Economic Review
Second Quarter 2000

The Role of Forecasts in Monetary Policy
By Jeffery D. Amato & Thomas Laubach

Forecasts of future economic developments play an important role for the monetary policy decisions of central banks. For example, forecasts of goal variables can help central banks achieve their goals and make them more accountable to the public. There are two primary explanations for the benefits of forecasts. The first is that monetary policy affects goal variables such as inflation and output only with substantial lags. Policy actions should, therefore, be based on forecasts of goal variables at horizons consistent with policy lags and be taken when these forecasts are inconsistent with policy goals. Under such an approach, the quality of a central bank's forecasts and the effectiveness of its actions to bring forecasts into alignment with targets provide a basis for judging the performance of policymakers and for holding them accountable.

The second, and less intuitive, explanation is that by focusing on a forecast of only one variable -- inflation -- a central bank can potentially achieve multiple goals. This approach can be successful even if there are tradeoffs among the various goal variables. For example, the approach can combine a commitment to long-run price stability with concern for the effects of monetary policy on output.

Amato and Laubach argue that the lagged effects of monetary policy make the use of forecasts necessary. They also argue that delegating a single goal—such as inflation stabilization—to the central bank facilitates accountability, but at the risk of not achieving other goals. They then examine how the Eurosystem and the Bank of England, both of which have been assigned a single goal, address the existence of tradeoffs among goals. Finally, the authors provide evidence that a monetary policy aimed primarily at stabilizing inflation forecasts—as practiced by the Bank of England, for example—can, in fact, achieve multiple goals.

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The Discount Window: Time for Reform? 
By Craig S. Hakkio & Gordon H. Sellon Jr.

For many years, the Federal Reserve's discount window has played an important role in monetary policy. Discount window borrowing helps individual depository institutions manage their reserve accounts in the presence of unexpected deposit and payments flows. Improved reserve management, in turn, helps stabilize the overnight federal funds market by reducing the volatility of short-term interest rates. Moreover, announced changes in the Federal Reserve's discount rate have often signaled important shifts in the stance of monetary policy and have frequently been associated with large changes in market interest rates, exchange rates, and asset prices.

In the 1990s, however, fewer and fewer institutions have relied on the window to meet short-term credit needs. Consequently, the usefulness of the discount window in smoothing reserve imbalances and stabilizing interest rates may have been reduced. In addition, changes in monetary policy operating procedures and the formal announcement of monetary policy decisions by the Federal Reserve may have reduced the effectiveness of discount rate changes in influencing market interest rates and asset prices.

Hakkio and Sellon analyze the changing role of the discount window in monetary policy and examine the case for discount window reform. One alternative to the traditional discount window is a "Lombard-type" lending facility in which depository institutions can borrow more freely than under the current system but at a higher rate. While there appear to be good arguments in favor of modernizing the discount mechanism, a number of conceptual and practical issues must be addressed before implementing a Lombard-type lending facility. An additional consideration, going forward, is the projected reduction in the supply of Treasury debt over the next few years. A shrinking supply of Treasury securities could complicate the use of open market operations in providing reserves to the banking system and require the Federal Reserve to place greater emphasis on the discount window. Consequently, any redesign of the discount window would need to address this issue.

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Is Risk Sharing in the United States a Regional Phenomenon?
By Bent E. Sorenson & Oved Yosha

Regions within the United States routinely experience economic fluctuations that differ from those of other regions. For example, in the past few years, falling wheat prices have slowed growth in the value of total output in Kansas. Such developments can pose concerns for policymakers because macroeconomic tools like monetary policy affect all regions, not just specific regions. Fortunately, several mechanisms help insulate regional income and consumption from region-specific output fluctuations. Diversification of asset ownership across regions, made possible by national capital markets, smoothes regional income and, in turn, consumption. The federal tax system also helps protect regional income and consumption from region- specific changes in output. Finally, adjustments to saving further insulate consumption from variation in output. In effect, each of these mechanisms mitigates the effect of region-specific economic fluctuations by pooling risks across regions--by providing risk sharing.

Although earlier research has documented the pattern of risk sharing for the United States as a whole, patterns may differ across broad regions of the nation. Eastern states, for example, may benefit more from income smoothing through capital markets due to their proximity to Wall Street. Moreover, geographic distance may affect whether and how risk is shared. For instance, it may be easier for Kansas residents to own property, such as a farm or hotel, in Colorado than in Massachusetts. Similarly, business owners in Kansas are more likely to obtain loans in Missouri than in New York. In this case, geography may affect the ability of risk sharing to mitigate region-specific fluctuations in output. Because geography matters, this article examines whether risk sharing occurs more in some regions than in others and whether risk sharing is greater within large regions of the United States than between regions.

Sorensen and Yosha present the conceptual framework of risk sharing and develop a method for estimating the amount of risk sharing provided by different mechanisms. They report estimates of risk sharing patterns within and across a set of large U.S. regions. These estimates reveal some important regional differences. Moreover, the estimates indicate there is more overall risk sharing within regions than between regions. The risk sharing provided by capital markets and the federal tax system is essentially the same within and across regions, implying that these are nationwide mechanisms. In contrast, risk sharing through saving adjustments is more local, occurring just within regions.   

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