Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Sustaining Price Stability

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Sustaining Price Stability

Article excerpt

The year 2003 was a watershed in Federal Reserve history. In his semi-annual testimony to Congress on monetary policy in July, Chairman Greenspan declared that measures of core consumer inflation had decelerated in the first half of the year to a range that could be considered "effective price stability."1 The Chairman paused briefly to acknowledge, with understated satisfaction, the achievement of this goal, which Congress had assigned to the Federal Reserve and the Fed had pursued for over two decades. He quickly pointed out, however, that the Fed would be confronted now with new challenges in sustaining price stability-specifically preventing deflation as well as inflation. Earlier in the year, at the conclusion of its May meeting, the Federal Open Market Committee (FOMC) had expressed concern for the first time that inflation might decline too far, saying that "the probability of an unwelcome substantial fall in inflation, though minor, exceed(ed) that of a pickup in inflation from its already low level."2

The case for maintaining price stability-in the United States and elsewhere-is rooted in experience and theory, which indicate that monetary policy best supports employment, economic growth, and financial stability by making price stability a priority. The full rationale for price stability has been elaborated elsewhere, and we will refrain from repeating it here.3 This article, instead, is about how to sustain price stability now that it has been achieved. We build our argument in several stages. First, we present a framework for understanding the inflation and deflation processes. Our framework, borrowed from the "new neoclassical synthesis" macroeconomic model, focuses on the management of the markup of price over marginal cost by monopolistically competitive firms.4 Next, we provide examples of shocks that are potentially inflationary or deflationary and explain how interest rate policy actions can counteract them effectively to maintain price stability.

The Fed's current hard-won credibility for low inflation is a foundation of efficient monetary policy because it anchors expected inflation. We review briefly why inflation scares create problems for monetary policy. Addressing the challenge noted by Chairman Greenspan, we explain why deflation scares are equally problematic. Unfortunately, credibility for containing inflation does not necessarily imply credibility against deflation because while there is no upper bound on nominal interest rates to resist inflation, there is a lower bound at zero. We explain how the Fed can use monetary policy-even at the zero bound-to preempt deflation and acquire credibility against deflation to complement its anti-inflation credentials.

Communication has come to play an increasingly important and substantive role in the Fed's conduct of monetary policy because open and effective communication is a crucial ingredient in building and maintaining credibility for price stability. Good communication requires clear long-run policy objectives and clarity in conveying the reasoning behind short-run policy actions aimed at achieving those objectives. In line with our macroeconomic framework, we believe that both purposes would be well served if the Fed publicly announced an explicit long-run inflation target and made more prominent use of price-cost gap, employment gap, and output gap indicators in explaining the stance of monetary policy. In particular, we explain how, in our view, these changes would help minimize the kind of communication problems the Fed faced in 2003 in signaling its concern about deflation and its policy intentions for dealing with the rising risk of deflation at that time.

Having outlined what we want to accomplish in this article, let us emphasize that what follows is our understanding of the issues and our suggestions for dealing with them. Some of our views are shared by our Fed colleagues, others are not. This is no cause for embarrassment. …

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