speeches · April 1, 2007

Speech

William Poole · President

Understanding Inflation NationalAssociationforBusinessEconomics(NABE) NewYorkChapter NewYork,NewYork April2,2007 Our economy is fundamentally dataareoftenrevised.Finally,monetarypolicy sound. The GDP gap is small. cannotaffectnear-termconditionsanyway.Thus, Putting aside near-term uncertain- afocusonmedium-andlong-termfundamentals ties, mostly related to housing and isalwaysappropriate. housing finance, economic activity is growing Thecausesofourcurrentprosperitywillbe at approximately the same rate as potential. studiedbyeconomistsforsometime.Today,I Although fourth quarter GDP growth is now wishtodiscussoneofthose:ourimprovedunder- estimated to be a 2.5 percent pace, down from standingofhowpricestabilitycontributesto the advance estimate of 3.5 percent, much of overalleconomicstability.Thatunderstanding this markdown was due to a downward revision isreflectedintheFederalReserve’scommitment in inventory investment. Final sales of domestic tomaintainingalow,stablerateofinflation. output—GDP minus the change in inventories— Effortstoimprovecommunicationsandincrease grew at a robust 3.7 percent annual rate in the thetransparencyofpolicymakingareessential fourth quarter and were 3.3 percent higher than aspectsofthatcommitment.Thepublicmust a year earlier. Unemployment in the fourth quar- understandnotonlythepolicyobjectivesbut terstoodat4.5percent,aslowasanypointinthe alsotheFed’sobjectivesandthedecision-making currenteconomicexpansion.Theemployment processthroughwhichitseekstoattainthose rate—the fraction of the non-institutional popu- objectives—somethingthatIhavereferredtofor lation 16 and older with jobs—stood at 63.3per- manyyearsas“synching”theFedandfinancial cent, also its high point in the economic expan- markets.Thisprocessiseasedifpolicymakers sion. Forecasters anticipate that these favorable followwhatmacroeconomistsrefertoas“rule- fundamental conditions will continue; they fore- based”behavior,particularlyrulesfocusedon see the economy’s output during the next two pricestability. years remaining near potential, with a growth Beforeproceeding,Iwanttoemphasizethat rate averaging approximately 3 percent. theviewsIexpressherearemineanddonot Asalways,myviewoneconomicgrowth necessarilyreflectofficialpositionsoftheFederal andinflationemphasizeslonger-runconditions. ReserveSystem.Ithankmycolleaguesatthe Icouldpointtonumerouspastepisodesofeither FederalReserveBankofSt.Louisfortheircom- fasterorslowergrowthforafewquartersthatwe ments.RichardG.Anderson,vicepresidentinthe nowignorebecauselong-rundevelopmentsdomi- ResearchDivision,providedspecialassistance. natedtheoutcomeandindeeddominateourcur- However,Iretainfullresponsibilityforerrors. rentassessmentoftheseperiods.Inassessing short-rundevelopments,itisalsoessentialto keepinmindthatforecastshavestandarderrors. THE DUAL MANDATE Overafour-quarterhorizon,aGDPforecasthasa standarderrorofabout1.5percentagepoints UndertheFederalReserveAct,theFedhasa andaninflationforecasthasastandarderrorof dualmandatetofosterbothmaximumemploy- about0.5percentagepoints.Weknowalsothat mentandpricestability.Iregard“pricestability” 1 MONETARYPOLICYANDINFLATION aszeroinflation,properlymeasured.Whatdoes tochange40yearsago.Overtime,themainstream “properlymeasured”mean?Priceindexeshave viewintheeconomicsprofessionhasincreasingly biasesofvarioussortsandexpertsgenerally emphasizedtheimportanceofpricestabilityfor believethatU.S.indexesoverstateinflationbya achievingmaximumemploymentandmaximum modestamount.Ifstatisticiansunderstoodthese sustainableeconomicgrowth.Imyselfhave