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Formalizing the Success of Past Policy

Top of the Ninth

June 1, 2005


Gary H. Stern Former President (1985 - 2009)
Formalizing the Success of Past Policy

While the public and policymakers alike remain rightly concerned about the economic challenges that lie ahead, the successes of our recent past should provide a considerable degree of reassurance. Despite numerous hurdles and unforeseen crises, our economy has performed remarkably well for most of the past two decades. Growth in gross domestic product has been strong on average; employment gains have been substantial; productivity has been increasingly robust. This isn't to say that there haven't been episodes of economic weakness in the last 20 years and, certainly, some aspects of our economy deserve greater attention. I do believe, however, that the overall picture is one of a sound and flexible economy that can absorb significant shocks without major repercussions.

Many factors have played into this healthy performance, but I would contend that monetary policy has contributed by establishing and maintaining price stability, and by convincing market participants that the Federal Reserve's commitment to price stability is strong and durable. This was no simple achievement, particularly given the era of high inflation and economic stagnation that preceded it, and it stands as a clear tribute to the Federal Open Market Committee and to the leadership of its chairs during this period, Paul A. Volcker and Alan Greenspan.

In thinking about how to sustain the economic performance that we've enjoyed in recent decades, and mindful of the role that price stability has played in that success, I am becoming increasingly convinced that monetary policymakers may want to more formally institutionalize the low inflation policy that we've followed implicitly over recent decades. Further, I am becoming persuaded that establishing a regime of inflation targeting may be an effective means to do so.

In the remainder of these comments, I lay out the rationale for taking such a step, emphasizing the empirical and conceptual underpinnings for a formalized low inflation policy and delineating the costs of trying to smooth economic fluctuations. I then provide a general outline of what I view as a useful approach to inflation targeting. And, of course, I'd like to remind you that I am speaking for myself, not for others in the Federal Reserve. (Finally, I use the terms "price stability" and "low inflation" interchangeably here.)

The value of price stability

For inflation targeting to make sense, there must, among other things, be value in attaining and maintaining low inflation. While the empirical evidence is perhaps not altogether overwhelming, it does suggest that economies grow best in low inflation environments. Certainly the performance of the U.S. economy since the early 1980s is consistent with this assessment, for the economy has done remarkably well, on average, for better than 20 years now. Further, the performance of our economy from 1979 to 1983 illustrates the havoc inflation can wreak. Inflation of the magnitude we had during that period contributed to significant redistributions of real income and wealth and clouded price signals, thereby distorting resource allocation and inhibiting growth.

As these brief descriptions suggest, low inflation should be a primary policy objective because price stability is essential to the efficient allocation of resources and the promotion of economic growth. Further, research has established that, in determining levels of income and welfare, the trend growth in an economy clearly dominates fluctuations around the trend. This means, in short, that it is more important to maintain and, if possible, to raise the trend growth of output than to reduce its variance. It thus behooves monetary policymakers to emphasize achievement of price stability and thereby facilitate growth, while recognizing that there may be opportunities for constructive countercyclical policy from time to time.

Finally, this discussion of the value of low inflation would not matter much if monetary policy had no appreciable effect on inflation. But there is a compelling body of evidence suggesting that over periods of five years or longer, growth in the money supply is a major determinant of inflation. This empirical result holds across a wide range of economies and time periods. Thus, monetary policy can achieve price stability, and can be held accountable for doing so.

Countercyclical policy

There are several reasons why countercyclical monetary policy that focuses on economic stabilization—that is, smoothing out business cycle fluctuations—should be pursued with considerable care and caution. For one thing, as already noted, even successful countercyclical policy is likely to make only modest contributions to income and welfare. Second, as I hinted earlier, "real business cycle" research indicates that some fluctuation in economic activity, such as that stemming from technological innovation or other supply-side shocks, is a normal feature of a healthy economy. Markets and market participants frequently adapt to such shocks more quickly and effectively than monetary policy can. The concern is that active stabilization policy, although well-intentioned, may actually lower welfare because of its interference with efficient private sector responses to such unavoidable shocks.

It is also possible that countercyclical concerns may divert policymakers from the primary goal of price stability. If the evidence cited above is correct, this diversion could lower the trend of output and economic welfare relative to what could have been achieved had price stability been maintained. A more insidious form of this concern arises from the "time inconsistency" problem: Even though policymakers know of the deleterious long-run consequences of inflation, at any point in time it appears attractive to inflate in order to generate short-run gains in output. The ultimate result of such an approach is, of course, the loss of price stability and its persistent benefits.

The promise of a target

Policymakers with sound judgment and extensive experience may well avoid falling prey to these problems. Our success over the past two decades demonstrates that policy can achieve price stability while responding in some measure to business cycle shocks. Nevertheless, to avoid significant policy mistakes in the future, it may be advisable to see if a more formal process can be institutionalized, a process that would, in effect, distill and apply the policy lessons of our past.

Given this objective, I believe there is considerable promise in an inflation targeting framework as a means of establishing and achieving long-term price stability. Under the regime I have in mind, as long as the forecast of inflation is within its agreed-upon target range over an agreed-upon multiyear period, monetary policymakers would be free to attempt to smooth output. On the other hand, if inflation is outside the acceptable range (or is projected to move outside it), then policy would be directed to restoring inflation to the range. Output stabilization would explicitly be a second priority to price stabilization.

Implicit in the preceding paragraph are a number of unanswered questions. Which measure of inflation do we use? What is the right target range? What is the appropriate time period? How are inflation forecasts prepared? These matters are not trivial, and their answers will lead us along the path to implementation. For example, while an inflation target centered on zero might be optimal given some theoretical considerations, the persistence of rigidity in market wages suggests a case for a modestly positive rate of inflation. If current dollar wages do not fall when prices do, then real earnings will rise during deflationary periods, threatening to decrease employment during such episodes. A potential solution to this "sticky wage" problem is a mildly positive rate of price increase on average.

In the end, the essential point is this: Monetary policymakers have at their disposal a method for institutionalizing past success that is attractive on both conceptual and practical levels. A policy procedure that relies on inflation targeting could help us avoid the mistake of attempting too much economic stabilization and allow us to better focus on maintaining price stability. Such a focus should help to extend the economic progress of the past two decades.

For an extended discussion of inflation targeting and the FOMC, see "Avoiding Significant Monetary Policy Mistakes," Gary H. Stern and Preston J. Miller, Federal Reserve Bank of Minneapolis Quarterly Review 28 (December 2004), 2-9.