The Role of Research in Monetary Policy Transcript

Jekyll Island Conference

November 06, 2010

Charles Davidson: Welcome to the podcast of the Jekyll Island Conference sponsored by the Federal Reserve Bank of Atlanta and Rutgers University. We're in Jekyll Island, Ga., at the Jekyll Island Club Hotel with conference panelists who gave presentations on the role of research in monetary policy. Moderator Dave Altig, who is research director of the Atlanta Fed, talks with presenter Marvin Goodfriend, professor of economics at Carnegie Mellon University, and panel discussant Athanasios Orphanides, governor of the Central Bank of Cyprus.

Dave Altig: Athanasios, you said, you made a point of saying that, really, research was part of the policymaking process from almost the beginning of the founding of the Fed. Do you want to expand on that a little bit?

Orphanides: Yeah, sure. As with any policy decisions, policy research that informs the debate is very important. The Fed was founded before the First World War, and really during the war, there wasn't monetary policy decisions that could be made. All of the efforts were on supporting the war effort. But as soon as the war stopped in 1919, the Fed hired a lot of staff—first in New York, board people, Federal Reserve Board people from Washington originally working in New York. They started collecting data because aggregate data for the United States did not really exist up to that point. And within a few years, they had a framework that was remarkable in how modern it looks in retrospect and was used to help the policymakers stabilize prices and stabilize the economy at the same time.

Altig: So, Marvin, you were recounting a somewhat more recent history than that. One of the case studies that you discuss is the beginning of the release of information about the policy decisions in real time in the mid-nineties. You made a point that this was sort of the confluence of academic research coming together with changes in Fed policy and actually attitudes from Congress about what the Fed ought to be doing. So what's the totality of your story there?

Goodfriend: Well, it's an amazing triple of preparation for this momentous moment in the Fed's history, and it was February 1994, and for the first time, it announced immediately after it made its policy decision that it had changed the federal funds rate. Before that, the Fed delayed the announcement of its interest rate actions by as much as eight weeks. And so the current target for the federal funds rate was actually never publicized until it was already out of date. And so once the Fed made this move in February 1994, it understood that from then on every action it would take would be on the front page of every newspaper in the world. That's what we see now.

That couldn't have happened without the three sorts of preparation that I mentioned that you were outlining. The academics had been talking for a few years about the Fed moving interest rates around, even though the Fed was a little reluctant to admit to that. And the Fed itself had found a way to make monetary policy on a systematic basis to stabilize prices, and it was able to talk productively with the public. You couldn't do that in the days when monetary policy was more chaotic, in the past. And then the last preparation was that the Congress, in its role as monitor of the Fed, was demanding more transparency. And in February 1994, the Federal Reserve made the move to come clean, to announce fully and publicly the interest rate policy action of the moment.

Altig: Now, you were an important contributor to that academic research, so correct me if I'm wrong, but my recollection is it was received relatively poorly within some corners of the system at the time you did it in the eighties.

Goodfriend: Yeah. So, I can tell the story relatively quickly, but it will take a few seconds. The Federal Reserve was—well, the Federal Open Market Committee was sued under the Freedom of Information Act, which was a federal law passed in the 1970s. And the Federal Open Market Committee was sued under the act to make public immediately its deliberative process for monetary policy. And the Fed fought that lawsuit successfully. The suit was won by the Fed in 1981. It took about six years for the Fed to fight it. I got to the Federal Reserve as a young economist in 1980, and I was reading this in the newspapers. And so I decided to write an article on it. Why did the Fed value secrecy in monetary policy? And so I wrote a paper, and the paper was finished sometime around 1985, “Monetary Mystique: Secrecy in Central Baking.” And we had a Federal Reserve System Research Committee meeting—we used to meet periodically to vet each other's research work—and there was a session at the Minneapolis Fed., which is where the meeting was being held that year, “Secrecy in the Federal Reserve.” And people didn't think that was a subject we should be talking about.

What was interesting about the whole episode is that I was able to publish the paper in a very good journal in 1986, and in 1994 or 1995, Alan Blinder, appointed by Bill Clinton to the Federal Reserve Board, pronounced that paper very worthwhile research and pushed the Fed to become more transparent.

Altig: Do you think that it was originally met with some resistance because one of those three pillars that you mentioned as sort of catalysts to more transparency, those weren't really in place at the time?

Goodfriend: I do believe that, yes. I think it was important that all three pillars were put in place for this to finally take place.

Altig: Now, Athanasios, you were an important player at the Board of Governors on the staff during the period of time when the Fed was becoming increasingly more transparent, starting with the episode Marvin recounts. But it took a while for it to kind of completely play itself out. Is there anything you remember about—did you have discussions about what was sensible to be revealed, and did it change the way the staff approached its work in any way? What was the thinking at the time?

Orphanides: Oh, indeed, there was a lot of discussion. If we follow the historical record from the Federal Reserve, that discussion goes back decades. There was for a time a sensitivity that if something is announced without a good explanation of what it's about, it could be misunderstood. And there was a concern that the markets might overreact to initial announcements. So it actually took some debate to feel more comfortable that any of the potential costs and fears of becoming more transparent over time would be counter-weighted by the benefits of openness and transparency.

