Full text of Statements and Speeches of W. Lee Hoskins : Economic Priorities in 1989 and Beyond : Economic Outlook Conference, Greater Cincinnati Chamber of Commerce, Cincinnati, Ohio

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- -FRB

:

CI,EVE],AND

HOSKINS

.

I!7

.

ADDRES SES

.

.

Economic

Priorities

i

n ì 989 and

Beyond

N. Lee Hosklns, presldent
Federal Reserve Bank of Cìeveìand

Economl c 0uilook Conference
Greater Cincinnati Chamber of Commerce

Cincinnati, Ohio
December

7,

I gBg

In thlnklng about next year's
lssues: the economlc outlook for

economy,

I

would

llke to focus on two

1989 and long-term obJecilves

for

monetary

pol I cy

As the events

of the past year cìearly

demonstrate,

surprlses' Not much more than a year

of

llfe ls full

of

ago'tve were sorilng..through the debris
the stock market decllne, and attemptl'ng to gauge
the lmpact of the
shock

on I nvestors,

bus I nessmen

and consumers. General

ly, I t

seemed t^aaron.or

a ,o

at least a coollng ln the economlc expanslon, and perhaps
even more.
l^lell, ln retrospect, lt dldn,t qulte work that way,
and we would

expect

be well

advlsed

to bear that rn mrnd as

thtnk about ì9g9. crearry, a year ago,
underesilmated the underryrng strength and vrgor
of the expansron. Led by

capltal lnvestment

''e

and export demands, and supported by

consumptlon, the economy shook

we

solld lncreases ln

off

the chllllng effects of the stock market
decllne and moved ahead more rapldly than all but
a few would have guessed.
Today' as one evaluates the economy

ln the closlng weeks of ìggg, lt ls a
pretty posltlve plcture. There are few of the lmbalances
whlch normally
precede a slowdown or recesslon. Inventorles,
for example, do not appear to
be hlgh. capacrty strarns and favorabre profrt
margrns ,,ourd
suggest

contlnued strength

to contlnue to

ln

buslness lnvestment. Strong growth abroad seems
I lkely
support export demands.

The conventlonal

or

consensus vlew

of the comlng year, after

incorpora¡ng

factors, proJects conilnued economrc expansron, though
at a more
moderate pace than the past year, and in
an envlronment of sillì moderate
these

-2-

lnflatlon' Those forecasters who see trouble on the horlzon are bet¡ng that
economlc pollcy wlll have to forcefully deal wlth
capaclty stralns and rlslng
prlces, wlth the resurt berng recessron. l,reìr, as you
wourd rmagrne, I do not
plan to address that lssue today

I

would slmply note

that

of the consensus vlew of next year
appear pretty soundly based to me. The economy ls
closlng. thls year on a very
strong note' Those who expected a pause br a slowdown
ln the rapld pace
many elements

of

the expanslon ln the second half

of the year, have lnstead seen conilnued
strength ln new orders, and rapld growth ln employment
and lncome. our
economy has moved

closer to

fuìl

capaclty, aìthough we should recognlze that
we really don,t know preclsely where that ls.
Forelgn economles, both

tn l'{estern

Europe and

Asla, have acceìerated ln

the past year, agaln contrary to the forecasts of a year
ago, and there ls
I lttle yet to suggest wrdespread or srgnrfrcant
srowrng.

Inflatlon last year, whlle not as bad as the pesslmlsts feared, 11as
a good
deaì worse than the optlmlsts hoped. Regardless of whlch
lndex one uses, the
rate of rnfrailon

moved upward

percentage polnts

lnto the 5 percent area. Not surprlslngly,

thrs past year, by one to one and a half

have responded and are arso rrsrng arong the same percent
5

the

wages and costs

track.

So, for

flrst

tlme slnce lggl the thrust of prlces and wages ls upward.
one key overrldlng lssue for .l989 ls whether a slowlng
economy wlll hold
lnflatlon ln the 5 percent area, or whether another step-up is already
baked

lnto the cake, so to speak, and how economlc poìlcymakers wiì.¡ react if
lnflatlon does lndeed accelerate agaln.