biaseswithprecision,theindexescouldbecor- becomepassionateaboutpricestability.Itis rected.Imyselfmakearoughguessthat,forexam- importanttorememberthatthetwogreatest ple,theconsumerpriceindexoverstatesinflation employmentdisastersinU.S.historywerethe byaboutonepercentagepointayear. GreatDepressionandtheGreatInflation.Defla- Withpricestability,theaveragelevelofall tionfromlate1929to1933drovetheU.S.econ- prices—correctlymeasured—wouldneither omydownanddown,andtheunemployment increasenordecreaseduringthemedium-and rateroseto25percent.DuringtheGreatInflation, long-run.Pricestabilityinthissensedoesnot from1965to1981,theUnitedStatessufferedfour imply,however,thatthepricesofindividualgoods recessions,thelastofwhichin1981-82drove andserviceswillnotchange,nordoesitimply theunemploymentratetoapeakof10.7percent thatanumberofpricescannotchangesharply attheendof1982,thehighestsincetheGreat duringovertheshortrun,nordoesitimplythat Depression. therecannotbelargechangesinrelativeprices. Experienceabroadconfirmstheconnection Iffossilfuelsormetalsbecomemoreexpensive betweenpriceinstabilityandunemployment. relativetoothergoodsandservices,sobeit— Foroneexample,Japansufferedadecadeof stabilizingtherelativepricesofenergyandmetals deflationinthe1990s;economicgrowthwas isnotaresponsibilityorevenwithinthepower minimalandunemploymentrose. ofmonetarypolicy.Differentialsinproductivity growthamonggoodsandservicesalsomaycause sharpchangesintherelativepricesofsomeprod- SOLIDIFYING PRICE STABILITY ucts—thesearenottheresponsibilityofmonetary policyeither. Thecentralbank’sprimarytooltomaximize InrecentyearsseveralFOMCmembershave employmentandgrowthispricestability.The referredtoa“comfortzone”of1-2percentinfla- centralbankcanrefineitspursuitofpricestability tionmeasuredbythepriceindexforpersonal inthreeimportantways.First,theleadershipof consumptionexpenditures,excludingthevolatile acentralbankshouldformaconsensusaround foodandenergycomponents.Becauseagreement thegoalofaspecificlowinflationrate;thepar- onsomereasonablylowrateofinflationismore ticularchosennumberislessimportantthancom- importantthanexactlywhatthatrateis,Iamper- mitmenttoaspecificgoal.Second,thecentral fectlyhappytostatemypersonalinflationobjec- bankmustdevelopaconsistentpolicymodel,or tiveasaninflationratemeasuredbythecorePCE decisionframework,forrespondingtoincoming priceindexof1.5percent,plusorminus0.5 data.Theframeworkmustexplainhowpolicy- percent.1 makersreconcilenear-termmovementsininflation, Itusedtobethoughtthatthedualmandate overwhichmonetarypolicyhasalmostnoinflu- requiredtheFedtotemperpursuitofitsinflation ence,withthepathofmedium-tolong-term goalfromtimetotimeintheinterestofminimiz- inflation,forwhichthecentralbankisalmost ingdisturbancestoemployment.Thatviewbegan whollyresponsible.Constructingthepolicy 1 Ihavediscussedthisrangeinseveralpreviousspeeches.Forarecentexample,seeW.Poole,“Inflation,FinancialStability,andEconomic Growth,”GlobalInterdependenceCenterAbroadinChileConference,Santiago,Chile,March5,2007[http://www.stlouisfed.org/news/ speeches/2007/pdf/03_05.pdf].EarlierexamplesincludeW.Poole,“TheMonetaryPolicyModel,”BusinessEconomics,October2006,41, pp.7-10,andW.Poole,“InflationTargeting,”JuniorAchievementofArkansasInc.,February16,2006,publishedintheFederalReserveBank ofSt.LouisReview,May/June2006,88(3)pp.155-163. 