America's New Culture Of Change.

• Author: Rivlin, Alice M.
• Position: Federal Reserve Board - Interview

The International Economy's interview with Alice Rivlin. The former Fed Vice-Chair speaks outs on monetary policy, moral hazard, and the idea of a "new paradigm."

TIE: Is the road ahead going to be tough for the Federal Reserve?

RIVLIN: I don't think so. I think the tough time for the Fed was in 1996 and 1997, when there was the question of, do you go with what you've always thought is true, and what the models seem to be telling you, or do you go with the intuition that something is really happening here, and we'd better wait and see? I was a wait-and-see person, as was [Chairman Alan] Greenspan. That was a difficult decision because you had nothing firm to go on. Right now, I think, there is no difficulty. You just have to keep pushing the rates up until you see some effect. There may be some questions of whether [to raise rates] 25 or 50 [basis points], but there's no question about direction or whether to move. So it seems to me this is an easier setting for decisions right now. It's more conventional.

TIE: Economist Paul Krugman recently gave a speech, which argued that the economics profession used to have two reliable pillars of strength -- Okun's Law and the NAIRU. And these aren't working. His argument is that the economics profession is at sea. The radar's not working. Do you agree?

RIVLIN: You're only at sea if you once thought you had a compass. I never thought we had a firm number for the NAIRU. The NAIRU -- a general notion that at some point the economy gets to running too fast and that you run out of workers -- is a very useful concept. But I never thought that I had a firm number for the NAIRU.

TIE: So it's like monetarism. It sounds great until you start trying to pin down what exactly the philosophy means.

RIVLIN: Exactly. And the only people who thought they knew exactly what the NAIRU was were the modelers. But the essence of modeling is that it only tells you what the average past experience has been. So there's always a lag when something is changing. People did lower their estimates of the NAIRU as the data came in. But I never thought I knew what it was.

TIE: So when the economy is strong, the Fed has no choice but to keep firming up until they see some results. The problem, of course, is that the lags are always difficult to time. You're never quite sure what drives those. It's almost inevitable that you're not going to get it exactly right. Like you say, there is probably no risk of overshooting right now. But there's an almost inevitable risk that the Fed is ultimately going to overshoot.

RIVLIN: I think it depends on what other forces are helping you. If the stock market continues to wobble sideways or comes down, then that helps the Fed, obviously. The danger that they'll overshoot becomes less because they know that, and as they see the stock market coming down they can be less aggressive. That doesn't seem to me to cause a problem. Suppose there's an enormous amount of confidence and the markets keep going up again. Then the Fed's job is harder.

TIE: Has there ever been a period when the Fed hasn't overshot?

RIVLIN: I think '94 was a very good example of a tightening that worked, and I think arguably prolonged the expansion at a more sustainable rate until this productivity increase kicked in. Now what would have happened if the Fed hadn't risen in '94, who knows? But possibly an overheating, and then an overreaction.

TIE: Has the Fed been targeting the stock market? Is the wealth effect a concern?

RIVLIN: The wealth effect is a concern. That doesn't mean that they're targeting the market. In fact, I think that's a silly phrase, "targeting the market." They don't have a target instrument. Targeting the market means you've got something you can shoot directly at the target. They don't have that. They only have the Fed Funds rate. And it doesn't target anything. And there's no way it can. So that's the wrong way of putting the question. Is the stock market important because the wealth effect is important? Yes.

TIE: But should the same concern come into play on the downside? Should the Fed, during periods when the consumption needs to be stoked up a bit, focus on the direction of the stock market? Doesn't it work both ways?

RIVLIN: The focus of monetary policy has to be the economy as a whole, and there can be lots of things influencing that, including the stock market and the value of the dollar and a number of other...