-3-

Thls leads

to the second lssue whlch I beìleve we need to bear in
mind' Slmply put, how do the posslble outcomes In the year ahead relate to
monetary pol lcy and to the effort to achleve longer-term obJec¡ves?
l,lhat are
these obJecttves or what should they be? Unfortunately, nelther
econom,lsts
me

nor pollcymakers agree

fully

on obJectlves.

In recent years,

however, we have

I wlll argue today that there should be one
overrldlng obJectlve for monetary pollcy -- the provlslon of a stable.prlce
envlronment. I wlll also offer some suggestlons about how I thlnk
thls
come

closer to agreement.

obJectlve can be achleved.

Our monetary system

ls a complex network of rules,

lnstltutlons. Ideally, lt

procedures and

efflclent allocailon of resources by
reduclng transactlon and lnformatlon costs. Any monetary system
should
promote an envlronment ln whlch money provldes a
unlt of account, an efflclent
medlum of exchange, and a stable store of value. How well
the monetary.system
promotes the

operates depends on the natlon's central bank. Speclflcally,
what obJectlves the Federal Reserve seeks

achlevlng them. The Federal Reserve Act
Balanced Growth Act

of

to achleve and lts

lt

depends on

success ln

of ì913, the Full Employment and

1946, and subsequent amendments

to those Acts --

have

glven the Federal Reserve responslblllty for multlple obJecilves, tncludlng
stabtllty ln the purchaslng power of the dollar, stablllty and growth of the
economy, and

In

my

the prlce

hlgh leveìs of

employment.

vlell, the baslc obJectlve of

level.

nrcnetary

poìlcy should be to stabilize

varlables such as employment, output, and jncomes, for
example, cannot be controlled dlrectly. The supply of goods and servlces

-4-

avallable to consumers depends on the quantlty of producilve resources and
they are used. Monetary pollcy can do llttle to dlrectìy affect the total
quantlty

how

of land, labor, and physlcal capltal that is avallable, or the

efflclency wlth whlch these resources are used. The Federal Reserve can,
however, control the prlce level and, by provldlng a stable prlce
envlronment,
can encourage lnvestment and

real

economlc'

growth.

Througþ

prlce stablllty,

the Federal Reserve can provlde an envlronment ln whlch other
obJectlves stand a better chance of belng met.

economlc

Nelther the Federal Reserve, nor other pollcymakers, have adopted thls
vlew compìetely, but they have moved closer to tt. Alan Greenspan, for

ln hts most recent Humphrey-Hawklns Tesilnrcny stated, ,,BJ prlce
stablllty I mean a sltuatlon ln whtch households and buslnesses ln maklng
example,

thelr

savlngs and lnvestment declslons, can safely lgnore the

sustai ned general I zed prl ce I ncreases

of aìl prlces lfould exhlblt

posslb¡lty of

or decreases. Essenil al ly, the

no trend over

tlme.

The strategy

for

average

monetary

pollcy needs to be centered on maklng further progress toward and ul¡mately
reachlng stable prlces. Prlce stablllty ls a prerequlslte for achlevlng
the
maxlmum economlc expanslon

ful

I

conslstent wlth a sustalnable external balance at

employment.,'

Nelther the statement nor the context ln whlch lt was made suggest that
the Federal Reserve ls not concerned about other obJecilves. Nevertheless,

the statement ls a clear dellneatlon of what I belleve

is

the approprtate

for dlscusslng monetary poltcy lssues for 1989 and beyond. I would
go even further. To pronote general economlc welfare, the Federaì
Reserve
framework

should stablìlze the prlce leveì, even lf
aslde.

