Gary H. Stern - President, 1985-2009
Published June 1, 2006 | June 2006 issue
Editor's note: These remarks were delivered to the American Academy in Berlin, Germany, on April 11, 2006.
As you might expect, my remarks tonight are based on my experiences as a Federal Reserve official—for nearly 30 years now, and counting—as well as what we have learned, and prospectively can learn, from both economic theory and empirical research as they pertain to economic policy issues. The characteristics I will be emphasizing are in some ways widely accepted, but they are also easy to overlook or to forget in the frequently challenging and hectic world of day-to-day or month-to-month policymaking. Thus, the principles that I will identify, although not new, are well worth repeating.
By way of preview, I will be focusing on the value of selecting a clear policy objective, making a credible commitment to achievement of the objective and communicating effectively both about the significance of the objective and about the tactics of policy. I will employ experiences from recent U.S. economic history to illustrate some of these points, and I will also discuss the constructive role academic research has played from time to time in establishing the policy framework. Finally, let me remind you that, as always, I am speaking only for myself and not for others in the Federal Reserve.
To launch this discussion, let me review a bit of U.S. economic history, covering the last two and a half decades or so, roughly from 1980 to 2005. Remarkably, many participants in the financial world today, as well as their counterparts in public policy, are too young to have experienced, or perhaps even to remember, the "great inflation" in the United States of much of the 1970s and first years of the 1980s. Between 1978 and 1981, for example, consumer prices in the United States rose in excess of 10 percent per annum, a number that seems almost incredible today. If the time horizon is extended back to 1973, the average annual inflation rate is in the neighborhood of a still rapid 9 percent.
This episode was unexpected and disturbing from a number of perspectives, including, of course, the levels reached by both inflation and nominal interest rates; rates on 10-year U.S. Treasury notes averaged nearly 14 percent in 1981, and a widely accepted measure of mortgage yields was close to 15 percent in that year. I hope that these statistics provide a sense of how different those times were in comparison with what we have become accustomed to today.
Among the most distressing aspects of the environment of the early 1980s was the extent to which high inflationary expectations were deeply embedded in the economy. The financial press of those days depicted double-digit inflation as a permanent "fact of life" that would have to be accepted and adjusted to for better or worse. There seemed to be a view, even among sophisticated analysts, that nothing could be done to effectively reduce inflation.
But the Federal Reserve, when Paul Volcker became Chairman, did not accept this state of affairs. Volcker clearly recognized the consequences and costs of ongoing, rapid inflation for economic performance and standards of living and determined to address the problem. The cure, although not as costly as the disease, was difficult in its own right. Highly restrictive monetary policy was imposed by the Federal Reserve, and the U.S. economy experienced a serious recession in 1981-82, accompanied by significant job losses and a peak unemployment rate near 11 percent. Nevertheless, Volcker's policy set the stage, I will argue, for the long economic expansions of the 1980s and 1990s.
Volcker's "quasi-monetarist" approach to policy successfully broke the back of inflation and demonstrated sufficient resolve—sufficient commitment, if you will—so that expectations of future inflation diminished appreciably. Although no monetarist in the strict, Friedmanesque sense of the term, Volcker recognized that inflation could not be long sustained without excessive money creation, and thus he and his colleagues acted to restore monetary discipline. I would note in this context that academic research on inflation, which demonstrated convincingly that inflation is in the end a monetary phenomenon, was important to the accurate diagnosis of the source of the problem. This contribution of economic research is important to acknowledge because public policy should, in my opinion, take advantage of and integrate such information as it becomes available and, of course, convincing.
