inflation has risen over the past two years, pushed

up primarily by higher prices for energy and other commodities

and industrial inputs. Inflation excluding food and energy,

however, has been quite moderate, in part due to very modest

growth in unit labor costs. Survey based measures of consumer

inflation expectations at longer horizons have remained stable

despite the large increases in energy prices, though some

of them remain slightly above the 1.5 to 2.5 range for the

CPI index that some have cited as a reasonable definition

of price stability in the United States.

These favorable developments in fundamentals have been accompanied

by important developments in financial markets.

Expectations of future inflation have fallen, and there appears

to be confidence in continued stable, low inflation. Credit

spreads and measures of future volatility derived from financial

market data have fallen, suggesting that investors and savers

expect the greater realized stability in growth is likely

to endure. Real interest rates at longer horizons have remained

relatively low, reflecting at least in part that the global

supply of savings has increased relative to demand for investment.

A range of different asset prices has risen significantly,

and the expected volatility of many asset prices has fallen.

These developments in market prices have occurred in the

context of important changes in financial intermediation,

including the substantial expansion of access to consumer

credit and capacity for homeowners to borrow against the equity

in their homes, the greater use of financial instruments for

transferring and mitigating risk, and the growth of financial

flows between countries. And in this context, balance sheets

have continued their impressive growth, with assets and liabilities

of both households and of economies as a whole growing faster

than income.

These broad trends are obviously related. Less overall concern

about inflation and real risk, the positive outlook for productivity

growth, and the increasing depth and sophistication of financial

markets, all might be expected to induce an increase in the

scale of gross liabilities and assets relative to income,

for leverage and net borrowing to increase relative to income.

While policymakers can witness the movements in key financial

market variables, it is difficult to say for sure what their

implications are for economic fundamentals, that is, for inflation

and output. And even if we had more confidence in the forces

behind past movements in asset values, we would still face

substantial uncertainty about their future behavior. The relatively

low compensation for risk priced into asset markets today

does not necessarily mean the future will justify that confidence.

This uncertainty surrounding the current behavior of asset

values complicates the task of assessing the future trajectory

of asset prices, and the impact of alternative monetary policy

paths on asset values. And by widening the already substantial

degree of uncertainty that surrounds estimates of the equilibrium

real rate of interest, these developments complicate the task

of assessing the appropriateness of a given stance of monetary

policy against the objectives of the Federal Reserve.

While the evolution toward more efficient and globally integrated

financial markets is surely a positive for long-run economic

growth both here and abroad, it also challenges policymakers

to constantly update and question our understanding of the

behavior of financial market indicators and the signals that

these indicators can provide in the policymaking process.

And as financial markets continue to broaden and deepen, the

behavior of asset prices will play an important role in the

formulation of monetary policy going forward, perhaps a more

important role than in the past.

What might this mean for the Fed and for other central banks

in practice?

There is a well established, and I believe fundamentally correct,

case against directing monetary policy at specific objectives

for asset values or the future path of those values. In other

words, asset values should be neither a target nor a goal

of monetary policy. The rate of increase in asset values alone

seems to tell us very little about underlying and future inflation.

Because we know so little about how to assess the appropriateness

of asset values against fundamentals, because we have so little

capacity to both forecast and predictably affect the future

path of asset prices, and because we know relatively little

about how changes in wealth affect the real economy and inflation,

we cannot use monetary policy responsibly or effectively to

achieve specific objectives for asset values. Monetary policy

does not today and is unlikely in the future to offer us an

effective tool for directly reducing the incidence of large

or sustained deviations of asset values from what might turn

out to be their fundamental values, what some call bubbles.

That said, monetary policy still has to take into account

the impact of significant movements in asset values on output

and inflation. Financial asset prices, by their nature, allocate

resources between the present and the future and thereby affect

consumption, investment and future growth. History provides

us with numerous examples in which significant movements in

asset prices have had sizable effects on the path of output

relative to potential and on price stability.

And experience suggests that asset values can be very sensitive

to movements in monetary policy or to the perceptions of future

policy moves. The challenge for central banks is to determine

how movements in asset values and expected asset values affect

the evolution of the economy. There is little to suggest that

the task has gotten easier with the increasing complexity

of financial markets, and it has more likely gotten harder.

The incorporation of asset price movements into monetary

policy formation is hard to do, in part, because we don’t

know that much about the transmission mechanism from movements

in asset values to the underlying economic fundamentals we

care about. We cannot estimate with a high degree of confidence

the effects of realized asset price movements on economic

outcomes. The relationship, for example, between changes in

housing prices or equity prices and household savings and

consumption varies substantially across time and circumstances,

a fact that only exacerbates the difficulty of sorting out

the effect of changes in wealth from other factors, such as

greater confidence in future real growth resulting from the

acceleration in productivity growth.

And successfully integrating asset prices into monetary policy

formulation is also hard to do because of the difficulty of

assessing how potential alternative paths for monetary policy

will feed through to overall financial conditions and thereby

for output and inflation—in other words it is difficult

to forecast how changes in current or expected policy will

affect asset values.