lt

means

putilng other obJec¡ves

-5-

rore of money, and therefore, the rore of monetary poHcy,
rs to
provlde transaction and lnformatlon servlces.
If the Federal Reserve
stablllzes the prlce level, then transactlon and lnformailon
costs
The

economy

wlll be reduced,

ln

and we

declslon-maklng and resource

wlll

have an optlmum cllmate

allocatlon. If the Federal

the

for

Reserve

falls

to

inflation-free environment, lt wlll obscure relailve prlce,slgnals,
ralse transactlon costs and add to uncertalnty. Increased
uncertalnty about
future lnflatlon and about monetary pollcy obJecilves dlmlnlshes
efflclency of
resource use and adds to the rnstabilrty of the
economy.
If monetary pollcy cannot control real economlc varlables dlrecily,
achleve an

why do

people belleve

lt

can lnfluence the variables lndlrecily through stablllzlng
the prlce lever? Accordrng to economrc theory, people
attarn the
hrghest

posslble level of welfare ln a competltlve
economy wlth no transacilon costs
and perfect lnformatlon. In thls world, prlces
act as lmportant slgnals,

lndlcatlng the quantlty of partlcular
Transactlon

goods and servlces

to be produced.

costs. In the real world, money and monetary pollcy

do have

a

role {o play because there are transactlon costs and people
do not have
perfect lnformatlon. Let us flrst conslder the lnefflclencles
that

arl se from

transactlon

costs.

Labor contracts glve employers conslderable dlscreilon

over employment at a flxed-dollar wage
the fact that the contracted wage rate

for lnflatlon.

rate.

Transacilon costs are evldent

ls not fully

However, people take expected

by

and continuousìy adjusted

lnflatton into account when
enterlng into these contracts. Once wages are flxed, firms
then choose output
and employment levels to maxlmlze proflts. If lnflailon
ls hlgher than

-6-

orlglnally

fall'
profl

expected when the contracts were slgned, the

Flrms

t

wlll

increase output and employment

reaì

wage

rate wlll

to take advantage of

hlgher

margl ns.

resultlng expanslon of actlvlty ls unsustalnabìe and therefore
lnapproprlate because lt arlses from declslons that have
been dlstorted
The

.

lnflatlon, rather than represenilng

an approprlate responsp

to

by

economlc

fundamentals. Once thls mlsaìlocatlon of resources ls reallzed,
a cos¡y
readJustment of resources must be undertaken. Eventuaìly,
labor suppìles,
vrages and employment wl l

Monetary

level,

pollcy should

l

to the underlyl ng fundamental condl ¡ons.
be deslgned to prevent unexpected changes ln the prlce
adJust

and thereby keep the problems assoclated wlth

flxed

wage and prlce

contracts to a mlnlmum. In short, lnflatlon reduces economlc performance,
holdlng output, employment, and lncomes below thelr longer-term

sustalnable

levels.
Informatlon

costs.

Another lmportant

role for

money and monetary

pollcy

ls to provlde lnformatlon.

For example, people face uncertalnty when chooslng
consume, because they do not know the real tnterest
rate.

to save or
Ïhe rdal lnterest rate, whlch represents the return to savlngs
ln

whether

terms of

future consumptlon,

ls slmply the nomlnal lnterest rate mlnus the expected
rate of lnflatlon. If people couìd predlct lnflatlon accurately,
the problem
would dlsappear. But because people are uncertaln about

future lnfìailon

the real lnterest rate, they are unable to plan opilmally for current
future consumptlon. The monetary authorltles can reduce the probìem

and

and

by making

the prl ce ì evel predl ctabl

e.

-7-

Buslnesses also face

thls sort of uncertalnty.

Investment declslons

the cost of capltal and on the expected return. Expected returns
depend lmportantly on how accurately current lnterest
rates reflect future
lnflatlon' Not havlng thls lnformatlon ls cosily. l,le know lt ls because we
see flrms paylng for lnsurance by partlclpailng ln flnanclal
futures
depend on

and

optlons markets.

last

Many

of the deveropments rn the frnancrql

20 years represent attempts by the

uncertalnty about

lnflatlon.

prlvate

economy

markets rn the

to protect ltself

from

lf

the prlce ìevel cannot be predlcted wlth
certalnty, the costs assoclated wlth lnflailon uncertalnty can be
reduced lf
the Federal Reserve focuses more sharply on a stable prlce leveì.
Even

ïhese

examples

lllustrate

why

I

conclude

that the only obJecilve of

monetary pollcy

should be a stable prlce level.
l^lhl

le the ultlmate goal of the Federal

domestlc economrc growth and
achleve these goars

fuil

Reserve

emproyment,

I

ls to rnalntaln

stable

beileve the onry way to

rs to stabilrze the prrce rever.

