Monetary policy is one of the principal responsibilities
of the Federal Reserve, and certainly the one which receives the most
attention. Simply stated, the goal of monetary policy is to achieve
maximum economic performance over time. There is considerable agreement
that the most significant contribution the Federal Reserve can make
to this goal, characterized by sustained economic growth and improved
living standards, is to achieve and maintain low inflation. However,
the channels through which inflation influences growth are not clear,
nor is it universally accepted that inflation even influences growth.
In addition to long-run emphasis on low inflation, there is a belief
that monetary policy can improve economic performance by decreasing
volatility in business activity that is, by smoothing the business
cycle. However, given the greatly diminished importance of the monetary
aggregates in the policy process, a major challenge currently confronting
the Federal Open Market Committee (FOMC) is to guarantee that short-run
decisions designed to address cyclical concerns are consistent with
the long-run low inflation objective. Formerly, the monetary aggregates
helped to assure that monetary policy was anchored to low inflation
and was "time consistent," but these roles have not as yet been filled
by other variables or changes in procedures. Several proposals address
these gaps in our practices, but our knowledge is insufficient to make
a selection. In my view, it is imperative that we address these issues
As suggested above, the commitment to low inflation is widely shared
among the members of the FOMC. Nevertheless, a host of questions arise
associated with the focus on low inflation: Will the low inflation environment
contribute over time to growth and to higher standards of living? If
so, how? How does low inflation contribute to financial stability? Can
the Federal Reserve achieve and maintain low inflation? What weight,
if any, should be given to cyclical fluctuations in unemployment and
economic activity in policy determination? How should the Federal Reserve
implement a low inflation policy?
Inflation and Growth
Evidence has accumulated suggesting that economies perform better,
in terms of growth, employment and living standards, in low inflation
environments than they do when inflation is persistently high. This
evidence is principally a comparison across countries and over
long periods of the association between economic performance,
measured by, say, growth of output or growth of productivity, and inflation.
The correlations indicate a negative relation; that is, the higher the
inflation, the lower the rate of real growth. This evidence is neatly
summarized in several recent academic papers.1
Evidence suggesting that low inflation promotes growth has motivated
recent decisions by a number of central banks and governments, most
notably New Zealand. Canada, the United Kingdom and Sweden also have
moved in recent years to establish monetary policy regimes with official
low inflation targets. Such actions indicate the preeminence of this
goal and frequently signify increased independence for the central bank
in pursuit of its policies as well. Decisions to adopt a policy objective
of low inflation suggest that other policy-makers are reading the evidence
pertaining to inflation and growth as we are.
An issue logical to consider next is: Why is low inflation relatively
favorable for growth? After all, association does not prove causality;
the relation between growth and inflation reported above may simply
be fortuitous, or the causality may run the other way. This is indeed
a difficult question, in part because until recently there were not
well-articulated theories to explain the relationship. However, basic
economic reasoning suggests that there are at least two channels through
which inflation influences real economic performance. First, in contrast
to high inflation, low inflation leads to improved resource allocation
because price signals are more easily and more accurately interpreted.
Second, low inflation contributes to financial stability.2 Let me explain.
Relative prices provide a guide in the allocation of resources. For
example, a change in relative prices resulting from a change in demand
patterns should shift resources and production from the activity whose
price has fallen (relatively) to that whose price has risen, while a
general rise in the price level inflation should not alter
resource allocation in this way. But in an inflationary environment
it may be difficult for individual decision makers to distinguish between
inflation on the one hand and a change in relative prices on the other,
and such confusion is especially likely if high inflation is correlated
with variable inflation (inflation rates which fluctuate substantially
from period to period), as it appears to be. Thus, resources may be
seriously misallocated during inflationary periods.
In addition, inflation creates a problem in estimating the real interest
rate. The real (that is, inflation-adjusted) interest rate the
relative price of current to future goods is not explicitly given
as a market price, but rather people deduce it from the nominal (that
is, unadjusted) interest rate by taking inflation into account. When
inflation becomes variable, this task of determining the true relative
price becomes more difficult. The resulting misallocation of resources
will adversely affect growth and living standards, because resources
are not being put to their best use. Further, if the tax system is not
indexed, inflation may adversely affect incentives to work and to invest.
