The Sept. 26 decision by the Federal Reserve to maintain status quo in monetary policy in the face of mild inflation and a relatively restrictive federal funds rate draws attention to the Fed's objectives and operating guidances.
Clearly, the Fed's objective, often stated, is price stability, in fact and in perception. Perception is important because the Fed's goal is to eliminate the expectation of inflation from decision making. However, the Federal Reserve has never defined price stability - what rate of price increases, by what measure, for how long?
Its refusal to define price stability probably arises out of a reluctance to set a target that would force it into an action that might be consistent with the target but inconsistent with its interpretations. Inflation measures, such as the consumer price index and its contents and the gross domestic product deflators, are lagging indicators.
In contrast, monetary policy must be forward looking. Thus, if the Fed were to use inflation measures for guidance, it would be analogous to driving a car by looking in the rearview mirror. Accordingly, the Fed appears to be using as its primary navigational tool the actual and prospective rates of growth of GDP relative to the potential rate of growth.
It evidently views that tool as especially appropriate when the economy is operating at high rates of resource utilization, a condition that seems to exist at this advanced stage of the expansion. With the economy on a growth track of 2% to 2.5% in the third quarter and operating at approximately full potential, the Fed is evidently more concerned with growth exceeding 2.5% in the fourth quarter than it is with a restrictive federal funds rate.
We gauge the current federal funds target at 75 basis points above the upper limit of the neutral zone. Monetarism appears to have been all but abandoned by the Federal Reserve. Despite a large volume of rigorous research by the staffs at the board of governors and the district Federal Reserve banks, the Fed does not have a clear understanding of the transmission of monetary policy actions to the economy as to magnitudes, timing, and mechanism.
Accordingly, it is not being guided by rates of growth of any of the reserve or monetary aggregates. Consequently, against a background of high resource utilization, the determinant of monetary policy action over the next several months is likely to be the rate of growth of GDP, actual and prospective, relative to the 2.5% sustainable rate.
The latest data and our projections suggest that actual growth will exceed 2.5% by a significant margin in the fourth quarter and, perhaps, the first quarter of 1996 as well. Accordingly, we anticipate no further easing by the Fed in the remainder of 1995.
If the economy continues to grow faster than the sustainable rate, the Fed might even tighten a bit in the first quarter of 1996.
Mr. Sherman is director of research at M.A. Schapiro & Co.