2 UnderstandingInflation modelisfarfromatrivialtask.And,third,the inthedatabase).Thescalesinallthreepanels centralbankmustcommunicatethisframework arethesame.Aregressionlinealsoisshown, tothepublicinacredibleandtransparentway. althoughitmustbeinterpretedonlyasadescrip- Overthepastdecadeorso,theFedhasgravi- tivestatisticbecausemoneyandinflationare tatedtothepositionofplacingprimaryempha- endogenous,jointlydeterminedvariables.Gener- sisonthecorerateofinflation,asmeasuredby ally,boththeratesofinflationandmoneygrowth thePCEpriceindexexcludingfoodandenergy. havedecreasedoverthethreedecades,andthe Thereasonisthatfoodandenergypricesare scatterofpointshasbecomesomewhattighter. subjecttolargeshort-rundisturbancesthatare TheU.S.inflationrecordisshowninthe beyondtheabilityofmonetarypolicytocontrol. tableofthehandout.Thedataaretheimplicit Ifweexaminetotalandcorepriceinflationover pricedeflatorforpersonalconsumptionexpen- threeyears,theaveragesarequiteclose.Food dituresinthenationalincomeaccounts;thePCE andenergypricesdisplaysubstantialshort-run chain-priceindexbehavessimilarlyexceptfewer variabilitythatdoesnotaffectlonger-runinflation. historicalobservationsareavailable.Thetable Thebasic,strategicgoalisall-itemsorheadline showsdecade-averagemeaninflationratesand inflation;coreinflationisatacticalgoalinthe theirstandarddeviations;theleft-sidecolumns shortrun. areannualaverages,theright-sidecolumnsQ4- Howeverinflationismeasured,economists to-Q4changes.Formostperiods,theCPIalso agreethatmonetarypolicyhasatmostaminimal behavessimilarly,exceptin1980whenrising influenceontherateofchangeinthepricelevel mortgageratescontributedtoalargejumpinthe overrelativelyshorttimeperiods—months, CPIbutarenotincludedinthePCEindex. quartersorperhapsevenayear.Centralbanks Figure2shows10-yeartrailingmovingaver- areresponsibleformedium-andlong-terminfla- ages,inthespiritofabackward-lookingadaptive tion—suchinflation,asMiltonFriedmanwrote, expectationsmodel.Thefigureshowstheextent isamonetaryphenomenonthatdependsonpast, towhichmonetarypolicymakersfailedcitizens currentandexpectedfuturemonetarypolicy.As oftheUnitedStatesduringthe1970s,adecade apracticalmatter,themedium-tolong-term whenboththelevelofinflationanditsvariance likelyisaperiodoftwotofiveyears. approximatelytripled.Today,boththeleveland Thephenomenonofmoderninflation—a varianceofinflationhavereturnedtotheirvalues sustained,broad-basedincreaseintheeconomy’s ofthelate1950sandearly1960s. averagepricelevel—isonethatdependsonthe Thechallengeforpolicymakersistobecertain useofaninconvertible“fiat”money.Because thattherecentbehaviorofinflationpersists.To fiatmoneyisnotlegallylinkedtospecificquan- explainwhatweknowabouthowtodothat,I titiesofanymetalorothercommodity,itis nextdiscusstheperiodoftheGreatInflationof subjecttoindefiniteexpansion.Monetarypolicy- the1970sandwhatlessonsittaughtus. makersareacutelyawareofthelinkagesbetween excessivemoneycreationandinflation.Although todaycentralbanksdonotconductpolicyby THE GREAT INFLATION AND targetingmonetaryaggregates,theclassiclinkage REFORM OF OCTOBER 1979 betweenmoneyandinflationpersists.Figure1 showsthecorrelationduringthreedecades,fora UnderstandinginflationintheU.S.economy cross-sectionofapproximately70countriesas cannotomitdiscussionoftheGreatInflationthat availableontheInternationalFinancialStatistics endedwiththepolicyreformofOctober1979— database.Inflationismeasuredasthecountry’s thepremiereventinU.S.inflationhistory.During headlineinflationmeasure,andmoneyismeas- the1970s,consumerpriceinflation(measured uredasabroadmoneyaggregate(thesumofthe bythepricedeflatorforpersonalconsumption variableslabeled“money”and“quasimoney” expenditures)averaged61/2percent,approxi- 3 MONETARYPOLICYANDINFLATION Figure1.