In the extreme, considerable resources may be devoted to efforts to
avoid or to offset the ravages of inflation. And, without widespread
indexation, inflation may well result in capricious transfers of wealth.
All of these effects diminish when inflation is persistently low.
Indeed, in the Federal Reserve, our working objective is to reduce inflation
to the point where it no longer is a factor in economic decision making.
As we succeed, resource allocation moves closer to optimal, with attendant
benefits in growth and living standards.
The second broad reason why low inflation favors growth is that it contributes,
in my judgment, to financial stability. A low inflation economy is less
likely to engender the sharp swings in asset prices and in expectations
about such prices that have been so devastating to the financial system
from time to time. Consider, for example, the damage wreaked by inflation
on the savings and loan industry and some of its customers 15 or so
years ago. Similarly, the "credit crunch" which inhibited the U.S. economy
just a few years ago can be traced in part to capital pressures at commercial
banks stemming from earlier misjudgments about inflation and asset values.
In a fundamental sense, problems associated with misjudgment of asset
prices and their prospects are no different than the confusion about
relative and general price changes described earlier. Investors and
creditors misjudge price signals and draw incorrect conclusions, financial
resources are then misallocated, and disruptions occur.
Financial stability is vital to a prosperous economy in a number of
ways. Implicit in the preceding discussion, credit decisions, which
determine the allocation of financial resources, are likely to be closer
to optimal in a low inflation economy. This follows from the common
sense notion that bankers and their customers will on average do a better
job of assessing business prospects in an atmosphere of relatively stable
Financial stability also enhances an economy's ability to weather
shocksrun-ups in energy prices, significant technological changes,
unforeseen developments in the economies of major trading partners,
and so forththe bane of policymakers and forecasters alike.
Such events will cause dislocations, to be sure, but a financial system
which can absorb them without significant feedback to economic activity
helps to limit the extent and duration of the disruption. In these circumstances,
real growth will be affected less than it would be under conditions
in which the financial sector magnifies and spreads the effects of the
shock. Furthermore, it is likely to be easier to identify the effects
of shocks and the proper responses to them in a noninflationary environment.
Policy and Inflation
To this point, I have suggested that low inflation can make significant
contributions to growth and prosperity through its effects on real resource
allocation and on financial stability. This suggestion is not of much
moment, however, if monetary policy cannot achieve, and maintain, low
inflation. On this subject, fortunately, evidence and opinion are largely
of one mind.
One of the few topics about which most macroeconomists agree is that
inflation is first and foremost a monetary phenomenon.3 It results from a long-term pattern of money creation which is excessive
relative to the economy's ability to produce real goods and services.
Further, there is widespread agreement that the supply of money is determined
by the central bank in the long run. Thus, with appropriate policy,
the Federal Reserve can achieve and maintain low inflation it
should be expected to do so and can be held accountable for doing so.
In a general sense, then, the operational responsibility of the Federal
Reserve is to provide for long-run growth in money consistent with low
inflation. And, as I emphasized earlier, there should be significant
economic benefits to the extent the Federal Reserve achieves this objective.
The preceding policy "prescription" glosses over at least one difficult
issue, namely: The mandate to avoid excessive long-term money creation
permits considerable latitude in how the stock of money moves in the
short term and, therefore, is not necessarily useful for short-run policy
determination. In the past, monetary aggregates were used to tie the
short run to the long run, but the short-run relation between money
and the economy has seriously deteriorated. Likewise, confidence in
the use of monetary aggregates in practical policy setting has understandably
been undermined.4 Experience has convinced
me that the aggregates are now of little value in short-term decision
making. This leaves a significant gap in our procedures, especially
when we want to calibrate a response to business cycle developments.
