Frankfort, Ky. — A key part of the Federal Reserve's ability to track and contain inflation is that the Fed is successful at both extracting information from observable data used in economic models and applying judgment beyond observable data.
William Poole, president of the Federal Reserve Bank of St. Louis, made that point among others in a speech to students, faculty and community leaders today at Kentucky State University.
"Policymakers often have to act 'observation by observation,' evaluating data and responding to events," said Poole. He cited the Asian financial market crisis, international capital market events that felled Long Term Capital Management, the 9/11 terrorist attacks and, most recently, Hurricanes Katrina and Rita. "Moreover, large shocks often differ from each other in size and effect, further taxing the Fed's knowledge, skills and judgment," he said.
Poole noted that some "shocks" appear gradually, surrounded by controversy and disagreement, citing the 1990s rise of productivity as an example. ""Federal Open Market Committee transcripts show that Chairman Greenspan was concerned as early as 1992 that official data were understating productivity growth, " he said. "No model would have substituted for his experience, intuition and discussions with industry contacts."
Poole said theoretical price determination models provide a framework within which detailed judgments based on anecdotal and other information are brought into policy decisions. "Inflation tracking involves tracking market expectations of inflation and a careful analysis of wage trends, productivity and profit margins. All of these help me frame my outlook for inflation and what monetary policy would be appropriate to keep inflation low and stable," said Poole.
"It's highly desirable that policy practice be formalized to the maximum extent possible—that's a clear implication of modern forward-looking models," said Poole. "However, monetary economists have not yet developed a formal rule that is likely to have better operating properties than the Fed's current practice. Current Fed policy practices have a large systematic component, even though I could not write down that practice in its entirety in a single equation or set of equations," he said.
Poole said the Fed's current policy rule is "a pattern of behavior which yields an environment in which policy actions are highly, though not perfectly, predictable in the markets." Operating monetary policy by such a rule makes tracking inflation, he said, "a far simpler task than in the 'bad old days' when markets formed their expectations and forecasts without a clear understanding of the policymaking process."