—AverageInflation andGrowth RateofMoney across Countries 1975 to 1985 100 90 80 70 60 50 y=0.48x + 5.49 40 30 20 10 0 -10 -10 10 30 50 70 90 110 130 150 Money Growth 4 rotalfeDecirPPDG 1985 to 1995 100 90 80 70 y=0.51x + 0.80 60 50 40 30 20 10 0 -10 -10 10 30 50 70 90 110 130 150 Money Growth rotalfeDecirPPDG 1995to 2005 100 90 80 70 60 y=0.47x - 3.88 50 40 30 20 10 0 -10 -10 10 30 50 70 90 110 130 150 rotalfeDecirPPDG Figure 1 Average Inflation and Growth Rate of Money Across Countries, 1975 to 1985 Money Growth SOURCE:InternationalMonetaryFund/Haver. UnderstandingInflation Figure 2 U.S. Personal Consumption Expenditures: Implicit Price Deflator Figure2.—U.S. Per1s0o-nYaela rCMonosvuinmgpAtvioenra EgexspoefnAdnitnuuraels:D IamtaplicitPrice Deflator (10-YearMovingAverasgeofAnnualData) Percentagechanges 10.0 8.0 6.0 4.0 2.0 0.0 -2.0 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Mean Standard Deviation S SOURCE:BureauofEconomicAnalysis/Haver. matelydoublethehistoricalaveragesince1930 hedoesn’tmentionit,theUniversityofMichigan’s andtripletheaverageofthepriortwodecades. surveyofinflationexpectationsbeganinJanuary Inflationwasn’tsteadyoverthedecadeeither— 1978.Atitsinception,themedianexpectedrate theyear-to-yearvariancewastriplethatofthe was5percent;twoyearslater,itwas10percent. previoustwodecadesandthereweretwoperiods Clearly,monetarypolicyhadbecomeunhinged ofdouble-digitinflation,morethan11percent frompricestabilityduringthisperiod.Butwhat during1974andmorethan10percentfrom wastheroleofrelativeprices? 1978-80,measuredbythePCEdeflator. Theenergyshockof1973-74wasthelargest The1970sillustratetheimportanceofawell- shockofitstype,uptothattime.Energyprices thought-outcommitmenttopricestabilityasa increasedapproximately25percentin1974, bulwarkagainstlargeshockstoindividualcom- boostingnear-terminflationtoapacemorethan modities—thatis,largerelativepricechanges— twicetheestimatedbaseline,ortrend,rate.Infla- feedingthroughintomoregeneralinflation.Ina tionslowedquicklyin1975,however,asenergy 1982paper,AlanBlindersoughttoquantifythis pricessteadied,withheadlineinflationatapproxi- process.First,hemeasuredthebaselineinflation matelya5percentpaceinthesecondquarterof rate,themedium-tolong-termtrendinflationdue 1975andaslowas3percentin1976’ssecond tomonetarypolicy.Intheearly1960s,itwasnear quarter.Thereafter,however,inflationrebounded 1to2percent,intheearly1970snear4to5per- toarelativelystablebaselinepaceofapproxi- cent,andin1980near9to10percent.Although mately51/2to61/2percent. 5 MONETARYPOLICYANDINFLATION Table 1 U.S. Inflation Rates by Decade PersonalConsumptionExpenditures:ExplicitPriceDeflator Annualaveragepercentchange AnnualQ4/Q4percentchange Dates Mean Standarddeviation Mean Standarddeviation 1930-1939 –2.21 5.65 1940-1949 6.05 4.03 1950-1959 2.19 1.78 2.31 1.59 1960-1969 2.15 1.23 2.26 1.41 1970-1979 6.44 2.19 6.64 2.55 1980-1989 5.07 2.64 4.82 2.46 1990-1999 2.41 1.06 2.37 1.16 2000-2006 2.32 0.52 2.25 0.59 SOURCE:BureauofEconomicAnalysis/Haver. Inflationrosesharplyonceagainduring andincreasedduring1981’sfirstquarterata28 1977-1980.Blinderestimatesthatthebaseline percentpace,beforestabilizingafterMarch1981. ratereached81/2percentin1979and10percent Theinflationofthe1970swasacombination in1980.TheMichigansurveyhit10percentin oflarge,rapidchangesinrelativepricesforfood November1979andremainedatthatleveluntil andenergyoverlaidontopofarisingunderlying May1980—whenthecombinationoftighter inflationtrend.Economistshavelongdebated monetarypolicyandthecreditcontrols,author- thedirectionofcausation:Didtheincreasingtrend izedbyPresidentCarteronMarch14,sharply ininflationcausetherelativepricechanges—for slowedsecond-quartereconomicactivity.Relative- example,asoilproducerssoughttooffsetfalling pricechangesaffectingfood,energyandmortgage realprices—ordidtheshockstorelativeprices interestratespushedheadlineCPIinflationfar