Business Cycle Considerations
Indeed, a critical question is: How can the Federal Reserve achieve
low inflation and effectively respond to business cycle excesses in
an environment in which the money supply is not a useful short-term
guide to policy? Having previously addressed the money-inflation issue,
I will turn to two other aspects of this question: (1) Can monetary
policy influence real activity in the short run? and (2) If it can,
These questions have long been debated in academia and in the Federal
Reserve, and a consensus has not emerged. My position is that monetary
policy has effects on real economic variables in the short term, but
the magnitude of such effects is uncertain and the timing between policy
action and its effects is variable. Thus, our knowledge of the short-run
effects of policy is insufficient to permit us to act aggressively in
This is a fairly conventional position. Certainly the Federal Reserve
behaves as if monetary policy has real effects, and empirical evidence
supports the notion.5 But because of uncertainty
about magnitude and lags, policy-makers have to be cautious in their
response to unexpected deviations in economic performance. The fundamental
reason is that there is a real risk of aggravating the situation
that is, our actions could be destabilizing rather than constructive.
Some would go further and would maintain that even a cautious response
to business cycle fluctuations is unwise, given all the reservations
expressed over the years about fine tuning. But in my view it is not
too difficult to argue in favor of some response. Given that monetary
policy has real effects, it is only necessary to observe that short-run
volatility inhibits long-run real growth. Put more forcefully, boom-bust
cycles damage the economy, and therefore policy should be employed countercyclically
to moderate, if possible, the tops of booms and the bottoms of contractions.6
Countercyclical policy to avoid or at least to moderate boom-bust
cycles thus seems defensible but, as already suggested, such a policy
should be pursued cautiously. It could be destabilizing if policy-makers
are wrong about the size and timing of the effects of their actions,
and thus it conceivably could inadvertently deepen a recession or stimulate
inflation. Moreover, if not carefully implemented and explained, countercyclical
policy might create confusion about the long-run objective of the FOMC,
could disrupt private sector planning and decision making, and could
add uncertainty and inflation premiums to market interest rates.
An Anchor for Policy
Money growth ranges provided a framework that reconciled the long-run
commitment to low inflation with short-run reactions to economic developments.
To see how, let me explain the roles the monetary aggregates formerly
played in the policy process. The place to begin is with the quantity
theory of money. According to the quantity theory, there is a relation
between the rate of growth of the money supply, growth in real economic
activity, and inflation. The linkage between money and the variables
we care about inflation and real growth is provided by
the velocity of money. This is precisely where recent difficulties have
arisen for, as we have seen recently, money velocity has deviated from
previous experience, and accurate prediction has become increasingly
challenging. Over time, this deterioration in the relation between money
growth and nominal business activity has afflicted virtually all of
the conventional measures of money.
The quantity theory in its crude form would suggest a strict, mechanical
pursuit of a precise target for money-stock growth. Although such a
policy regime was approximated briefly to re-establish monetary policy
credibility after the inflationary episode at the end of the 1970s,
monetary aggregates have been used in a looser, more discretionary way
in policy determination since that time. But it seems to me that the
deteriorating relation between money growth and nominal business activity
has undermined the advisability of even this looser policy regime.
To see why, consider how this regime worked. When the monetary aggregates
were useful in policy determination, a rate of growth for an aggregate
could be specified consistent with the FOMC's inflation objective and
its understanding of the relations in question. For example, if the
trend rate of growth in real GDP was estimated at 2.5 percent per annum,
money velocity constant, and 3 percent an acceptable inflation outcome
for the period in question, then money should expand at 5.5 percent
per year. In practice, the Committee not only selected a midpoint for
money growth 5.5 percent in this example but also established
a range around the midpoint, recognizing both that these relations do
not hold precisely on an annual basis and that flexibility to respond
to unanticipated developments is desirable. When conditions turned out
as expected, open market operations were conducted to keep the path
of bank reserves or the federal funds rate, depending upon the short-run
operating rule, consistent with desired money growth and, ultimately,
In this setup, the range for money supply growth fulfilled several
functions. The midpoint of the range was typically established consistent
with the Committee's inflation objective. When the aggregates were employed
successfully, midpoints were reduced gradually over time, in keeping
with the FOMC's desire to bring inflation down. The money supply was
thus the "anchor" of policy the variable on which the FOMC focused
in order to pursue a low inflation policy.
The upper and lower bounds of the ranges served as the limits within
which the Committee was prepared to see money growth deviate from its
midpoint. That is, the ranges defined acceptable short-run deviations
in money growth perhaps for cyclical reasons which nevertheless
were viewed as consistent with the Committee's commitment to low inflation.
