From the text of Alan Greenspan's speech on central banking at a Federal Reserve Bank of Kansas City symposium in Jackson Hole, Wyoming, as reported by Bloomberg:
In the spirit of this conference, I asked myself what developments in the past eighteen years--both in the economy and in the economics profession--were most important in changing the way we at the Federal Reserve have approached and implemented monetary policy.
A succinct description of why there is no longer any "money" in "monetary policy"...
M1 was the focus of policy for a brief period in the late 1970s and early 1980s. That episode proved key to breaking the inflation spiral that had developed over the 1970s, but policymakers soon came to question the viability over the longer haul of targeting the monetary aggregates. The relationships of the monetary aggregates to income and prices were eroded significantly over the course of the 1980s and into the early 1990s by financial deregulation, innovation, and globalization. For example, the previously stable relationship of M2 to nominal gross domestic product and the opportunity cost of holding M2 deposits underwent a major structural shift in the early 1990s because of the increasing prevalence of competing forms of intermediation and financial instruments.
... and what replaced it:
In the absence of a single variable, or at most a few, that can serve as a reliable guide, policymakers have been forced to fall back on an approach that entails the interpretation of the full range of economic and financial data. Policy is implemented through nominal and, implicitly, real short-term interest rates. However, reflecting the progress in economic understanding, our actions are now better informed about the pitfalls associated with relying on nominal interest rates to set policy and the important role played by inflation expectations in gauging the stance of monetary policy.
How understanding the role of expectations has informed FOMC communications:
Our appreciation of the importance of expectations has also shaped our increasing transparency about policy actions and their rationale. We have moved toward greater transparency at a "measured pace" in part because we were concerned about potential feedback on the policy process and about being misinterpreted--as indeed we were from time to time. I do not intend this brief and necessarily incomplete review of events to illustrate how far we have come or to despair of how far we have to go. Rather, I believe it demonstrates the inevitable and ongoing uncertainty faced by policymakers.
On the "risk management" approach to monetary policy:
Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy...
In effect, we strive to construct a spectrum of forecasts from which, at least conceptually, specific policy action is determined through the tradeoffs implied by a loss-function.
An example? Sure.
In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then- gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates.
The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. Moreover, the risk of a sizable jump in inflation seemed limited at the time, largely because increased productivity growth was resulting in only modest advances in unit labor costs and because heightened competition, driven by globalization, was limiting employers' ability to pass through those cost increases into prices. Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs.
Does the Committee pay any attention at all to all this asset-price stuff? You bet.
Our forecasts and hence policy are becoming increasingly driven by asset price changes.
Beyond that, not much comment, excepting this warning:
[The] vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
And finally, a very modest assessment of why things have, on balance, gone very well during the Chairman's tenure:
The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances. That process of correction limits the size and the consequences of cyclical imbalances. Enhanced flexibility provides the advantage of allowing the economy to adjust automatically, reducing the reliance on the actions of monetary and other policymakers, which have often come too late or been misguided.
In fact, the performance of the U.S. economy in recent years, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence that we have benefited from an enhanced resilience and flexibility.
We weathered a decline on October 19, 1987 of a fifth of the market value of U.S. equities with little evidence of subsequent macroeconomic stress--an episode that provided an early hint that adjustment dynamics might be changing. The credit crunch of the early 1990s and the bursting of the stock market bubble in 2000 were absorbed with the shallowest recessions in the post-World War II period. And the economic fallout from the tragic events of September 11, 2001, was limited by market forces, with severe economic weakness evident for only a few weeks. Most recently, the flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years.
Did the central bank help? Yes, but again in a very modest , even if extraordinarily important, way:
I acknowledge that monetary policy itself has been an important contributor to the decline in inflation and inflation expectations over the past quarter- century. Indeed, the Federal Reserve under Paul Volcker's leadership starting in 1979 did the very heavy lifting against inflation. The major contribution of the Federal Reserve to fashioning the events of the past decade or so, I believe, was to recognize that the U.S. and global economies were evolving in profound ways and to calibrate inflation-containing policies to gain most effectively from those changes.
Hear, hear.
UPDATE: Calculated Risk takes note of the Chairman's closing remarks. Mark Thoma too. More, from Bloomberg.
UPDATE: Another report, from Tax Policy Blog.
LAST UPDATE I NEED ON THIS ONE, I THINK: Basically, The Mess That Greenspan Made has it all