By prrce

stab¡rty., I

a condltlon ln whlch people expect and therefore act as though prlces
wlll be stable. People can adapt best to zero lnflailon. I don,t mean that
all thè dlfferent components of prlce lndexes wlll be unchanglng.
prlce
mean

Each

lndex has

lts

own

pecullar characterlstlcs. Non-monetary factors

measurement problems

and

wlll always affect prlce lndexes, but the short-term

varlatlon ln the lndexes should be Just that--short-term varlailons

around

zero trend.

Thl

s brlngs

prl ce stabt

! I ty.

me

to

my

qaln polnt, the need for a strategy for achievlng

Havlng chosen

a stable prlce leveì as the approprlate

a

-8-

obJectlve

for

monetary

pollcy, what ls a senslble strategy for achlevlng it?

Indeed we have made much progress

ln recent years.

There are some lessons in

that progress for us to conslder.
The

flrst,

and most lmportant, element

of a successful strategy ls.to
enìlst the support of market expectatlons, by announclng clear, expìlclt goaìs
and actlng In a credlble manner to achleve them. l^lhen Inflailon
was at
double-dlgit rates at the end of the r970s, people dld not belleve
that
lnflatlon would stop rlslng, because the often-promlsed end to lnfla¡on
was
not deìlvered. In that envlronment, statlng general pollcy goals
slmply was
not credlble. The Federal Reserve galned credlblllty ln the l9g0s
by reduclng
lnflatlon and prevenilng rt from rrsrng above a 3 to 5 percent zone.

I thlnk we can lmprove the performance of our economy by announclng a goal
of zero lnflatlon to be achleved over some reasonably short ilme perlod 3
-to 5 years. If, as I belleve, 5 percent ls the rate of lnfla¡on today, then

I

suggest the acceptable upper

zero lnflatlon

ls the goal,

such a

a stable prlce level by 1993.

ls thd f lrst part of

an

ltmlt

should be 4 percent a year from

path,

lf

now.

steadfastly pursued, rrould

If

produce

I thlnk an expllclt goal wlth a ctear ilmetable

effecilve strategy.

part of an effectlve strategy ls demonstrailng a determlnailon
to achleve lt. l'lhlle lt may seem that there ls never a good ¡me to begln,
prlce stablllty must be the focal polnt of our pollcy dlscusslon.
If price
The second

stablllty ls the overrldlng goal, other obJectives must not lnterfere with
efforts to achleve lt. I believe that prompt and full expìanations of pollcy
and of pollcy changes, perhaps lmmedlately folìowing the actual
decision,
would help reduce uncertalnty and allow markets

to operate more efflclen¡y.

-9-

Market expectatlons would

expllcit

statements

of

better

be

pol I cy

market expectatlons would, ln

based and presumably more

accurate

wl

th

lntentlons and changes thereln. More efflclent

turn,

serve

to dl scl pl I ne pol I cy decl slons.

of a rellable short-term llnkage between the monetary aggregates
and the prlce level adds to the dlfflculty of knowlng what. ls the approprlate
rnonetary pollcy to achleve a zero lnflatlon goal. Externally, markets. must
be
abìe to Judge whether the Federal Reserve's actlons are conslstent wlth the
The lack

deslred outcome. Because pollcy works wlth a long and varlable lag,
becomes more

dll.flcult

than ever to know whether the Federal Reserve

lt
ls

uslng

a good reclpe or a bad one.
The fr:amework we use

for

maklng declslons must allow

for uncertalnty

and

mlnlmlze the costs assoclated wlth mtstakes. In achlevlng prlce stablllty,
some rlsks are more acceptable than others, because some mlstakes
are elther

ìess costly or more easlly reversed. Inflailon, once embedded ln
expectatlons, contracts and resource aìlocatlon declslons, ls very cos¡y to
deal wlth. Thls fact argues strongly for a declslon framework whlch illts

short-run lmplementatlon declslons

away from

the rlsks

of lnflailon

acceleratlon.

