www.federalreserve.gov/boarddocs/speeches/2004/200405202 -> www.federalreserve.gov/boarddocs/speeches/2004/200405202/
The Federal Reserve Board eagle logo links to home page Remarks by Governor Ben S Bernanke At an economics luncheon co-sponsored by the Federal Reserve Bank of San Francisco (Seattle Branch) and the University of Washington, Seattle, Washington May 20, 2004 Gradualism As a general rule, the Federal Reserve tends to adjust interest rates incrementally, in a series of small or moderate steps in the same direction. Between January 2001 and June 2003, for example, the Fed reduced its policy rate, the federal funds rate, a total of 550 basis points in thirteen separate actions. Four of the actions were reductions of 25 basis points in the policy rate, and nine were reductions of 50 basis points. Moreover, the easing cycle that began in 2001 probably represented a more rapid adjustment than normal for the Fed--for good reason, I think, as I will discuss later. The easing that spanned the 1990-91 recession and subsequent recovery is a better example of how drawn out the process of adjusting rates can be. That episode lasted for more than three years, from June 1989 to September 1992, and involved twenty-four policy actions that cumulated to a total reduction of 675 basis points in the funds rate. Of these twenty-four actions, twenty-one were rate cuts of 25 basis points, and three were cuts of 50 basis points. Gradual adjustment tends to characterize periods of rate increases as well as periods of decreases. Even the policy tightening that occurred during 1994-95, though distinctly more rapid than most episodes of rate adjustment, involved seven steps over a period of twelve months, with an ultimate increase in the policy rate of 300 basis points. Of these increases in the policy rate, three were of 25 basis points, three were of 50 basis points, and one was an unusually large 75 basis points. More recently, the eleven-month tightening cycle that began in June 1999 involved five increases of 25 basis points and one of 50 basis points. Researchers have documented that the Federal Reserve is not unique in its tendency to adjust the policy rate in a long sequence of steps in one direction: Central banks in most other industrial countries generally behave in a similar manner (Lowe and Ellis, 1998; This relatively slow adjustment of the policy rate has been referred to variously as interest-rate smoothing, partial adjustment, and monetary policy inertia. An alternative to gradual policy adjustment is what an engineer might call a bang-bang solution, or what I will refer to today as the "cold turkey" approach. Under a cold turkey strategy, at each policy meeting the Federal Open Market Committee (FOMC) would make its best guess about where it ultimately wants the funds rate to be and would move to that rate in a single step. In the abstract, the cold turkey approach is not without appeal: If you think you know where you want to end up (or are at least are willing to make your best guess), why not just go there directly in one step rather than drawing out the process? As I have already suggested, however, in practice the FOMC seems to take a gradualist approach. Are there times when other approaches, such as cold turkey, might be more appropriate? As always, I emphasize that my colleagues in the Federal Reserve System do not necessarily share the views I will express today.
Today I will focus on three of these: Policymakers' uncertainty about the economy should lead to more gradual adjustment of the policy rate; gradualism in adjusting the policy rate affords policymakers greater influence over the long-term interest rates that most affect the economy; I will begin by discussing the implications of uncertainty for policy choices and then consider the other two arguments for gradualism. I will conclude by briefly revisiting the empirical case for gradualism and then discussing some implications for current policy. Many central bankers and researchers have pointed to the pervasive uncertainty associated with analyzing and forecasting the economy as a reason for central bank caution in adjusting policy. Because policymakers cannot be sure about the underlying structure of the economy or the effects that their actions will have on economic outcomes, and because new information about the economic situation arrives continually, the case for policymakers to move slowly and cautiously when changing rates seems intuitive. In a classic article published in 1967, William Brainard of Yale University showed in the context of a simple economic model why this intuition might make sense. Specifically, Brainard showed that when policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions. An analogy may help to clarify the logic behind Brainard's argument. Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won't try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament? Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). In a policy context, the analogous situation is one in which policymakers hope to guide the economy in a particular direction but fear overshooting, either to the inflationary upside or the recessionary downside. Overshooting the objective of stable, non-inflationary growth is perceived as costly by policymakers because overshooting creates unnecessary volatility in the economy and delays the achievement of macroeconomic stability. Like the golfer with the unfamiliar putter, monetary policymakers are far from certain about the impact that a policy change of a given size will have on the economy, as already noted. Given this uncertainty, the Brainard argument suggests a gradual approach to policy adjustment. In contrast, by applying the stronger policy impetus that may be called for by the cold turkey approach, policymakers might inadvertently drive the economy away from its desired path, increasing economic volatility. Brainard's argument relies on a specific form of uncertainty, namely, policymakers' uncertainty about the effects of their actions on the economy, but other types of uncertainty may also provide a rationale for policy gradualism. For example, because economic data can be quite noisy, policymakers must inevitably operate with imperfect knowledge about the current state of the economy. Generally, all else being equal, the noisier the economic data, the less aggressive policymakers should be in responding to newly arriving information (Orphanides, 2003). A cold-turkey approach, by contrast, carries the risk that policymakers will take strong action in response to information that may later be revealed to have been seriously inaccurate. Another potential advantage of gradualism is that, by taking small steps, policymakers give themselves the opportunity to assess the effects of their actions and perhaps to refine their views on how large a policy change will ultimately be needed (Sack, 1998). In terms of the golf analogy, by taking a few strokes of moderate firmness one may learn more about the elasticity...
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