tendtopushupwardthetrend?And,didFOMC abovethebaselinepace—atthattime,theCPI actionsworsenthesituationbyseekingtosustain includedmortgagerates.CPIinflationmoved thepaceofeconomicactivity?Blinderconcludes above101/2percentinJanuary1979,andexceeded thatthe“behaviorofmoneysupplytellsusalmost 12percentinnineoftheyear’s12months;the nothingabouttheburstsofdoubledigitinflation annualaverage,DecembertoDecember,was131/4 in1974and1979-80.”Perhapsthisclaimistrue. percent.But1980wasworse,astheCPIroseata But,whydidthemedium-andlong-termbaseline 14.6percentpaceduringtheyear’sfirsthalf.Not inflationrate,primarilyduetomonetarypolicy, untilMarch1981didtheinflationrateslipcon- continuetoincreaseduringthe1970s?Whydidn’t sistentlybelow10percent.Thebehaviorofenergy thepricesofothergoodsdecreasesignificantly prices,measuredastheenergypricecomponent asenergypricesincreased? oftheCPI,wasextraordinary.Energyprices Ihaveelsewhererecentlydiscussedsomeof increased37percentduring1979onafourth theseissues;so,letmebebrief.2Thereisnorea- quarter-to-fourthquarterbasis,increasedduring son,logically,whychangesinrelativeprices— 1980’sfirstquarterata41percentannualrate, evenlargechanges—shouldpassthrough 2 W.Poole,“Inflation,FinancialStability,andEconomicGrowth,”presentedatGlobalInterdependenceCenter(GIC)AbroadinChile Conference,UniversidadAdolfoIbáñez,Santiago,Chile,March5,2007. 6 UnderstandingInflation automaticallyintoheadlineinflation.Shouldn’t rate.Superimposedonthisframeworkwasthe therateofincreaseofsomeotherpricesslowor, conceptofalong-run“equilibrium”unemploy- perhaps,somepricesevenfallastherelative mentrate,whichwewillcall“U*.”Proponents pricechangesalternominaldemand?Ihavesug- acknowledgedthatU*couldneverbemeasured gested,ashavevariousresearchstudies,thatthe preciselyfromaggregatedatabecauseofshifting reasonsuchchangesdidnotoccurduringthe demographicsandforotherreasons.Morerecent GreatInflationwasthattheFOMClackedaclear, econometricstudiessuggestthatU*cannotbe forward-lookingframeworkformonetarypolicy- estimatedaccuratelyinalmostanycase—even makingcontainingacommitmenttopricestability. thebestestimateshavestandarderrorsof2per- Withoutit,theCommitteereactedtoeventsas centagepointsofunemploymentormore.3 theyhappened;thatis,itsbehaviorconsistedof Finally,someproponents—andmanycriticsof aseriesofindividualpolicyactionsthatdidnot thisview—notedthattheunderlyinginflation- adduptodefineacoherentpolicyregime.Critics unemploymenttradeoff,commonlyreferredto havearguedthatsuperiorpolicywouldhave asthePhillipscurve,tendedtoshiftforalarge occurrediftheCommitteehadoperatedaccord- numberofreasons,includingchangingexpecta- ingtoaregime,inwhichthepolicyinstrumentis tionsoffutureinflationandsupplyshocks. arulefortheconductofpolicy.Theessentialdif- Thisframeworkpredictedaveryhighcostto ferenceistheextenttowhichthemarketsand reduceinflation:atypicalestimatewasthateach thepublicunderstandthat(1)policyisforward 1percentagepointreductioninthebaselineinfla- looking,accordingtoaruleorstrategy,and(2) tionratewouldcostapproximately1percentof canthereforeinferthefuturecourseofpolicy. annualGDP.Manyanalystsconcludedthat,in Thepredominantschoolofthoughtduring presentvalueterms,thecostovertheinfinite the1960sand1970staughtthatinflationpos- futureofsteadyinflationatthebaselineratewas sessedaninherentmomentum.Generally,itwas lessthanthenear-termdisinflationcostmeasured arguedthatconsumersandbusinessesformed inforegoneoutput. theirinflationexpectationsinanadaptive,auto- Theflawsinthismodelarenowwell-known. regressivemanner—essentially,alongdistributed LastyearinmyNABElectureIoutlinedthecur- lagwithfixedcoefficients.Academiceffortstended