How Monetary Policy is Formulated
(part A)
by
Charles Lamson
Comfort the afflicted and afflict the comfortable.
---Finley Peter Dunne
You must lose a fly to catch a trout.
---George Herbert
Setting the Stage
The major goals of monetary policy include sustainable economic growth, full employment, stable prices, and a satisfactory external balance. The Fed is charged with designing and implementing economic policies that will enhance the health and performance of the U.S. economy and achieve these goals.
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The Policy Process
The essential elements of the policy process and the problems surrounding the conduct of monetary policy can be illustrated with the aide of Exhibit 1. The policy goals combined with the expected economic performance, guide policy actions, which then, in turn, alter spending, saving, borrowing, and lending decisions. Study this exhibit carefully because the rest of this post focuses in some detail on the elements and linkages it depicts.
Papers describing the goals and the process of implementing monetary policy are available in downloadable format at www.federalreserve.gov/pf/pf.htm.
At first glance, the challenges facing policy makers do not seem all that impossible. Compare the expected performance of the economy to the goals. If the economy's performance is expected to be close to the goals, leave the policy unchanged; if the economy's performance is expected to fall well short of the goals, alter the process accordingly. The reasoning is so simple and seemingly sensible that it leads one to wonder how policy and policy makers can ever go astray. Any policy maker, however, will tell you that making policy is both difficult and frustrating, laden with a never-ending series of problems and pitfalls. Obviously, we need to reflect a bit more deeply about the process depicted in Exhibit 1.
We begin with some specific questions about some basic generalities. How do policy makers figure out what the expected performance of the goal variables is likely to be? How do they decide what to do if they believe action is called for? Once they act, how do they know the actions taken are sufficient?
To begin, let us assume policy makers have already established goals and numerical objectives. The next step as depicted in Exhibit 1 is to determine the likely performance of the economy if policy remains unchanged. How do policy makers do this?
The basic approach is to use various statistical methods and models, judgement based on historical experience, and incoming data on the full range of factors comprising and determining aggregate demand and aggregate supply to develop a forecast for the variables of major concern, such as real gross domestic product (GDP), inflation, the unemployment rate, and exchange rates. The data that are used include information about retail sales, industrial production, consumer confidence, business capital spending plans, wages, personal income, profits, and the external balance of payments. Assuming it is January, forecasts for key variables typically cover the first quarter of the year (January to March) and extend over a 12- to 18-month horizon. If the incoming data and the forecasts suggest the economy's performance is deviating significantly from the goals and priorities, the policy makers will consider a change in policy, so as to move the economy's likely performance closer to the goals.
Current Conditions versus Forecasts
Two aspects of the forecasts and incoming data used by policy makers deserve special note. First, forecasting is an imperfect science, so forecasting errors can be fairly large. The greater the volatility in economic variables, the larger the errors tend to be. Because of the possibility of significant errors, policy makers typically do not give heavy weight to forecasts in policy discussions.
Second, there is a strong tendency to focus on incoming data and to use them to guide policy. These figures, which define "current economic conditions," attract considerable media attention and generate much of the political pressure that periodically bears down on policy makers. For example, if the current data suggest that the economy is growing slowly, there will be considerable pressure on policy makers to stimulate the economy. They will be urged to boost aggregate demand and economic growth even though forecasts suggest that the economy will strengthen in six to nine months without further policy action. This nearsightedness and impatience, which are partly a reflection of the lack of confidence in the forecasts, are a critical part of the policy-making process and go a long way toward explaining what policy makers do or fail to do.
Assessing the Economic Situation
Generally, as data reports are published, policy makers, in effect, ask themselves two simple questions: Are the data consistent with our economic outlook and desires, so no change in policy is needed? Or are the data signaling that the economy's performance has deviated so markedly from what was expected that we should consider a change in policy? In reality, the process of filtering and assessing incoming data (much of which is estimated) is somewhat more difficult than one might imagine. The problem is that many monthly data releases are quite volatile or noisy, possessing a large element of what statisticians call irregular variance. The irregular variance or random fluctuations in the data make the data unreliable as policy indicators. As a result of potentially large month-to-month fluctuations, it is often necessary to have data for two to three months on hand before the underlying cyclical or trend movements in an individual data series become evident.
When analysts try to generalize from individual data series (or sectors of the economy) to the economy as a whole, they often encounter another problem. The noise in the individual series may cause a collection of different series to transmit conflicting signals on the underlying strength of the economy. For example, the data reported for February might show that retail sales are stronger than expected, suggesting that the rate of consumption spending is increasing. At the same time, new orders for capital goods and housing starts are weak, suggesting that the rate of business fixed investment and residential investment spending is slowing. Here again, if the economy is in fact deviating from its expected track, it will usually take several months of data releases covering the full spectrum in the economy's performance before the ambiguities in the monthly data are resolved.
In sum, policy makers need time to recognize that a change in the economy's performance has occurred. This time between a significant and unexpected change in the economy's performance and policy makers' recognition of that change is called the recognition lag in the policy-making process.
From Assessment to Action
As evidence begins to accumulate that the economy was deviating significantly from the desired path, a consensus develops among policy makers that policy needs to be altered. For example, if the economy is strengthening considerably and inflationary pressures are building, there is a need to reduce the growth of aggregate demand somewhat. At this point, the focus shifts from assessing the economy and considering whether anything needs to be done to deciding exactly what should be done. What policy tools should be used, how large or small should the policy adjustment be, and when should the policy change take place?
But resolving these questions takes time. The net result is that policy actions can be paralyzed for awhile and policy makers may do too little too late. In any event, the policy-making process includes a policy lag - the time between the point when the need for action is recognized and the point when an adjustment policy is decided upon and set in motion.
From Action to Effect
When policy makers act, does the economy respond immediately? In general, the answer is no. The policy action will set in motion a series of adjustments in the economy that will gradually alter the performance of the economy relative to what it would have been in the absence of any new policy actions. To illustrate, suppose that the economy has been growing quickly with inflation accelerating, and the Fed decides to pursue a more restrictive monetary policy. To cut the growth in aggregate demand, the Fed takes actions that reduce the supply of funds, and interest rates rise. Will firms cut their investment spending right away? Not necessarily. If a new plant is half-completed, capacity utilization in its existing plants is high and the demand for a firm's products is expected to remain fairly strong for the foreseeable future, then the firm (and other firms like it) will continue spending on investment projects. Gradually, however, as the rise in interest and reduction in the availability of funds allow the growth of aggregate demand, sales and capacity utilization will fall, and expectations about the future will be modified. At this point, investment spending plans will be reevaluated and possibly postponed or cancelled, leading to a further deceleration in the growth of aggregate demand. 
On the aggregate supply side, the slowing of the growth in aggregate demand will be associated with a downward revision in price expectations and an adjustment of wages and other input prices. Here again, historical experience suggests that this process will be gradual rather than instantaneous.
The net result is an impact lag in monetary policy - that is, the time between when an action is taken and when the action has a significant impact on prices, employment, and output. How much time you ask? Available research suggests that significant effects generally begin to show up after six months to a year or more and continue accumulating for several years.
Recap
Policy goals, combined with expected economic performance, guide policy actions. Policy makers tend to give greater weight to incoming data about current economic conditions than to forecasts, which can be unreliable. The recognition lag is the time that it takes for policy makers to recognize that economic conditions have changed and that a policy change is necessary. The policy lag is the time between the recognition of the need for action and the implementation of the policy adjustment. The impact lag is the time that it takes for the policy action to have a significant impact on the economy.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 621-625*
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