Because the ranges were relatively narrow, policy remained disciplined
and, even if in error, was unlikely to be highly destabilizing.7
Consistent Policy Over Time
With the monetary aggregates no longer of significant value in the policy
process, we find ourselves without an effective policy anchor
that is, without a quantitative way of indicating the FOMC's long-run
objective and of guiding open market operations toward that objective
and without a means to define acceptable countercyclical action,
whereby acceptable I mean an effective response to incipient booms or
busts which does not compromise our long-run objective. What I am striving
for is the concept of policy consistency over time: a countercyclical
response which is consistent with, or can be reconciled with, the FOMC's
long-run goal and which, furthermore, is seen as consistent by the public.
To be sure, policy has been implemented effectively and largely successfully
in recent years, in my view, without an explicit anchor and a method
to assure time consistency. Nevertheless, the FOMC's judgment may not
always be adequate, and hence it is desirable to find a more systematic
way to conduct policy so as to achieve and maintain low inflation and
to moderate business cycle extremes.8
There are several ways we might go about establishing a framework
for a more systematic policy capable of addressing these two matters.
But before describing specific proposals, we need criteria by which
to evaluate the options. Based on the preceding discussion of the roles
formerly played by measures of the money supply, important criteria
- Does the proposal contain a clear and appropriate policy anchor
which guides monetary policy to the low inflation objective? More
formally, is there a variable that bears a close and unchanging
relationship with inflation that the FOMC can influence in a predictable
- Does the proposal have an effective way of delimiting the policy
response to business cycle fluctuations? Again, more formally, is
there a way of putting a range around the anchor that allows responses
to fluctuations, but limits those responses to ensure consistency
with the FOMC's low inflation goal?
Of the three following proposals, none is especially original, and
none is entirely satisfactory. Nevertheless, they are offered to illustrate
a range of available approaches and to stimulate further thought about
how we can best establish an anchor for, and assure time consistency
in, monetary policy.
One approach to a more systematic framework for policy implementation
is to resurrect the monetary aggregates, based on the following considerations.
We would acknowledge that the aggregates have lost value as short-term
guides to policy, but at the same time we would reaffirm that inflation
remains a long-term monetary phenomenon. The responsibility of the central
bank, thus, would not change: It is to keep money supply growth within
bounds over long periods say 10 years so as to keep inflation
This proposal effectively satisfies the first criterion specified
above. Money growth would once again become the anchor of policy, with
exclusive emphasis on its long-run performance in view of its shortcomings
as a short-term guide. Assuming past relations hold, long-run monetary
control should result in long-run inflation control. The evidence as
to which aggregate to select is mixed, but it appears to be a "horse
race" between M2 and the monetary base; either would probably do.
The proposal to concern ourselves only with the long-run performance
of a monetary aggregate fares less well against the second criterion
of disciplining the response of monetary policy to changes in business
conditions. On one interpretation, in the single-minded pursuit of moderate
money growth and low inflation, the proposal would permit no reaction
to significant deviations in business activity from what was anticipated.
This is a potentially costly policy stance if earlier observations about
the desirability of containing instability that is, smoothing
boom-bust cycles are accurate. But another interpretation of
the proposal suggests that "anything goes." This is because the proposal
simply leaves open the questions of when or how to respond to unanticipated
or undesired developments in the economy.
A second alternative to enhance systematic policy implementation is
to focus directly on the policy objective, the rate of inflation, and
adjust the instrument, say the federal funds rate, to influence the
objective as desired. Intuitively, this approach is appealing, for it
does not involve "extraneous" variables like intermediate policy targets.
Presumably, an empirical model of the economy would be used to solve
for the path of the federal funds rate consistent with the FOMC's inflation
goal, and the Committee would authorize open market operations to achieve
the funds rate path.
Arrayed against the two criteria specified above, the virtues and
shortcomings of this proposal are evident. Since it focuses directly
on inflation, it would seem to satisfy the first criterion of providing
an appropriate anchor for policy. One has to be cautious, however, because
our goal is optimal long-run economic performance and, as discussed
above, the evidence suggests that low inflation over the long run is
favorable for growth; but I am aware of no evidence which indicates
that inflation control period by period is conducive to real growth.