rentstateofmacroeconomictheoryformonetary tofocusonwhetherthelengthofthedistributed policy.4Theemphasistodayisonforward- lagwasinvarianttotherateofinflation—some lookingbehavior.Theintroductionofmodel- evidencesuggestedashorterlagathigherinfla- consistent,or“rational,”expectationsinto tionratesorduringaperiodofmorevariable macroeconomicsduringthe1970semphasizeda inflation—andwhetherthecoefficientssummed simplebutessentialidea:consumersandbusi- tounityornot. nessesintheeconomyunderstandthedynamic Theseapproachesneverexaminedwhether economyinwhichtheylive.Thistheorydoes thefixed-coefficientmodelwascorrectinthe notdenythepersistenceininflation—theper- firstplace.Althoughthedistributedlaggavethe sistenceisreal,notanillusion.Butthecauseof inflationprocesspersistence,current-period thepersistenceisnotaninherentmomentum actualinflation,itwasargued,dependedonly uniquetothesocialpsychologyofinflation.If weaklyontheunemploymentrate—highunem- thecentralbankisperceivedasbeingprepared ploymenttemperedwageincreaseswhich,after toacquiesceinhigherinflationandunprepared subtractingproductivitygains,weretheprimary topursuepoliciesconsistentwithlowerinflation, determinantofchangesinthebaselineinflation thenbothinflationexpectationsandactualinfla- 3 Staigher,StockandWatson(1997) 4 W.Poole,“TheMonetaryPolicyModel,”BusinessEconomics,October2006,41,pp.7-10. 7 MONETARYPOLICYANDINFLATION tionwillrise.Andthereverseisalsotrue:Ifthe objective.NobellaureateRobertLucas(1981) centralbankisperceivedasunwillingtounder- creditstheintroductionofthisconcepttoMilton writehigherinflationandpreparedtopursue Friedmaninhis1948AMonetaryandFiscal policiesconsistentwithlowerinflation,then FrameworkforEconomicStability.6Inthesame expectationsandactualinflationwillfall. article,LucasnotesthatFriedman’smaximwas Thislineofthoughthasprofoundlyaltered losttopolicymakersduringthetwodecadesof ourunderstandingofinflationandmonetary prosperitythatfollowedthe1948Employment policymaking.Whenexpectationsareassumed Act,settingthestagefortheGreatInflation. tobeformedinasluggishautoregressivemanner, Actualpolicymaking,ofcourse,requires itisnaturaltoviewpolicymakingasaseriesof largedosesofexperienceandjudgment—former individualactions—determinedmeeting-by- ChairmanAlanGreenspanarguedthatmodel meetingandbasedheavilyontheincomingdata. uncertaintycounseledcautioninpolicymaking. Insuchaframework,italsoisnaturaltoview Modelsomitmanyreal-worldproblemssuchas theFOMCashavingasinglepolicyinstrument— incompleteandasymmetricinformation,the theovernightfederalfundsrate.Policyconducted highcostofinformationandthevaluetoboth inthisfashionleavesill-definedthedecision workersandfirmsofmulti-periodcontracts. structuregoverningfuturepolicy,andmakesit Nevertheless,theessentialinsightofrational difficult,andperhapsimpossible,tocommuni- expectationssurvives—asoundpolicyruleor cateclearlytothepublicthelonger-termobjec- regimeisessentialforagoodoutcome. tivesandstrategyofpolicy.Policymakersmay Someanalystshavearguedagainstrulesfor lackcredibility,andtheiractionsmaylack monetarypolicymaking,viewingthemasstrait- transparency. jacketsforpolicy.Ifpolicymakersadoptamodel, Therationalexpectationsliteraturemakes howdotheyrespondwhentheeconomychanges clearthatpolicyregimesarethecorrectwayto significantly?Modernmodelsclarifythatthe interpretpolicy.TomSargenthasdefineda benefitsof“rule-like”behavioraccrueevenif regimeas“afunctionorruleforrepeatedly thecentralbankfromtimetotimechangesits selectingsettingsforeconomicpolicyvariables policyregimeorrule.7Whatisrequiredisthatat asafunctionofthestateoftheeconomy.”5Others eachinstancewhenpolicymakersdecidetotake