Must-Read: Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20

Must-Read: July 20, 1994: Alan Greenspan reintroduces Knut Wicksell’s 1898 Geldzins und Güterpreise, and so shifts America’s macroeconomic discussion from the quantity of money to the natural (or equilibrium, or neutral) rate of interest.

As I remember it, I then spent my lunchtime seated at my computer in my office on the third floor of the U.S. Treasury, frantically writing up just what Alan Greenspan was talking about. For over in the Capitol, Greenspan had just said:

1. Pay no attention to Federal Reserve policy forecasts of M2.
2. Instead, pay attention to our assessments of the relationship of interest rates to an equilibrium interest rate.

In Greenspan’s view:

[the] equilibrium interest rate [is]… the real rate… if maintained, [that] would keep the economy at its production potential…. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation…

And I said: this is Wicksell. Greenspan is announcing that the Fed is no longer asking in a Friedmanite mode “do we have the right quantity of money?”, but rather asking in a Wicksellian mode “do we have the right configuration of interest rates”:

Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20: “In addition to focusing on the outlook for the economy at its July meeting…

…the FOMC, as required by the Humphrey-Hawkins Act, set ranges for the growth of money and debt for this year and, on a preliminary basis, for 1994…. The FOMC lowered the 1993 ranges for M2 and M3–to 1 to 5 percent and 0 to 4 percent, respectively…. The lowering of the ranges is purely a technical matter, it does not indicate, nor should it be perceived as, a shift of monetary policy in the direction of restraint It is indicative merely of the state of our knowledge about the factors depressing the growth of the aggregates relative to spending….

In reading the longer-run intentions of the FOMC, the specific ranges need to be interpreted cautiously The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place. At one time, M2 was useful both to guide Federal Reserve policy and to communicate the thrust of monetary policy to others. Even then, however, a wide range of data was routinely evaluated to assure ourselves that M2 was capturing the important elements in the financial system that would affect the economy…. The so-called “P-star” model, developed in the late 1980s, embodied a long-run relationship between M2 and prices that could anchor policy over extended periods of time But that long-run relationship also seems to have broken down with the persistent rise an M2 velocity.

M2 and P-star may reemerge as reliable indicators of income and prices…. In the meantime, the process of probing a variety of data to ascertain underlying economic and financial conditions has become even more essential to formulating sound monetary policy….

In assessing real rates, the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction. Maintaining the real rate around its equilibrium level should have a stabilizing effect on the economy, directing production toward its long-term potential.

The level of the equilibrium real rate–or more appropriately the equilibrium term structure of real rates–cannot be estimated with a great deal of confidence, though with enough to be useful for monetary policy. Real rates, of course, are not directly observable, but must be inferred from nominal interest rates and estimates of inflation expectations. The most important real rates for private spending decisions almost surely are the longer maturities. Moreover, the equilibrium rate structure responds to the ebb and flow of underlying forces affecting spending. So, for example, in recent years the appropriate real rate structure doubtless has been depressed by the head winds of balance sheet restructuring and fiscal
retrenchment.

Despite the uncertainties about the levels of equilibrium and actual real interest rates, rough judgments about these variables can be made and used in conjunction with other indicators in the monetary policy process. Currently, short-term real rates, most directly affected by the Federal Reserve, are not far from zero; long-term rates, set primarily by the market, are appreciably higher, judging from the steep slope of the yield curve and reasonable suppositions about inflation expectations. This configuration indicates that market participants anticipate that short-term real rates will have to rise as the head winds diminish, if substantial inflationary imbalances are to be avoided

While the guides we have for policy may have changed recently, our goals have not. As I have indicated many times to this Committee, the Federal Reserve seeks to foster maximum sustainable economic growth and rising standards of living. And in that endeavor, the most productive function the central bank can perform is to achieve and maintain price stability…