July 07, 2003

A Platonic Dialogue on the Practice of Monetary Policy

Glaucon: How does it stay so cool down here? I thought this place wasn't air conditioned?

Admetos: It's the big stairwell. All the hot air rises up to the top floor.

Glaucon: Where the Real Estate Center is?

Admetos: Exactly.

Glaucon: So what's your view of the Federal Reserve?

Admetos: The market was surprised, but I wasn't. I saw it as Old Quarter-Point Al being true to form.

Glaucon: Quarter-Point Al?

Admetos: What a number of bond traders call Federal Reserve Chair Alan Greenspan. And he does seem to like to move in quarter-point increments--to raise or cut interest rates by 0.25 percentage points, 25 basis points at a time.

Glaucon: Why?

Admetos: Ah. There is a puzzle. You tell me. Why do you think?

Glaucon: Well, the purpose of monetary policy is to get the economy to the magical point of full employment and price stability... It does this by changing the interest rate and thus changing business and consumer incentives to borrow and spend... The Federal Reserve is thus in the business of trying to figure out what, in Knut Wicksell's terms, the "natural" rate of interest is... And then it tries to adjust by setting the interest rate above the natural rate of interest if it thinks the economy needs cooling off and below the natural rate of interest if it thinks the economy needs stimulating...

Admetos: Yes, yes, I know all of this. I know that you have to say it to bring non-monetary economist readers of this dialogue up to speed, but could you please hurry? I'm getting bored...

Glaucon: Sometimes there's no change in the Federal Reserve's estimate of their target--the adjusted natural rate of interest, and the Federal Open Market Committee leaves interest rates unchanged. Sometimes there's a little bit of information that it has gone up or down, and they raise or lower it by a quarter of a percentage point. Sometimes there's a lot of information and the Federal Reserve changes its estimate by a lot, and...

Admetos: And they are still likely to raise or lower it by only a quarter of a percentage point--but to follow that by an additional move in the same direction after the next FOMC meeting, and the next, and the next. Why?

Glaucon: Well there's Brainard and Friedman's argument...

Admestos: Yes. A good one. If you're not certain how strong your tools are, you know that big shifts in policy introduce noise and uncertainty into the system. So other things being equal, you'd rather make a move now that is smaller than you suspect will ultimately be needed.

Platon: Wait a minute. That cannot be true for the Ideal Form of monetary policy (whatever monetary policy might be).

Glaucon: Yes it can. The Ideal Form of monetary policy has to take account of the fact that it is to be implemented in a world of uncertainty, confusion, and ignorance. Failing to take account of such variability would would create a most imperfect eidion of monetary policy indeed--one hardly suitable to be called an Ideal Form!

Platon: But...

Admetos: Glaucon's right.

Platon: But an Ideal Form that necessarily admits of its own imperfection? My metaphysics...

Admetos: We're not doing metaphysics. We're doing political economy!

Platon: Political economy?

Glaucon: The craft of household management, but not for one household alone, for the entire city-state instead.

Platon: Sounds like a set of issues unworthy of an aristocrat's or a philosopher's thought to me...

Admetos: Ignore him, Glaucon. It's a good argument. Is it enough to account for what we see?

Glaucon: I don't think so...

Admetos: Well, then?

Glaucon: I don't know.

Admetos: You don't know? And you call yourself a monetary economist!?

Glaucon: The conventional argument is that larger than quarter-point moves in interest rates would destabilize financial markets. This argument has two parts. The first is that because everybody expects Greenspan to move in quarter-point increments, if he makes bigger moves people will conclude that something very strange and unusual is going on, and so...

Admetos: You don't want to change interest rates suddenly by more than 25 basis points unless you want people to conclude that something very strange and unusual is going on. OK, that explains why Greenspan now that he has established this pattern of expectations needs to move in 25 basis-point increments. But why did he establish this pattern? And should his successor continue it?

Glaucon: I don't know. I've never understood the second part of the argument. The second part of the argument is that you don't want to make big changes in interest rates because you want to keep financial markets calm. Why don't you tell me why changing the short-term overnight Federal Funds interest rate by only 25 basis points every two months keeps financial markets calm?

Admetos: I thought I was asking the questions here?

Glaucon: You were asking the questions. Now I'm thirsty. I want to hear you talk for a while. And you have no patented monopoly over the Socratic method.

Admetos: I don't?

Glaucon: You don't. We're pretending we're in ancient Greece, remember? There's no Patent Office to grant you a Teaching Method Patent.

Admetos: Well, then. Let me see. Large movements in interest rates change asset prices a lot. If asset prices rise, then financial institutions that are long-term debtors might get into trouble and approach bankruptcy. If asset prices fall, then financial institutions that are long-term creditors might get into trouble and approach bankruptcy. The Central Bank is supposed to keep the financial system safe and sound. Waves of bankruptcy or near-bankruptcy are bad news. So maybe small moves in interest rates are a way of keeping financial institutions from undergoing the large shifts in their balance sheets that threaten to put them into bankruptcy.

Glaucon: But suppose that the Federal Reserve has kept interest rates low for a while--for a couple of years, say, as was the case in 1992 and 1993. And then in the spring of 1994 Quarter-Point Al raises the Federal Funds rate from 3.00% to 3.25% per year at an FOMC meeting. What does this shift in policy do to asset prices?

Admetos: Well, bond traders know that Quarter-Point Al is raising interest rates...

Glaucon: But they don't know by how much he will raise them in the end...

Admetos: Exactly. They don't know whether Alan Greenspan intends this is the first of one increase, the first of four, or the first of ten--they don't know whether he intends this to be a move to a target rate of 3.25% per year, or the start of a move to a rate of 4.0% per year, or 5.5% per year...

