2005 Annual Report

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REFLECTIONS ON MONETARY POLICY: FLEXIBILITY, TRANSPARENCY AND INFLATION GUIDELINES

By Michael H. Moskow
President and Chief Executive Officer
Federal Reserve Bank of Chicago

Monetary policy has come a long way in the past quarter century. Price stability has always been part of the Federal Reserve's policy mandate, and one of our major accomplishments of the last 25 years is that we have actually achieved this goal.

We have learned a lot about monetary policy during the last 25 years - and we're still learning. We have gained important insights about the tactics of monetary policy as we moved from an environment of moderate inflation to one of price stability. In particular, we have learned a good deal about the benefits of maintaining appropriate flexibility when implementing policy. We also have learned about the importance of communications and transparency in that implementation - notably their role in reducing the uncertainty that households and business owners face when making economic decisions such as how much to spend, save and invest, or what prices to charge for their products.

Some argue that the best way for central banks to increase transparency and reduce this uncertainty is by adopting explicit numerical targets for inflation. However, there are a number of outstanding questions that should be addressed before a central bank decides to move to a regime of explicit numerical guidelines. Importantly, central banks usually think about these questions only in terms of achieving a target for inflation. But the Federal Reserve has two goals: It is charged with the dual mandate of fostering maximum sustainable growth as well as price stability.

Economists have thought a lot about these questions in recent years. In my opinion, they have not yet come up with adequate answers. So these questions continue to challenge a wide range of experts: academic researchers who study monetary theory, economists who advise businesses and households on how monetary policy may affect their investment decisions, and central bankers who try to formulate effective monetary policy in a constantly changing - and inherently uncertain - economic system.

The Tactics of Monetary Policy During the Transition to Price Stability

When thinking about the interaction between inflation and monetary policy, it's useful to remember University of Chicago economist Milton Friedman's important observation: Inflation is always and everywhere a monetary phenomenon. I learned this lesson the hard way in the early 1970s when working at the Council of Economic Advisers and at the Council on Wage and Price Stability. Overly expansive monetary and fiscal policies had contributed to a rise in inflation from near 1 percent in the early 1960s to more than 6 percent in early 1970. These rates were unacceptably high, and wage and price controls were implemented in 1971 to deal with the problem.

These controls did more harm than good. They did not break inflationary expectations, and inflation rates spiked back up when the controls were lifted. Furthermore, the distortions to relative wages and prices caused by these policies - and by other controls and guidelines that followed - resulted in the misallocation of productive resources in the economy.

Today, many of those involved in implementing wage and price controls have vowed to fight fiercely any future efforts to reinstate them. But that certainly was not doctrine back then. For example, in the 1970s, Federal Reserve Chairman Arthur Burns thought that monetary policy should not take sole responsibility for bringing down inflation. He believed some kind of wage and price review authority was a necessary additional element of anti-inflationary policy. The experiences of the 1970s, however, stress that anti-inflationary efforts outside of the realm of monetary policy are far less important for lowering inflation than reversing the accommodative policies pursued by the Fed.

Much hard-fought progress against high inflation had occurred by the time of my arrival at the Chicago Fed in September 1994. At that time, the Federal Open Market Committee (FOMC) was embarking on a pre-emptive strike against emerging price pressures in order to prevent inflation from rising. These policy moves were successful. Subsequently, a series of events resulted in the achievement of price stability.

The history of this 11-year period highlights the importance of flexibility in the implementation of monetary policy. Part of this flexibility is the willingness to debate and discuss new ideas. A good example is the tactical discussion in 1995 and 1996 about opportunistic disinflation. This was a discussion about whether policymakers should deliberately move to lower inflation or whether they should wait for the reductions that typically occur when the economy softens somewhat. In other words, should the effort to reduce inflation involve daily skirmishes or less regular battles when the opportunity arises?

Interestingly, opportunism won out in a different way. The opportunistic arguments in the mid-1990s largely were based on the idea that inevitable slowdowns in aggregate demand could be exploited to lower inflation. In fact, the productivity acceleration during the second half of the 1990s allowed for lower inflation without reductions in aggregate demand or economic activity — inflation came down at the same time that unemployment was falling. But because productivity growth had been persistently slow for the previous 20 years, few people considered the possibility of a productivity resurgence at the time of the opportunistic-versus-deliberative policy debate.

The next episode that is important to highlight occurred in 2003. Following its May 2003 meeting, the FOMC acknowledged a relatively new risk to the economy: the possibility of an unwelcome fall in the inflation rate. For a central bank that had worked steadily for 25 years to reduce inflation, this sure was something new. But it highlighted the fact that with the achievement of price stability, monetary policy had to be based on flexible thinking; it had to acknowledge that inflation could be either too high or too low. And policy had to be conducted in recognition of that fact.

These episodes are well-known to business and monetary economists who have studied the path that the U.S. economy has followed to reach the neighborhood of price stability. Interestingly, it is a peculiarly American path.

While other central banks pursued a numerical inflation objective, the U.S. achieved price stability without having an explicit numerical target. Of course, it wasn't that important to have a numerical definition of price stability when actual inflation exceeded price stability by everyone's measure. At the time, Chairman Alan Greenspan offered a useful, though non-explicit, definition: It's when businesses and households are not taking inflation into account in their economic decisions. So as long as the plans of households and businesses still accounted for inflation, it seemed clear that price stability had not yet been reached.

Furthermore, while other countries have suffered sluggish growth to achieve lower inflation, the U.S. did not. This is because our disinflationary monetary policy could be implemented against the backdrop of a step-up in productivity growth and because monetary policy did not adhere to a rigid mechanical rule, but adapted to the incoming evidence on inflation and output.

This flexibility has been an important hallmark of monetary policy tactics over the past 20 years. This has caused heartburn among academics and others who worry about excessive discretion and advocate a more rigid, rules-based policy. Instead, the Greenspan Fed generally has responded adeptly to changing economic conditions and financial risks that threatened macroeconomic performance, and has done so without abandoning the discipline of its dual mandate to pursue maximum sustainable growth and price stability.

The Fed's reaction to financial risk is another hallmark of flexible policy. This actually is an old prescription for central bankers that Walter Bagehot (the founding editor of The Economist) gave in the 19th century: Provide liquidity to solvent financial institutions during financial market crises. Such action was clearly evident during the stock market crash of 1987, the extended monetary accommodation in the face of financial headwinds of the early 1990s, the Russian default in 1998, and the period after the 9/11 terrorist attacks.

In some instances, the injection of liquidity ran counter to the inflation risks that the FOMC perceived just before the crisis. But as events bore out, such flexible monetary policy responses did not jeopardize the pursuit of the nation's long-run goal of price stability. That is because an important element in this "disciplined approach to flexibility" is that long-run policy goals generally have been clearly articulated and are understood by the public.

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