Animal Spirits, Confidence and Monetary Policy

From 2001 until the last months of Alan Greenspan’s administration, the Fed’s policy was intended to support output growth and price stability. Monetary policy was accommodative whenever prices tended to fall too much, as in 2003, and accommodation was removed when prices tended to rise. The Fed conducted monetary policy, privileging the action on the short-run Federal Fund rate. As a result, in a context of recession and deflation, short-run interest rates dropped from 6 per cent to 1 per cent between 2000 and mid-2004 but, after several years of decreases, a tightening in monetary policy was decided upon in June 2004. Because of an increase in inflation in 2004, rates rose from 1 per cent to 3 per cent in 2004 in order to curb inflationary pressures. Beyond the technical aspects of policy making, the way Fed addressed markets is of primary interest. It openly communicated its strategy to markets and it favoured gradualism in interest rate adjustment in order to influence the economy’s expectations. Nevertheless, the door was left open for incremental changes in stabilization plans in case indicators like the current values of profits, labour productivity or the rate of capacity utilization capsized. The Fed’s objective was to be able to gauge the impact of its intervention ‘in real time’ instead of being constrained to make that judgement in advance. As a consequence, monetary policy was defined in a flexible way that avoided monetary surprises.