Glaucon: In history it was the third...

Admetos: So they form a weighted average of those three scenarios according to what their guts tell them, and mark long-term asset prices down to a level consistent with their guess of what Federal Reserve policy is...

Glaucon: Yes...

Admetos: But since they have no confidence in their guess, they are unwilling to engage in large-scale stabilizing speculation, and so shifts in demand and supply for bonds cause big swings in the price...

Glaucon: Yes...

Admetos: And these swings make investing in long-term bonds riskier, and so assets like long-term bonds are marked down further by this risk premium...

Glaucon: Yes...

Socrates: So it would seem that you have proved that restricting yourself to quarter-point moves in monetary policy makes asset prices more, not less, volatile, and thus is more likely, not less likely, to generate situations in which the financial system creeps close to the point at which its safety and soundness is called into question.

Glaucon: It would seem so, Socrates...

Socrates: "Seem"?!

Admetos: Only this, Socrates. We're monetary economics professors. Alan Greenspan may be the best central banker the world has ever seen. We are confident that we would have done a much worse job than he has done over the past decade and a half had either one of us been in his chair.

Glaucon: And so there is a good chance that he knows something that we do not: that our analysis of the situation is partial, incomplete, and flawed.

Socrates: What could that flaw be?

Glaucon: We have no idea. Posted by DeLong at July 7, 2003 06:06 PM | TrackBack


With a touch of mischief in my heart, I presume that you meant Glaukon's brother Adeimantos, not Alkestis' husband Admetos, the fellow that had problems dying.

Posted by: Gene O'Grady on July 7, 2003 07:12 PM

Clearly you know a *lot* more about Plato's Dialogues than I do

Posted by: Brad DeLong on July 7, 2003 07:17 PM

What exactly has Greenspan done to earn such respect? He was Fed chairman during the 90s boom. He was also the Fed chairman during two stock market crashes and one property market crash (unless he resigns soon). Why so much reverence towards his quarter-point fudging? Had interest rates remained unchanged this time, what disaster would have resulted? For an economist, it it like watching Bobby Fischer play or something? "1/4% decrease?!? Brilliant! I would never have thought of that."


Posted by: msw on July 7, 2003 09:18 PM

What exactly has Greenspan done to earn such respect? He was Fed chairman during the 90s boom. He was also the Fed chairman during two stock market crashes and one property market crash (unless he resigns soon). Why so much reverence towards his quarter-point fudging? Had interest rates remained unchanged this time, what disaster would have resulted? For an economist, it it like watching Bobby Fischer play or something? "1/4% decrease?!? Brilliant! I would never have thought of that."


Posted by: msw on July 7, 2003 09:23 PM

Heaven forbid but there must come a time when the Fed chairmanship must pass to a successor. Greenspan has done a superb job in that capacity over a long time but the more he is billed as uniquely capable the bigger the potential problems looming from market uncertainties at the succession. Forgive the intrusion, please, but what happens could easily affect more than just the American economy. Isn't it prudent to start discussing a road map for the succession and perhaps highlighting the contribution to decision making by the Fed Board of Governors and the FOMC?

Posted by: Bob on July 8, 2003 03:40 AM

The day before the Fed announcement, my bank was advertising 3/1 ARMs at 2.875% and 15 year conforming fixed at 4.625% (these are the two rates I'm watching in contemplation of possible refinance). Two days after "interest rates were lowered by a quarter point" the bank was advertising 3/1 ARMs at 3% (they've since moved to 3.125%) and 15 year conforming fixed at 4.75% (holding).

Can we consider the possibility that Greenspan's moves are sometimes ineffectual?

Posted by: jam on July 8, 2003 04:06 AM

The "rush for the door" by holders of long-dated Treasuries in 1994 promted Greenspan to complain, as I recall, that he had done everything to announce his intention to start hiking rates short of jumping up and down on the table. He obviously hadn't. Efforts to get the message out are now more evolved. That should mean two things, in the monetary scheme you are describing. One is that the earlier failure of limiting moves to 25 bp when possible to limit volatility in financial markets may have been overcome somewhat. The other is that, given improved signaling, it is less necessary to stick to 25 bp moves merely to limit volatility in financial markets. That puts more weight on the uncertain impact of monetary policy changes. No surprises, please, but get the job done, by all means.

Posted by: K Harris on July 8, 2003 05:25 AM

I think we're seeing the famous analogy of Milton Friedman between monetary policy and Victorian literature. In the latter, not a mention of sex, and in this Socratic dialogue, nary a mention that to raise or lower the Fed Funds rate requires manipulating the money supply.

And, let's not forget that the denominator matters too. A 25 bp move when the FFR is 6%, is quite a different thing than when it is 2%

Posted by: Patrick R. Sullivan on July 8, 2003 08:37 AM

Watching high-level chess, you really don't get what's going on. At world championships, the IGM commentators don't understand Kasparov's moves, so they run them through computers. You assume his opponent does (more or less), which doesn't apply in Greenspan's case. In chess, you know he's smart because the opponent loses. Chess is very unforgiving.
I always refuse to take an umbrella with me because people might think it's going to rain. Sometimes it does, sometimes it doesn't.

Posted by: John Isbell on July 8, 2003 10:08 AM

By the way, folks. Notice that interest rates have turned up sharply since June 13. Alan Blinder has been telling us there is a bubble in bonds. The 10 year treasury yield has climbed from 3.1 to 3.75 since June 13. Pop???

Posted by: jd on July 8, 2003 10:42 AM
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