Mr Alan Greenspan, chairman of the Federal Reserve, yesterday defended the Fed's apparently ad-hoc approach to setting interest rates, calling it the best response to an intrinsically uncertain economic environment.
Speaking at the annual Fed conference in Jackson Hole, Wyoming, Mr Greenspan responded to criticism that the Fed's approach to policy, which relies more on judgments and less on formal targets, was confusing.
"We policymakers, rather than relying solely on the specific linkages expressed in our formal models, have tended to draw from broader, though less mathematically precise, hypotheses of how the world works," he said. "Some critics have argued that such an approach to policy is too undisciplined - judgmental, seemingly discretionary and difficult to explain."
But he rejected any suggestion that the Fed should adopt a more formal rule for setting interest rates, such as tying them to specific outcomes of inflation and economic growth. "That any approach along these lines would lead to an improvement in economic performance, however, is extremely doubtful," he said.
Many economists and investors have criticised the Fed in recent months for baffling financial markets with apparently contradictory signals about its campaign to combat deflation. Currently, the markets are pricing in sharp rises in interest rates next year, despite the Fed's insistence that they can be left low.
This confusion has raised calls for the Fed to be more explicit in saying exactly what it is aiming to achieve. Mr Greenspan did not directly address the issue of current policy. But his robust restatement of the prevailing Fed orthodoxy suggests that such a radical change is unlikely soon.
He rejected the notion that flexibility led to confusion, saying central banks should set policy in the context of an overall framework of risk management. He said it was perfectly sensible to concentrate on eliminating small but potentially damaging risks even at the cost of ignoring the demands of the rest of the economy.
During the Russian debt default in 1998, Mr Greenspan said, the Fed cut rates to head off the possibility of a freeze-up in international financial markets, even though the US economy was growing. "The product of a low-probability event and a severe outcome, should it occur, was judged a larger threat than the possible adverse consequences of insurance that might prove unnecessary," he said, adding that this philosophy underlay the Fed's anti-deflation campaign.
