Michael Gould and Dr. David E Spencer, Economics

In December 1996, Federal Reserve Chairman Alan Greenspan spoke of “irrational exuberance” fueling investment spending to unsustainable levels.¹ The pressure of the investment bubble and an extraordinarily tight labor market required the Fed to intervene to combat inflationary pressures which could have destabilized our economy.

In 1999, The Federal Reserve raised the Federal-Funds Target Rate, a measure of short-term interest rates, from 4.75% to 6.5%, effectively tightening monetary policy. Such an action was calculated to slow the growth of investment and bring our economy in line with sustainable growth rates. The action was a success—the speculative bubble in the stock market burst and firms have reevaluated the rates at which they can sustain growth. Now for the recovery.

Since the summer of 2000, the Federal Reserve has cut the short-term fed-funds target rate from 6.5% to 1.75%, leaving short term rates at their lowest level since the Kennedy administration.² Many assumed this was calculated to aid in economic recovery, as signs of recession were boding. Many firms had announced layoffs (even before the tragedy of September 11), unemployment had risen, and consumer confidence had fallen. In his July 18, 2001 report on monetary policy to congress Alan Greenspan said, “The period of sub-par economic performance, however, is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, and require further policy response.”³

The Fed’s constant adjustment of short-term interest rates to balance economic growth with inflationary pressures is known as monetary policy. Adjustment of short-term interest rates is just one of the tools of monetary policy, but it is essentially the only tool that has been used in recent years. Policy makers would like to eliminate the painful gyrations of the economic business cycle, removing the uncertainties that inflation and unemployment bring. Monetary policy has been empirically proven to have real effects on the economy, so it is tempting to think that skillful implementation of monetary tools could completely eliminate the business cycle.

Conducting monetary policy has several difficulties, however. Perhaps the most limiting is the lag of monetary policy –the time between a policy action by the Fed and its eventual impact on the economy. Alan Blinder, former vice-chairman of the Federal Reserve and current Professor of Economics at Princeton University, estimates that monetary policy has its greatest effect on real variables (output, employment) two to three years after it is enacted.⁴ In his testimony to congress Alan Greenspan explained, “If we react only to past or current developments, lags in the effects of monetary policy could end up destabilizing the economy, as history has amply demonstrated.”³

Some suggest that monetary policy that the Federal Reserve conducts has no effect on output at all, and only affects inflation. This is what I will test with an OLS linear regression model.

Model and Estimates

The dependent variable in this model is the natural log of the Total Industrial Production Index, a proxy for economic output. The independent variables are the log of multi-factor productivity, the log of the Federal-Funds rate, and the logs of the Federal-Funds rate, lagged from one to eighteen periods.

The coefficient on log of multifactor productivity was found to be positive and statistically significant to the one percent level. In fact, the partial correlation between productivity and output is 0.945. This is not surprising. The Federal-Funds rate variables are more interesting, however. Only â₂, the coefficient on the Federal-Funds rate was statistically significant In fact, â₂ is positive, again suggesting that the fed reacts to the current output conditions—when output growth is positive they tighten monetary policy, when it is negative, the fed loosens. When one considers the lags of monetary policy—up to two years—one would think that the fed is doing nothing that matters to affect output. Additionally, none of the coefficients of the lagged variables (up to eighteen lagged periods) were found to be statistically significant. This is consistent with the findings of other authors. (See B. Friedman)⁵

This implies that current monetary policy with the Federal-Funds rate as the instrumental variable is not effective to control output growth. The positive coefficient on the â₂ term implies that the fed does react to current data, but the fact that none of the other terms are statistically significant implies that they cannot (or do not) forecast a path for output and use the Federal- Funds rate to manipulate that future path. Other authors have shown that while the Federal- Funds rate not predict fluctuations is output, is has predictive power on the inflation rate.⁵

I found that the Federal-Funds rate does not have a statistically significant effect on output. This leads one to conclude that the Federal Reserve does not try to influence the future path of output but rather uses current output as an information variable to target future inflation.

Works Cited

1. Alan Greenspan, “The Challenge of Central Banking in a Democratic Society,” December 5, 1996.
2. Greg Ip, “Fed May Cut Interest Below Inflation Rate, Reaching Lowest Level Since Kennedy Era,” The Wall Street Journal, 2 October 2001.
3. Alan Greenspan, “Testimony of Chairman Greenspan,” July 18, 2001.
4. Alan S. Blinder, “The Strategy of Monetary Policy” The Region, September 1995.
5. Benjamin M. Friedman “The Role of Interest Rates in Federal Reserve Policy Making,” NBER Working Paper 8047, December 2000.