Below is a prepared speech given by Federal Reserve Chairman Ben Bernanke called "Monetary Policy Under Uncertainty" on October 19, 2007:
Monetary Policy under Uncertainty
Bill Poole's career in the Federal Reserve System spans two decades separated by a quarter of a century. From 1964 to 1974 Bill was an economist on the staff of the Board's Division of Research and Statistics. He then left to join the economics faculty at Brown University, where he stayed for nearly twenty-five years. Bill rejoined the Fed in 1998 as president of the Federal Reserve Bank of St. Louis, so he is now approaching the completion of his second decade in the System.
As it happens, each of Bill's two decades in the System was a time of considerable research and analysis on the issue of how economic uncertainty affects the making of monetary policy, a topic on which Bill has written and spoken many times. I would like to compare the state of knowledge on this topic during Bill's first decade in the System with what we have learned during his most recent decade of service. The exercise is interesting in its own right and has the added benefit of giving me the opportunity to highlight Bill's seminal contributions in this line of research.
Developments during the First Period: 1964-74
In 1964, when Bill began his first stint in the Federal Reserve System, policymakers and researchers were becoming increasingly confident in the ability of monetary and fiscal policy to smooth the business cycle. From the traditional Keynesian perspective, which was the dominant viewpoint of the time, monetary policy faced a long-term tradeoff between inflation and unemployment that it could exploit to keep unemployment low over an indefinitely long period at an acceptable cost in terms of inflation. Moreover, improvements in econometric modeling and the importation of optimal-control methods from engineering were seen as having the potential to tame the business cycle.
Of course, the prevailing optimism had its dissenters, notably Milton Friedman. Friedman believed that the inherent complexity of the economy, the long and variable lags with which monetary policy operates, and the political and bureaucratic influences on central bank decisionmaking precluded policy from fine tuning the level of economic activity. Friedman advocated the use of simple prescriptions for monetary policy--such as the k percent money growth rule--which he felt would work reasonably well on average while avoiding the pitfalls of attempting to fine-tune the economy in the face of pervasive uncertainty (Friedman, 1968).
Other economists were more optimistic than Friedman about the potential benefits of activist policies. Nevertheless, they recognized that the fundamental economic uncertainties faced by policymakers are a first-order problem and that improving the conduct of policy would require facing that problem head on. During this decade, those researchers as well as sympathetic policymakers focused especially on three areas of economic uncertainty: the current state of the economy, the structure of the economy (including the transmission mechanism of monetary policy), and the way in which private agents form expectations about future economic developments and policy actions.
Uncertainty about the current state of the economy is a chronic problem for policymakers. At best, official data represent incomplete snapshots of various aspects of the economy, and even then they may be released with a substantial lag and be revised later. Apart from issues of measurement, policymakers face enormous challenges in determining the sources of variation in the data. For example, a given change in output could be the result of a change in aggregate demand, in aggregate supply, or in some combination of the two.
As most of my listeners know, Bill Poole tackled these issues in a landmark 1970 paper, which examined how uncertainty about the state of the economy affects the choice of the operating instrument for monetary policy (Poole, 1970). In the simplest version of his model, Bill assumed that the central bank could choose to specify its monetary policy actions in terms of a particular level of a monetary aggregate or a particular value of a short-term nominal interest rate. If the central bank has only partial information about disturbances to money demand and to aggregate demand, Bill showed that the optimal choice of policy instrument depends on the relative variances of the two types of shocks. In particular, using the interest rate as the policy instrument is the better choice when aggregate demand is relatively stable but money demand is unstable, with money growth being the preferable policy instrument in the opposite case.