havelabeledthis“rule-likebehavior.”Apolicy anactionthatisnotconsistentwiththeirextant regime,insomecases,mightbeassimpleasa rule,thenewactionmustbeconsistentwithsome singleequation;anexampleistheTaylorRule, policyrulethat,inthemedium-tolong-term,will whichIandmanyothershavediscussedelse- achievethestatedpolicyobjective.Surelyitcan- where.Inthiscase,thepolicyrule,ratherthan notbethecasethatanoptimalpolicyresponseto federalfundsrate,istheinstrumentofmonetary anewsetofcircumstancescouldbedetermined policy—thefederalfundstargetisanendoge- byconsultingatableofrandomnumbers. nousvariablewithinthelargermodel.Thepre- Whenpolicydepartsfromusualpractice,it ciseformoftherule,solongasitisconsistent isincumbentthatpolicymakerscommunicate withpricestability,islessimportantthanpolicy- thechange—itsnatureandrationale—carefully makersdisplayingrule-likebehavior.The“rule” tothepublic.Monetarypolicyismorepowerful, certainlyneednotbeasimplelinearequation. andbetterabletoachieveitsgoals,iftheforward- Rather,theruleisamethodofdecision-making lookingbehaviorofconsumersandbusinessesis andacommitmenttoaspecific,articulated consistentwiththeforward-lookingbehavior 5 Sargent(1986).SeealsoSargent(1982)andSargent(1999). 6 Friedmanmadesimilarargumentsinhis1968presidentialaddresstotheAmericanEconomicAssociation.Poole(1986)analyzestheways thatpoliticalpressurespushpolicymakersawayfromrule-likebehaviorandtowardactingevent-by-eventtooffsettheproblemofthemoment. 7 Woodford(2003). 8 UnderstandingInflation suggestedbythepolicyruleorregime.Forseveral regimewillbecostly—theconcernsofthese years,Ihavereferredtothisas“synching”the Committeememberswerewell-founded.We marketsandmonetarypolicy.Thefundamental alsounderstand,however,thataclearpolicy mechanismformakingsynchingworkiscom- regimefocusedonpricestabilitycansharply municatingthepolicyregimeorrule—butrule- reduce,ifnoteliminate,thelikelihoodoffinding likebehaviormustbeadoptedbypolicymakers ourselvesinsuchasituation.8 inthefirstplacebeforeitcanbecommunicated tothepublic. Duringthelatter1970s,theFOMC’sminutes, CONCLUSIONS transcriptsandpublicstatementssuggestfrus- FortheUnitedStates,thelastfourdecades trationwithaneconomyinwhichinflation maybeviewedasone“longcycle”ininflation. increasedwitheasebutdecreasedreluctantly; Thatexperience,plusdevelopmentsineconomic theCommittee’sresponsewasthemonetarypolicy theory,havepermanentlyalteredourunderstand- reformofOctober1979.Twoyearsago,weheld ingofinflation.Thecyclebeganasinflation aspecialconferenceattheSt.LouisFed,onthe increasedduringthemid-1960swiththeFOMC’s occasionofthe25thanniversaryofreform,to accommodationofVietnam-eradeficitspending, reflectonthatmonetarypolicychange.Thepapers andreachedfullstrideduringthe1970sasmon- fromtheconferenceareavailableinaspecialissue etarypolicyhesitatedtoslowinflationduring ofourReview.Intheconferenceopeningremarks, episodesofmajorchangesinrelativeprices.The ChairmanAlanGreenspannotedthatby1979the cyclepeakedandchangeddirectionwiththe inflationsituationhaddeterioratedtosuchan October1979regimeshiftinmonetarypolicy, extentthat“iftheFedhadnotoptedtoinitiatea sharpinterestrateincreaseinthiscountry,the broughtaboutbyChairmanPaulVolcker’skeen marketwouldhavedoneitforus.”Heemphasizes understandingofwhatwasatstakeandskillin thatthe1970sinflationexperiencereinforcesthe changingpolicydirection.Thedisinflationof roleofpricestabilityasaprerequisiteforthe thelast25yearshasrestored,today,boththe efficientallocationofresourcesintheeconomy lowlevelandlowvolatilityofinflationthatwe andforfulfillingtheFed’sgoalofpromoting enjoyedpriortotheGreatInflation.Thedisinfla- maximumsustainableeconomicgrowth. tionhasbroughttousaneraofpricestabilityin