Indeed, even proposals to maintain constant growth in the money supply
have recognized that there could well be a lot of period-by-period price
Although a multiperiod inflation targeting procedure would seem to
ameliorate this problem, it also has problems. With a short-period horizon,
the instability problems associated with a single-period horizon remain.
But with a long-period horizon, there is basically no policy discipline
in the short run.
A third approach to the issue of the systematic implementation of
policy is for the Federal Reserve to focus on a short-term market interest
rate. One question is whether the interest rate should be nominal or
real. Based on stability considerations, a real interest rate seems
preferable. The argument that pegging a nominal interest rate can be
destabilizing is now familiar: Normally, high interest rates are associated
with restrictive monetary policy, but if expected inflation rises for
some reason and the Federal Reserve pegs the nominal rate, then policy
actually becomes increasingly expansive. A symmetric problem occurs
with nominal rate pegging when inflation expectations diminish or when
deflation sets in. This problem does not apply to a real short-term
interest rate, as I argue below.
Another question, then, is how to implement a real interest rate proposal.
One way would be to use an empirical macro model to solve for the real
rate, or the path of the real rate, consistent with the Federal Reserve's
low inflation objective. Given its best estimate, or best judgment,
of inflation expectations, the FOMC would then establish the nominal
rate that produced the desired real rate. Presumably, the more actual
and prospective inflation are above the goal, the higher the nominal
rate a given real-rate target would imply. If one believes that this
pattern of nominal rate setting is what the FOMC ought to be doing,
then a virtue of real-rate targeting is that the FOMC would implement
it in a stable and self-regulating way. Adjustment of the real-rate
target would be justified when the environment of the economy changes
in some fundamental way, such as an increase in the rate of return to
capital investment. Advocates of a real-rate target believe that it
would thus lead the FOMC to focus its deliberations appropriately on
long-term considerations, without sacrificing responsiveness to short-term
disturbances in the economy.
An advantage of this approach is that economic theory suggests that
real rather than nominal interest rates matter for spending decisions,
so the Federal Reserve would in fact be emphasizing a variable that
can be expected to affect economic performance. This observation implies
that this proposal could fare relatively well against the second criterion
of defining the policy response to cyclical disturbances in activity.
Since there could well be a long-run correlation between real rates
and inflation,9 the proposal would seem
to have the potential to achieve the Federal Reserve's low inflation
objective. However, the first criterion specified above calls for a
clear and appropriate policy anchor; a real rate may be appropriate
but its clarity is another matter. There is not agreement on measurement
of the real rate nor on its controllability.
Indeed, critics of the real rate proposal assert that the Federal
Reserve cannot hope to control a real rate of interest, which they view
as ground out by interactions in the real economy independent of monetary
policy. I hold a somewhat different view. In a world with interest-bearing
and noninterest-bearing government fiat debt bonds and money
there must be frictions in the marketplace which induce the public
to hold them both, since bonds dominate on a rate of return basis. An
implication of this observation is that monetary policy actions which
alter the relative supplies of money and bonds held by the public affect
real interest rates.
The Federal Reserve is committed to achieving and maintaining low inflation.
This is an objective the central bank can legitimately be expected to
accomplish and for which it can be held accountable.
Although important, accountability is not the reason to focus on low
inflation, however. Rather, a sustained environment of low inflation
should contribute over time to economic growth and to improvement of
living standards. The way in which low inflation contributes to these
outcomes is not entirely understood, and I have suggested in this essay
that positive effects on real resource allocation and on financial stability
There is only limited agreement at the moment about the systematic
conduct of policy, in view of the diminution of the role of the money
supply measures. I have offered several suggestions to address this
issue, including exclusive focus on the long-run growth in money, on
the inflation objective itself and on a real short-term interest rate.
Each of these proposals has its flaws, and I do not think that we possess
sufficient knowledge at present to make a selection with confidence.