These and other factors magnify the challenge of taking asset

prices into account in the formulation of monetary policy.

But to acknowledge these complexities does not weaken the

case for the importance of trying to make sensible judgments

about how monetary policy should respond to asset price developments.

Here are some considerations for how central banks should

navigate through these challenges.

First, in circumstances where the central bank observes a

large realized movement in asset prices and is confident in

its knowledge of the impact of those moves on the path of

aggregate demand, monetary policy may need to follow a different

path than might have seemed appropriate in the absence of

those developments. In other words, when policymakers have

already witnessed a significant move in asset values, and

are confident in what that move means for the outlook, it

should be prepared to adjust policy accordingly. Note that

in order for this seemingly straightforward proposition to

apply the central bank must be responding to its assessment

of what an already observed movement in asset prices will

mean for output and inflation.

Of course central banks must always be prepared to respond

when factors threaten to push aggregate demand away from aggregate

supply and impact the inflation outlook. Movements in asset

prices certainly have the potential to be one of those factors,

and the implications of this approach apply in both directions.

In other words, central banks have to be prepared to adjust

policy when past asset price increases could be a significant

factor putting upward pressure on aggregate demand, as well

as when past declines threaten to reduce output relative to

potential.

Although the potential case for adjusting policy applies

in both directions, the implications for policy may differ.

Because some asset prices may fall more abruptly than they

rise, and because the effects of downward moves in asset prices

on demand may be larger due to the greater negative impact

of deflation on the net worth of borrowers—witness the

United States in the 1930s or Japan in the 1990s, the case

for adjusting monetary policy in response to negative asset

price shocks is commonly considered more compelling than in

the alternative context. But this does not mean that monetary

policy should generally ignore the effects of increases and

only respond to observed declines in asset prices. The test

should be the size and circumstances of the asset price moves

and their impact on the forecast relative to the central banks’

objectives, not the direction of the asset price move.

Different considerations apply in the circumstances where

the central bank is considering how a potential future move

in asset prices may affect the forecast. These circumstances

call for even greater caution and care. Here is it very important

that the forecasts central banks consider in making monetary

policy decisions are explicit about assumptions for future

asset price movements, the uncertainty that surrounds them,

the sensitivity of the forecast to alternative assumptions,

and the costs and consequences of alternative paths for monetary

policy. Even in circumstances where asset prices may appear

to have moved away from fundamentals, and it seems reasonable

to consider the implications of some deceleration in the pace

of future increase or some decline, central banks need to

be very cautious about adjusting policy in anticipation of

that event, much less directing policy at inducing it. The

substantial uncertainty about the path of asset price movements

going forward necessarily reduces the case for altering policy

in advance of the move.

Consider the case in which it seems prudent for the central

bank to incorporate an assumption for a significant move in

the rate of change in future asset prices into its forecasts

for output and inflation. If the central bank’s assumption

is that asset prices are likely to fall over the forecast

horizon, perhaps in the wake of a sustained rise in those

prices, then it might in turn forecast a softer path for aggregate

demand. These changes in the outlook might imply a lower expected

path for the target rate than would have been implied by a

different assumed path for the behavior of asset prices. If

it turns out that the anticipated fall in asset prices does

not materialize, the policy constructed under the assumption

of a decline will likely have been too easy, and that might

itself contribute to further rises in asset prices.

This might sound like a more or less generic statement about

the perils of having to make policy based on forecasts, but

there is a sense in which the forecasting of asset prices,

or indeed even understanding the driving forces behind movements

in asset price after they have occurred, is particularly challenging.

This is why there is a vast literature focusing on these challenges

and characterizing the many "puzzles" of the behavior

of asset prices.

More generally, despite the fact that policymakers can’t

be completely confident in their assessment of the future

path of asset prices, it seems unavoidable that these assessments

will factor into policy decisions. This is not to say that

central banks should lean against bubbles or against asset

price movements themselves. Nor should the appropriate response

to a given change in asset prices be to change policy by more

than what would be appropriate to address the effects on the

central objectives of the central bank. But policy, in some

circumstances, will need to respond to asset price movements

when those movements alter the central bank’s assessment

of the risks to its outlook, and that change in the assessment

of the risks to the forecast should be part of the central

bank’s communication with the public.

This leaves us with no simple or clear doctrine for the role

of asset prices in monetary policy regimes. Asset prices probably

matter more than they once did, but what that means for monetary

policy necessarily depends on the circumstances.

Perhaps it makes sense to conclude with the more general

observation that changes in the size of balance sheets increase

the importance of sustaining the credibility of monetary policy,

because they increase the costs of a loss of credibility or

a negative shock to credibility. We live with considerable

uncertainty about the sustainability of the pattern of relatively

low risk premia and reduction in the cost of insurance against

future macroeconomic and financial volatility. That uncertainty

necessarily adds to the normally substantial degree of uncertainty

we face in making monetary policy judgments. All these factors

strengthen the case for being open about what we do not know.

And it reinforces the case for preserving confidence in our

commitment to keep underlying inflation low over time, and

for retaining the capacity to respond with flexibility to

the challenges we face in this uncertain world.

Thank you.

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