I want to underscore several features of this experience which illustrate principles that have proven to be of significant value in the succeeding 20-plus years of policymaking. First and foremost, the policy selected had to be, and was, appropriate to the problem at hand. As just noted, research and experience have shown that inflation is the result of excessive money growth, so restoration of monetary discipline was essential and was, in fact, imposed. Second, the commitment by policymakers to reduce inflation had to be sufficiently credible so that expectations of inflation would decrease and participants in the economy would begin to act in ways—that is, to make decisions—consistent with a diminution in inflation. And, finally, in this episode, communication of both the reasons for and the potential consequences of the policy had to be sufficiently convincing to garner reasonably widespread support. It is perhaps largely unappreciated, but Paul Volcker was masterful at building support for his policy among the general public, for in the end, the Federal Reserve cannot pursue measures that do not enjoy broad public support. Volcker helped guide the public to a consensus that high inflation hurt growth and thereby most citizens, and therefore that the Federal Reserve should focus on achieving price stability. This consensus remains critical to the credibility of Federal Reserve policy today.
I think it is fair to say that, in the ensuing years, Federal Reserve policymakers have taken these lessons to heart and have expanded upon them as well. Results, as measured by the performance of the economy, largely speak for themselves, and so I will give you only a quick snapshot of the history of the past two decades. The United States experienced a period of uninterrupted economic expansion from late 1982 until the middle of 1990. Over this period, net gains in employment totaled nearly 20 million workers, inflation generally held in a range, 4-4.5 percent, that was significantly below its performance of preceding years, interest rates broadly trended down and the U.S. equity market was strong.
The 1990s were in many ways a similar decade. Employment increases in the aggregate were in excess of 20 million workers, inflation declined and ultimately settled in around 2 percent, interest rates moved lower and equity prices appreciated. Moreover, the advance of labor productivity accelerated in a meaningful way. And, currently, the economy is into its fifth consecutive year of growth following the recession of 2001.
Let me be clear. I am not saying that Federal Reserve monetary policy was principally responsible for this positive performance, but there is little doubt that reducing inflation and establishing price stability was an important contributor. Indeed, it is difficult to imagine that the economic progress of the 1980s and 1990s could have occurred in the face of persistent double-digit inflation. At the same time, the history of the past 20-plus years is testimony to the flexibility and resilience of the U.S. economy, and to the significance of characteristics—the rule of law, honoring of property rights, integrity of the credit decision-making process, for example—that we in the industrial world largely take for granted.
During this period, those responsible for monetary policy—under the leadership of Alan Greenspan—identified a clear policy objective, committed to the pursuit and attainment of the objective and became more adept than formerly at communicating the likely course of policy, thereby reducing uncertainty associated with the path of policy. The policy objective was price stability, defined in a practical way to mean the absence of concern about prospective price changes in day-to-day decision-making by business, households, labor and so forth. So-called core inflation—that is, prices of goods and services excluding food and energy-came to be emphasized by monetary policymakers—formally, the Federal Open Market Committee, or FOMC—and the FOMC became increasingly comfortable over time in using empirical reaction functions, so-called Taylor rules and the like, to help frame the policy debate if not necessarily to determine the actual decision. That is, policy analysis came to rely more, although certainly not exclusively, on the concepts and tools of the economics profession. This evolution highlights once again the symbiosis between research and practical policymaking.
In addition, reliance on economic forecasts has long been an important component of monetary policy formulation since, in light of the lags between policy actions and their effects, a view of the economy's future performance is critical to decision-making.
Many central banks, although not the Federal Reserve at this point, have adopted explicit inflation targets to guide monetary policy. This approach is under discussion in the United States as well and, as I have stated on previous occasions, I am in favor of it, largely because inflation targeting would in my view formalize and institutionalize what we in the Federal Reserve have essentially been doing for much of the past 25 years. And, by inflation targeting, I specifically mean selection of an acceptable rate of—or range for—inflation over time, and then the conduct of policy so as to achieve this objective.
Inflation targeting has to my mind much to recommend it, in addition to institutionalizing something close to current practice. Such an approach is an effective way to communicate the intent of policy and thereby to reduce uncertainty about how policymakers will respond to ongoing developments and to changes in forecasts. The significance of effective communication should not be underestimated. Among other things, it can serve as a form of precommitment, so that market participants and others can more accurately anticipate forthcoming policy actions.