However, recent policy successes notwithstanding, establishing a method
for the systematic conduct of policy is worthy of serious consideration
and debate going forward. It is imperative that we identify an anchor
for policy and a procedure which assures time consistency, so that short-term
decisions are related appropriately to the long-term commitment to low
1 I am referring to “The
Growth Effects of Monetary Policy,” by V. V. Chari, Larry E. Jones
and Rodolfo E. Manuelli, Quarterly Review, Federal Reserve
Bank of Minneapolis, Fall 1995 ; "Private Information, Money, and Growth:
Indeterminacy, Fluctuations and the Mundell-Tobin Effect," by Costas
Azariadis and Bruce D. Smith, forthcoming in the Journal of Economic
Growth, 1996; and "Inflation and Economic Growth," by Robert J.
Barro, National Bureau of Economic Research, Working Paper 5326, 1995.
2 A third channel related to distortions stemming
from the interactions between inflation and financial regulations is
discussed in Chari, Jones and Manuelli, 1995.
3 A recent study shows a high correlation between
the rate of growth of the money supply and the rate of inflation; this
correlation holds across three definitions of money and in a sampling
of 110 countries. “Some Monetary
Facts,” by George T. McCandless Jr. and Warren E. Weber, Quarterly
Review, Federal Reserve Bank of Minneapolis, Summer 1995.
4 In "The Rise and Fall of Money Growth Targets as
Guidelines for U.S. Monetary Policy," 1995, Benjamin Friedman writes:
"In 1987 the Federal Reserve gave up setting a target for the narrow
money stock but continued to do so for broader measures of money. In
1993 the Federal Reserve publicly acknowledged that it had 'downgraded'
even its broad money growth targetsa change that most observers
of U.S. monetary policy had already noticed long before."
When Lawrence J. Christiano investigated the supposed change in the
relationship between money and the economy, he examined two types of
models the first showed a break in the relationship, and the second
revealed no break. However, in the second model the link between monetary
aggregates and inflation was so weak that it would be of no practical
use for short-term policy-making anyway. "Money
and the U.S. Economy in the 1980s: A Break from the Past?" Quarterly Review, Federal Reserve Bank of Minneapolis, Summer
5 John H. Cochrane, in "Identifying the Output Effects
of Monetary Policy," National Bureau of Economic Research, Working Paper
5154, 1995, cites a large amount of recent work which concludes that
anticipated monetary policy changes can have real effects on the economy.
For example, Cochrane cites David H. Romer and Christina D. Romer, "What
Ends Recessions?" in NBER Macroeconomics Annual (1994),
Cambridge: MIT Press; and Lawrence J. Christiano et. al., "Liquidity
Effects and the Monetary Transmission Mechanism," American Economic
Review 82, 346-53.
6 A recently published study marshals considerable
evidence that economic growth is inversely related to volatility (Garey
Ramey and Valerie A. Ramey, "Cross-Country Evidence on the Link Between
Volatility and Growth," American Economic Review, 85, 1138-1151).
7 Although the ranges occasionally were violated,
the FOMC had to explain the errors to Congress. The FOMC generally preferred
to abide by the ranges.
8 Interestingly enough, in his recent Nobel prize
acceptance speech, Robert E. Lucas Jr. grapples with similar issues.
Lucas concludes that, absent a better understanding of monetary non-neutralities,
it does not seem possible "to determine whether an optimal monetary
policy should react in some way to the state of the economy or should
be fixed on some pre-assigned objective ... In the meantime, policy
must be made, nevertheless, and existing theory, empirically well-tested,
offers much useful guidance."
9 The legal restrictions theory implies a long-run
relationship connecting monetary policy, real interest rates and inflation
(see Wallace). The broad implications of this theory seem consistent
with observations (see Miller-Todd and Chin-Miller).
Neil Wallace, "A Legal Restrictions Theory of the Demand for 'Money'
and the Role of Monetary Policy," The Rational Expectations Revolution (1994), Cambridge: MIT Press.
Preston J. Miller and Richard M. Todd, "Real
Effects of Monetary Policy in a World Economy," Journal of
Economic Dynamics & Control 19, 1995.
Dan Chin and Preston J. Miller, "Fixed
vs. Floating Exchange Rates: A Dynamic General Equilibrium Analysis,"
Staff Report 194, Federal Reserve Bank of Minneapolis, 1995.