. In the last few years
the lntentlon to reduce tnflatlon has been manlfested ln the graduaì reduc¡on
ln the upper llmlt of the M2 target growth ranges. The M2 aggregate is

of

that are

for transactions and ìess
llquld savlngs and smalì tlme deposlts. The usefulness of M2 stems from the
relatlve stablllty over long perlods of tlme of lts relailonshlp to total
composed

those assets

used primariìy

-l 0-

spendlng. In prlnclple, an aggregate wlth a stable turnover rate, such as M2,
can be used as a convenlent lndlcator that pollcy ls conslstent wlth
des.tred

ln the prlce level.
The upper llmlt on H2 growth can be thought of

long-run trends

as an upper

ltmlt on total

growth. Contlnued growth ln M2, ln excess of our long-term 3 percent
or so growth ln productlvlty, wlll resuìt tn 'lnflailon. Conilnued reducilon
spendlng

ln

M2 growth

wlll eventually mean reduced lnflation. In the last four years,

the Federal Reserve has gradually reduced the upper llmtt of the M2 growth
range from 9 percent to the 7 percent proposed last July for next year __
a
rate whlch by our calculatlons, lf malntalned for a long perlod of ¡me, would

be conslstent wlth the present 64

target range for

1989

at lts

prrrrnt lnflation.

The F0MC

wlìl revlew the

December meeilng.

Unfortunately, M2 ls not a useful
short-term gulde to pollcy actlons because the connecilon between

M2 and

tnflatlon ls qulte loose. Desplte the reductlon ln the M2 target range,and ln
M2 growth, lnflailon rs silghily hrgher than four years
ago. Infrailon
expectatlons, as measured by the Unlverslty of Mlchlgan's Survey of Consumers,
have begun to lncrease agaln. other surveys and economlsts forecasts,
as well
as the tnflatton forecasts embedded
slmTlar rebound

of

ln asset prlces,

have begun

to

show a

expectailons.

ls speclal because lt ls used ln transactlons, reduclng marke¡ng
and lnformatlon costs, and because as the unit of account lt is the
basis for
contractual obllgatlons. 0nly about one-third of M2 ls composed of those
Money

assets that provlde a medlum

of

exchange such as currency and deposlts in

checkable accounts. The balance

of

M2

conslsts

of

household savlngs whlch are

-t t -

extremely sensltlve

to lnterest-rate spreads. l^lhen market lnterest rates
fall, banks may be slow to reduce lnterest rates on deposlts
and M2 tends to
grow very rapl dly, as I n 1985 and 1986.
l'lhen market rates rl se, banks may
be
slow to ralse deposlt rates and M2 tends to grow
slowìy, as lt dld ln lggT and
as tt has ln 1988' The sensltlvlty of .r42 to changes
ln lnterest rate spreads

greatly dlmlnlshes

It

lts

usefulness as a shoit-term gulde to pollcy.
Furthermore, the Federal Reserve does not have
dlrect control

does over the monetary

base.

over, M2 as

The base contalns currency and member-bank

reserves whlch are Federal Reserve balance sheet

llabllliles. In prlnclple,

the base and the federal funds rate could be used
as conilnuous monltorlng
devl ces to r ndr cate whether daily, weekry
and monthry po¡ cy ac¡ons
are

conslstent wlth announced long-term goals. But
the rela¡onshlp between the
monetary base and the varlous measures of
the money supply, on the
one hand,

and the reported

of

prlce lndexes, on the other, ls not close over
short perlods

tlme.

