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 less likely.