Inflation targeting is a way to improve policymaker accountability since, once the target is specified, the public will have a metric for evaluation. Presumably, if the inflation objective is not achieved, policymakers will have an obligation to explain the error and to present plans to correct it. An explicit inflation target may also help to anchor expectations of future inflation, especially where policymakers have credibility, and this should contribute to sound private-sector decision-making and improved resource allocation in the economy. Overall, inflation targeting represents a vehicle for addressing the so-called time consistency problem in economics, wherein short-run policy decisions, although made with the best of intentions, prove inconsistent with the long-run policy objective.
In the United States, the Federal Reserve has what is called a "dual mandate," namely, a mandate to achieve price stability and sustainable growth in output. Some have worried that an explicit inflation target would overemphasize the first objective at the expense of the second. But both economic theory and practical experience strongly suggest that there is no conflict between these objectives and, in fact, that the most important contribution monetary policy can make to growth and rising standards of living is to achieve and maintain price stability. This is, in fact, one reason that I earlier described the performance of the economy through much of the 1980s and '90s—to illustrate that sustained growth went hand in hand with persistent declines in inflation rates and ultimately culminated in price stability or something quite close to it. This positive experience further solidified the consensus, first achieved under more difficult circumstances by Paul Volcker, supporting the Federal Reserve's commitment to price stability.
Still, there are numerous, challenging issues to confront before the Federal Reserve, or another central bank, commits to inflation targeting. To cite just a few: Which measure of prices should be used in the process? What is the appropriate time period over which inflation control is exerted? Presumably, if the period selected is too short, inflation control will come at the expense of excessive interest rate volatility; if it is too long, it will be meaningless. Related to this, how aggressively should the central bank react to deviations from the target? And should the target be a range or a number?
As noted at the outset, the overriding theme of this discussion is the characteristics of effective economic policy. I have tried to emphasize several such characteristics, including clear specification of the policy objective, possession of the instrument necessary to achieve the objective and the ability to utilize the instrument, and commitment to and clear communication of the objective. Federal Reserve monetary policy generally lines up well against these criteria, and, in my judgment, inflation targeting holds the promise of further, although perhaps only incremental, improvement.
But what of U.S. fiscal policy—that is, the tax and expenditure programs of the federal government and the resulting budget deficits or surpluses? Here, I believe, there is still considerable distance to cover. A clear objective, described in terms of the path of the budget balance over time or the role and size of the government in the economy, has not been specified. Individual programs may have strong rationales, but there is no apparent way to reconcile the aggregate of such programs with the willingness to impose taxes. Especially lacking, from my perspective, is a way to deal with the time consistency problem identified earlier—that is, to maintain commitment to a policy once it is selected. At present, there does not appear to be a means to preserve or to enforce effectively a commitment to a fiscal policy path over time. As a consequence, considerable uncertainty attends fiscal policy, and private-sector planning—be it by businesses or households—is likely adversely affected.
To date, this state of affairs seems not to have mattered much, at least insofar as macroeconomic performance is concerned. But, of course, we do not have the "counterfactual," a term we economists love to use, and used here to indicate that we do not know how the economy would have performed had uncertainty about fiscal policy been addressed. In any event, the absence of these desirable characteristics may matter in the years ahead when the collision between entitlement programs and demographics becomes pronounced and the magnitude of budget deficits increases appreciably, absent explicit action.
To be sure, there are proposals to address this issue, in whole or in part, through suggestions like a balanced budget amendment to the Constitution, a "lockbox" for Social Security, or "pay-go" plans; the latter was legislated for a time. But it is telling that such proposals have either never found much support or were abandoned after a few years. The now well-established consensus that monetary policy should consistently promote price stability was born out of painful experience with the lack of such a commitment. I would like to think that we can arrive at a sensible, time-consistent fiscal policy framework without the pain of difficult experiences. Apparently, the case for applying some of our knowledge and experience to fiscal policy has not yet been made effectively.
There seems no need for a conventional summary of the points covered earlier in these remarks because I intentionally tried to summarize along the way. Instead, let me just reemphasize one particular matter. Economic progress and prosperity depend on the performance of the economy over extended periods. For such progress, public institutions must make and adhere to long-term commitments to sensible policies that are made credible by a combination of theoretical knowledge, practical experience and broad public support.