In general, both the economy and the flnanclal markets
are buffeted by all
sorts of dtsturbances. The problem ls knowlng whlch
of these
should

accommodated, and whlch should be

be

reslsted to keep tnfla¡on ln check.

the source of the dlsturbances ls seldon clear, at least
at the ilme,
the Federal Reserve under the current operatlng procedures
usually fully
Because

accommodates shocks,

at least lnltlally.

base from one meetlng

FOMC

could target paths

the

ln reserve restralnt. Interest rates would

partlally, but automatlcaìly to resist inciplent lnfla¡onary

pressures.

for

to the next and react to deviations from the target with

automatlc, but I lmlted, changes
respond

The

-12-

Uslng the base as a short-run operatlng vehlcle would

as much Judgment
shocks
base

at

FOMC

meetlngs as

to the economy, the

FOMC

silll

requlre just

at present. Glven ilme to evaluate

would adJust the base

target.

gecause the

ls controìlable, lt

to explaln
declslons

how

flt

lt

would provlde the Federal Reserve wlth a better way
was exerclslng judgment and how the short-term
opera¡ng

wrthln the strategy of movlnþ toward prlce
Elabl I lty.
l,lhl I e I

merlt to uslng the monetary base as the operailng target, let
me make lt
clear that the obJectlve ls to stablllze the prlce level and thereby
see

ellmlnate

expectatlons

of

ìong-run

lnfìatlon.

0n an annual basls

I

would prefer to

target a controllable lnstrument, such as the monetary base. But
there have
been lmportant shrfts rn money demand over the past
decade, and I see no

to lgnore the posslblllty of future shlfts. consequen¡y, lt seems
probable that a preset target for any aggregate would
have to be adJusted to
reason

achl eve and mal ntal

Slnce our goal

n a stabl e prl ce I evel

.

ls to control the prlce level, lt

seems reasonable

to

use

of the prlce level as the lntermedlate target or as the frame of
refere'nce for adJustlng the operatlng targets. The forecast
of the prlce
the forecast

level over a one-to-three year horlzon would be more sensl¡ve
to poltcy
actlons than would the prlce leveì ttself.
l^lhen we

observe

rlslng prlce expectatlons,

forecast of the prlce level
current pollcy stance
I I ne wl

-- that ls,

and ralse our own condlilonal

the forecast condliloned on the

-- pollcy would be changed to brlng our forecasts in

th the des I red outcome

.

-ì 3-

Concluslon

I

belleve the Federal Reserve has the responslblllty

envlronment

of stable prlces.

by formally announclng a goal

The Federal Reserve can achleve

lnvestment pìans, and establ lshed

I

stable prlces

to achleve lt. Undoubtedly, there wlll

be short-term costs because many people

But

an

of zero lnflailon to be attalned over a

reasonable perlod and a speclflc plan

lnflatlon.

for provldlng

wlll have wrltten.contracts, developed

lnstltutlons ln anilclpailon of

conllnued

belleve that the adJustment costs can be mlnlmlzed

by

reductng lnflatlon gradually. Dlslnflatlon,

typlcally, ls assoclated wlth
temporarlly hlgher real lnterest rates. If we try to reduce
lnfla¡on too
fast, current flnanclal problems ln the Southwest and ln the developlng
countrles may be aggravated unnecessarlly.
0n the other hand,

If

credlblllty

problems may

people cannot perceive a reductlon

result from golng too

ln lnflailon, or lf

slow.

they percelve

a

central bank that ls elther unwllllng to commlt to the obJec¡ve
or unwllllng
to begtn the Journey, they are unl lkely to bel leve we wl l l el lmlnate lnf lailon.

I propose that we reduce lnflatlon by ì percent per year from lts current
rate' A year ago, I proposed that tre go from 4 percent lnflailon to zero ln
about 4

years.

Today, the

reasonable pollcy

wlll

now

lnflailon rate

has rlsen

to 5 percent and a

take a year longer and may entall hlgher costs.