AllanMeltzer,inhispaperfortheconference, whichrecentenergypriceshockshavehadbut consideredawidevarietyofexplanations,includ- modestnear-termeffectsoninflation.Pricesta- ingpoliticalbusinesscycles,dynamicinconsis- bilityhascontributedtoaresurgenceofproduc- tencyinpolicymaking,andtheuseofincorrect tivitygrowthbycreatinganenvironmentinwhich economictheoriesanddata.Heconcludesthat innovationsininformationandcommunication thepolicyfailurewassolargethatnosinglethe- technologymaybeconfidentlydeployedthrough orycanaccountforit—multiple,mutuallyrein- increasedcapitalinvestment.Thedurationand forcingfailuresarerequired.Amongthesewas amplitudeofbusinesscycleslowdownsalsohas thefailureofFOMCmemberstodistinguish diminished,achangethatChairmanBernanke betweenthecorrosiveeffectsofmorerapidinfla- haslabeledthe“GreatModeration.” tionasacauseofslowereconomicactivity, Whatlonger-termlessonshasthedecade becauseinflationincreaseduncertainty,and broughttoourunderstandingofhowmonetary theirfearthatseekingtoreduceinflationwould, policyaffectsinflation?Themostimportantles- itself,furthersloweconomicactivity.Today,we sonisthatpolicymakersmustregardconsumers appreciatethatslowinginflationintheabsence andbusinessesasunderstandingthedynamic ofaclearlydefinedandwell-articulatedpolicy natureoftheeconomy—andtheimpactsofpolicy 8 AnumberofpapershavestudiedtheOctober1979policyshiftasapolicyregimechange.Forarecentexample,seeCecchetti,etal.(2007). 9 MONETARYPOLICYANDINFLATION ontheeconomy—aswellastheydo.Thislesson Meltzer,AllanH.“OriginsoftheGreatInflation.” tellsustofocusonmonetarypolicyregimesand FederalReserveBankofSt.LouisReview,March/ policyrulesastheinstrumentofpolicy,notthe April2005. near-termchoiceofthefederalfundsratetarget. Bydoingso,theCommittee’sactionsaffectthe Poole,William.“MonetaryControlandthePolitical expectedfuturepathofinterestratesandanchor BusinessCycle.”CatoJournal,Winter,pp.685-99. Reprinted as Chapter 2 in James A. Dorn and inflationexpectations.IftheCommitteecommu- Anna J.Schwartz,eds.,TheSearchforStable nicatesitsobjectivesandstrategyinatranspar- Money.UniversityofChicagoPress,1987. entandcrediblefashion,thebondmarketand otherforward-lookingfinancialmarketswill Poole,William.“InflationTargeting.”FederalReserve amplifytheCommittee’snear-termdecisions BankofSt.LouisReview,May/June2006,pp.155-63. andtherebydoagooddealofitsworkforit. Asalwaysinanimportantlineofresearch, Poole,William.“TheMonetaryPolicyModel.” understandingremainsincomplete.Inparticular, BusinessEconomics,October2006,41,pp.7-10. weneedtofocuseffortonimprovingthepolicy rule—theregularityofpolicyactionsthatstabi- Poole,William.“Inflation,FinancialStability,and lizetheeconomyandmakeplanninginthemar- EconomicGrowth.”PresentedattheGlobal ketspossible.Butweshouldnotsellshortthe InterdependenceCenter(GIC)AbroadinChile enormousadvancesalreadyinplace. Conference,UniversidadAdolfoIbáñez,Santiago, ThankyouandI’dbedelightedtotakeyour Chile,March5,2007. questions. ReflectionsonMonetaryPolicy25YearsAfter October1979.Proceedingsofaspecialconference REFERENCES oftheFederalReserveBankofSt.Louis.Federal ReserveBankofSt.LouisReview,March/April Blinder,AlanS.“TheAnatomyofDouble-Digit 2005. 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Cite this document

APA

William Poole (2007, April 1). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20070402_poole

BibTeX

@misc{wtfs_speech_20070402_poole,
  author = {William Poole},
  title = {Speech},
  year = {2007},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20070402_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}