Over the past year or two, there has been considerable discussion of
price stability as the preeminent goal of Federal Reserve monetary policy.
This discussion has generated support for the goal but has also touched
off a variety of concerns, including the compatibility of this objective
with other policy goals, the potentially high cost of achieving price
stability, and the means of conducting policy to achieve this objective.
These concerns are worthy of serious consideration but, on balance,
price stability should remain the overarching goal of monetary policy.
In two pieces of legislation—the Employment Act of 1946 and the Full
Employment and Balanced Growth Act of 1978—Congress has specified objectives
for monetary policy. To paraphrase a bit, these objectives include achievement
of high employment, economic stability and growth, price stability and
balance in our international transactions. Clearly, these objectives represent
a highly desirable state of economic conditions, but I sense concern that
if prominence, or preeminence, is given to one, especially price stability,
others may be compromised. That is, these objectives may conflict in a
fundamental and lasting way, which implies that the policy challenge is
to somehow strike a reasonable balance among these objectives.
I don't find the vision of fundamental conflict persuasive for several
reasons. There is a plethora of evidence indicating that monetary policy
significantly influences price performance, implying that, if properly
designed and administered, policy can reasonably be expected to achieve
price stability in the long run. On the other hand, the influence of monetary
policy on the other objectives is limited and indirect at best. For example,
economic growth depends in part on demographics such as labor force growth,
and on the quality of the labor force, matters over which Federal Reserve
policies have no influence or effect.
Equally important, in the long run no fundamental incompatibility exists
among these multiple objectives. The principal contribution monetary policy
can make to achieve sustainable growth and high employment is to establish
an environment of overall price-level stability. Beyond demographic factors,
growth depends on the capital stock with which the labor force works.
Capital investment is likely to do well in a non-inflationary environment.
In sum, price stability is compatible with the other objectives specified
by Congress and is the principal contribution the Federal Reserve can
make toward attainment of those objectives and continuing economic prosperity.
Perhaps a more serious concern about dedicating monetary policy so exclusively
to achievement of price stability is that, while this objective is embraced
in the abstract, many fear that it would impose substantial costs on the
economy in practice.
Those who hold this view implicitly, if not explicitly, accept the Phillips
Curve notion of a trade-off between inflation and unemployment or lost
output. If this notion is accepted, there is little doubt that achieving
price stability could prove very costly indeed.
However, conventional Phillips Curve analysis ignores the potentially
crucial role of credibility in achieving policy objectives. If the Federal
Reserve adopts and implements an anti-inflation policy that is widely
believed and accepted by the publicthat is crediblethe costs
associated with reducing the rate of inflation may be modest.
In a recent publication, the Federal Reserve Bank of San Francisco made
this point very well. "Credibility means that the public quickly adjusts
its expectations concerning future policy in response to the announcement
of a change in policy, or to policy actions that suggest a new policy
stance. Thus, a central bank with 'credibility' can announce a new disinflationary
monetary policy and quickly achieve a lower inflation rate without a prolonged
economic downturn because the public expects it to follow through with
its new policy long enough to be successful. Consequently, wage and price
increases moderate quickly."
How much credibility does the Federal Reserve have at present? I can't
provide a quantitative answer, but probably not as much as I would wish.
Thus, there are likely to be some costs, in terms of foregone output,
in achieving price stability. But if an anti-inflation strategy is consistently
pursued, credibility can be earned and costs held to reasonable levels.
Assuming that price stability is, in fact, the paramount goal of policy,
what should the Federal Reserve do to achieve this objective? In my judgment,
policy formulation and implementation would probably have to change little
from current procedures. Growth in the monetary aggregates, especially
M2, would be used to help assess and guide policy, and M2 growth would
have to be reduced over a series of years to a pace consistent with stable
prices. In terms of M2 growth ranges, the upper end would have to be lowered
steadily to assure that there is no backsliding in this process.
We in the Federal Reserve would continue to recognize, as we do today,
that price measures themselves may bounce around in the short run, due
in part to swings in energy or agricultural prices that don't relate well
in every period to macroeconomic conditions. Similarly, we would continue
to recognize that current price performance results from past policies,
so we would not necessarily react to every new statistic on inflation.
And there would be nothing in our strategy to preclude a response to "shocks,"
such as a sharp break in stock prices, if that were appropriate. Stated
more positively, we would continue to bear in mind our responsibility
for the safety and soundness of the financial system, as well as the linkages
between financial problems and business activity. Setting course for price
stability need not constrain our ability to deal with these situations.
Indeed, to the extent that speculative excesses contributed in the past
to such problems, achievement of price stability may make such episodes