And there are a number of benefits. The literature Marvin was talking about before, there are significant benefits that can improve the position of a central bank and its ability to be effective in monetary policy when it's more transparent. One of it—very fundamental in a democracy—is that we want an institution like the central bank to be accountable for what it's doing. That allows the central bank to take tough decisions when tough decisions are in order—for example, raising interest rates when this may be unpopular at the time. And this is very hard to do if you're not transparent. Transparency can help the central bank when the framework works properly.

But I have to go back and say, why didn't we have transparency earlier? And to understand that, one has to go back to the experience of the 1960s and the 1970s, when, for a time, there was political pressure on the Federal Reserve, as is so nicely described in Allan Meltzer's history. In 1979, when with high inflation, the Federal Reserve decided to change its policy framework, focus on restoring price stability and prosperity in the nation, it was thought that perhaps the cost of being too transparent would overweigh the benefits and might complicate the other tasks of the Federal Reserve at the time. So it was only after the success of the Federal Reserve to bring inflation down—and this might be a fourth ingredient to the list of three ingredients that Marvin pointed out before—that it was much easier for the Fed to start becoming much more transparent.

One final point: The Fed has been, in its history, the most transparent central bank regarding its historical policy record. And this is very important. I mean, right now, with a log of five years, we have a complete record of the policy and deliberations of the central bank, and this is unique in the developed world.

Altig: Let me ask one last question of both of you. This was a session about research and the interaction of research and policymaking. You've both had careers that were very intimately involved in playing in this area. Your paper, Marvin, was a fine testament and I think Athanasios has signed on completely to all the positive spillovers from the efforts of economists, both within the central bank and outside of the central bank, in making monetary policy better. In the aftermath of the crisis of the last several years, there has risen in some quarters, from some very eminent economists and observers, the idea that economists were the problem and that the research community sort of became enslaved by old ideas and mistaken notions, and because of that missed something essential in averting the crisis. So I'd be interested in your take on that position.

Goodfriend: The answer is pretty short. I think it's wrong, and I think it's wrong for a couple of reasons. One is, first of all, the great success over the last 30 years has been the stabilization of inflation. It was economic research that led practical people to believe that stabilizing inflation would create a moderation of economic fluctuations and employment and an extension of business expansions, which is what it did. We had two of the longest business expansions in U.S. history before this latest crisis.

Next point I would make is, many of us, my own research included, recognized we needed to take money and banking seriously in our macro models, and I wrote and published a paper on introducing money and banking to the now-standard New Keynesian Model that appeared in 2007 before the crisis began. We were very modest about that. We recognized banking could create problems, and we tried to get ahead of the curve. I think economists have been doing as good a job as they can be in keeping up with this tremendously dynamic financial and market system that we've produced in the United States and around the world. I think economists have done a tremendous amount to find a way for central banks around the world to learn how to do monetary policy in a stabilizing way. And it's really, frankly, hard for me to see how people can criticize that, given the nature of the task, the reasonable success, the modesty that most of us who work in this have about the need for understanding money and banking better than we have.

And let me add one more point: I would say that the political economy of monetary policy and the political economy of regulation—that is, the politics—is the problem. It has interfered with our ability to regulate the system, to put in place practices which promote stability of financial markets and stability in housing markets. It's the political economy, in my book, that is where the problem lies in producing even better policy in the future.

Altig: Athanasios?

Orphanides: Well, I start by saying that the management of a macroeconomy is a complicated task. We need to keep in mind that the central bank does not have the powers to fix every problem that appears in a complicated economy. My take on the crisis is that it was not the result of monetary policy errors, by and large, but rather flaws in the regulatory and supervisory environment. We essentially allowed, I believe—and this happened not only in the United States, but internationally—financial innovation to get ahead of supervision and effective regulation, and this is why you have so much effort going into restoring the balance going forward.

So, if this crisis wasn't the outcome of bad monetary policy decisions, I wouldn't put so much blame on central banks, and I would go back to highlighting a couple of the positives that research has offered us. First of all, once we were in the crisis, the fact that we had policy research on the shelf that could inform central banks what to do was, in my mind, very important in containing the other sides of this crisis. And this is why we ended up not having a repeat of the Great Depression, which could have been a terrible outcome, indeed, if monetary policy and fiscal policy were not as effective this time. Overall, a prominent role for research cannot ensure that old mistakes are avoided, but there are times where policy research of the still implications of both theory and the historical experience and the empirical evidence for tackling a major challenge, such as the one we have right now, can really help contain the damage. I trust that when the evaluation of the current crisis is completed many years from now, we will find out that this was such an occasion where policy research was very beneficial.

Altig: Thank you both.

Charles Davidson: This concludes our podcast of the Jekyll Island Conference sponsored by the Federal Reserve Bank of Atlanta and Rutgers University. Thanks for listening, and please return for more podcasts. If you have comments, please e-mail us at