Current Topics Relevant to the Formulation of Monetary Policy

Raymond W Stone

Stone & McCarthy Research AssociatesFebruary 14, 2007

Objectives of Monetary Policy

• Maximum Sustainable Economic Growth and Employment

• Price Stability

What Is Maximum Sustainable Growth?

What Determines Maximum Sustainable Growth—Potential GDP?

• Productivity Growth

• Labor Force Growth

• Changes in Labor Market Conventions such as the length of the workweek

Labor Force Growth Slowing—Implications For Employment Yardsticks and Potential GDP?

What is Maximum or Full Employment?

Civilian Unemployment Rate vs Common Notions of Upper and Lower Bounds on NAIRU

2.502.753.003.253.503.754.004.254.504.755.005.255.505.756.006.256.506.757.00

Jan

-94

No

v-9

4

Sep

-95

Jul-

96

May

-97

Mar

-98

Feb

-99

Dec

-99

Oct

-00

Au

g-0

1

Jun

-02

Ap

r-0

3

Feb

-04

Dec

-04

Oct

-05

Au

g-0

6

Relationship—Potential GDP, NAIRU, and Inflation

• When actual GDP exceeds Potential GDP, inflation rises. Conversely, when actual is below potential GDP inflation eases.

• When the Unemployment Rate is below NAIRU inflation rises, and when above NAIRU inflation eases

• When GDP is around Potential, the Unemployment Rate is around NAIRU

What Do We Mean By Price Stability?

Core PCE Deflator ( yoy) vs Fed's "Com fort -Zone"

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

Should the Fed Target a Specific Inflation Rate or Range?

• Pros—Increased Transparency, More Coherent FOMC Debate, Might Better Anchor Low Inflationary Expectations, Increased Fed Credibility

• Cons—Reduced Flexibility to Address Deviations in Growth & Employment, Legislative Issues, Issues Surrounding Which Inflation Measure to Target and Appropriateness of Measure

Inflation Theme: Role of Energy Prices

CPI and Contribution From Energy (12-mo percentage)

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

CPI- >

Contribution From Energy

Inflation Theme: Problems Measuring Housing Costs

Core CPI and Contribution From OER (12-mo percentage)

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Core CPI- >

Contribution From OER

Fed Transparency

• Levels the Playing Field

• Reduces “Fed Related Risk Premium”

• Enhances Monetary Policy Transmission via “Expectations Theory of Yield Curve”

• Increases Fed Accountability

How Could the Fed Become More Transparent?

• Have C-Span Broadcast FOMC Meetings (bad idea)

• Make Fed Staff or FOMC Forecasts Available in More Detail, and With Increased Frequency? (both Pros and Cons)

• Provide More Detail In Post-Meeting Statement• Shorten Lag Between FOMC Meetings and

Release of FOMC Minutes (currently 3 weeks)• Publish Projected Fed Funds Rate Target (similar

to Bank of Norway)

Inferences From Yield Curve

FRB Economist Jonathan Wright's Model suggests that the Yield Curve in conjunction with the absolute level of the Fed Funds rate underscores a

heighten risk of recession in 2007.

Others Disagree

Greenspan, Bernanke and others feel that the Curve Inversion is related to special factors and not foreshadowing a Recession.

Greenspan referred to the shape of the yield curve as a "Conundrum"

Bernanke pointed to a "Global Savings Glut" as a key factor underpinning the curve inversion.

Should the Fed Target or Base Policy on “Asset Prices” Such as Stocks or Homes?

• Nobody is advocating targeting stock or housing prices. In fact, a number of Fed Officials including both Greenspan and Bernanke have insisted such would be inappropriate

• Some former Fed officials have expressed sympathy for the view supporting some precautionary “leaning against the wind” when it comes to “asset bubbles”

• Most believe that asset prices via the “Wealth Affect” influence spending decisions and Aggregate Demand. To the extend that shifts in aggregate demand relative to supply or potential have implications for the Fed’s mandate of maximum growth and price stability, policy adjustments might be required

• Tim Geithner (President of FRBNY) pushed the envelope on this issue “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. “

What About the Current Housing/Home Price Situation?

• Housing has both direct and indirect impact on the economy.

Lower Housing Starts Point to Weaker Residential Construction Spending

Weaker Residential Investment Spending Serves As a Direct Drag on GDP

Where Housing Goes, So Follows the Demand for Refrigerators, Furniture, and Other Household Durables

Where Housing Goes, so Follows Construction Payrolls

Slower New Home Sales Relative to Starts have Resulted in Record Levels of Unsold New Homes

New and Existing Home Inventory Overhang Has Resulted in Softer Home Prices

Increasing Home Prices Rendered an Increased Sense of Wealth and a Diminished Need to Save...

Now What?

Softer Home Prices Has Resulted in Diminished “Equity Withdrawal”

And Resetting of Adjustable Rate Mortgages Has Increased Total Mortgage interest Paid