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October 15,1989

know the Federal Reserve's goal. They

return to some "normal" growth trend,

would expect to see a policy stance
directed toward returning the price
level to its target path.

but at a higher level of output than will
be possible if we continue to operate
under the current system.

port the current inflation rate, but
would also lay the foundation for accelerating inflation. The result would
be an economy operating even further

A complete zero inflation policy would

Inflation adds risk to decisions and

require a transition period in which

retards long-term investments. It
changes the nature of the economic environment so that random inflation out-

eCONOMIC
COMMeNTORY

Yet, such a policy would not only sup-

below its long-run potential, with growing vulnerability to frequent and severe
recessions. A monetary policy that
leads to zero inflation, even if it risks a

zero inflation is approached gradually.
This transition should be stated as a
path for the price level. Adopting a
zero inflation policy today would mean
that the price level would continue to
rise for the next three to five years, for
example, but at a lower rate each year.
Eventually, the target would become a
constant price level.
• A Zero Inflation Policy Is a
Pro-Growth Policy
We know that both the U.S. and
Canadian economies are currently
operating at levels well below those that
could be achieved if we eliminate inflation. Zero inflation would make our
monetary system more efficient, contribute to better decisions, and result in
more efficient use of our resources.
During the transition to a higher level of
performance, the economy would grow
faster. Eventually, we would expect it to

comes overwhelm otherwise prudent
managers. Inflation causes people to
start up businesses and use costly accounting methods for the sole purpose
of hedging against it. In the absence of

Breaking the
Inflation-Recession Cycle

recession, is our best opportunity for
long-term growth.

inflation, the resources working in
these areas could be devoted to producing more goods and services. Inflation
interacts with the tax structure to stifle
incentives and limit investment, and it
undermines public trust in government.
Why do we allow inflation to clog the
wheels of our economy?

Federal Reserve Bank of Cleveland

ity. This is unfortunate. The perceived
trade-off between inflation and reces-

Fears of recession create an apparently
insurmountable barrier to price stabil-

by W. Lee Hoskins

sion is an illusion. In the end, inflation
itself is the cause of most recessions,
and continued inflation will reduce economic growth. To achieve maximum
sustainable growth in the economy in
the I990s, central banks should com-

Over
the years, many people have
come to believe that nations can prolong an economic expansion, or avoid
the pain of a recession, with more inflation. Given this choice, some observers
may view inflation as a reasonable gamble and, perhaps, as the lesser of two
evils. These are false choices, however.

-

mit today to achieving zero inflation.

• Conclusion
Monetary policy is being tested today.
Although we have enjoyed high levels
of economic growth, recent slowing in
economic activity in Canada and the
United States has prompted calls for
easier monetary policy-lower
interest
rates and more rapid monetary growth.

W. Lee Hoskins is president of the Federal

A look at recent history reminds us
vividly of the economic pain resulting
from inflation. Every recession in the

Reserve Bank of Cleveland. The material in
this Economic Commentary is based on a
speech presented to The Fraser Institute,
Toronto, Canada, on September 19. 1989.

recent history of North America has
been preceded by an outburst of cost
and price pressures. Let us not forget
the miserable economic situation at the
tum of this decade, when unemployment and inflation were at double-digit
levels and production was declining. If
we learned anything from those dismal

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

times, surely it was that the harm
caused by inflation takes years to undo,
and usually comes at the cost of permanent losses in income and economic

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

well-being.
Today, in both Canada and the United
States, people seem to be more aware
than ever that the proper role of the

Address Correction Requested:

central bank is to prevent these losses
by stabilizing the price level. Both Gov-

Please send corrected mailing label to
the above address.

ernor Crow and Deputy Governor
Freedman of the Bank of Canada have
publicly committed to monetary policies designed to stabilize the price
level. In the United States, Federal
Reserve Chairman Greenspan has
repeatedly stated that the way to attain
maximum long-run growth and the

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
ISSN 0428-1276

highest standard of living is to stabilize
the price level.
The message is simple. In the long run,
there is no trade-off between inflation
and recession. Ultimately, inflation itself causes recessions and results in
less-than-optimum economic performance. A monetary policy that strives
for price stability, or zero inflation, is a
pro-growth policy.
• Recessions:
Why Do We Have Them?
A recession is an economic downturn
that is widespread across enough industries or regions to make the slowdown general for the economy. Although we do not understand recessions
completely, we have seen that they can
be caused by monetary policy actions as
well as by nonmonetary factors.
In the early 1980s, recessions were
caused by monetary policy mistakes,
namely the excessive monetary growth
rates of the 1970s. This excessive
growth of money in both Canada and
the United States allowed inflation and
interest rates to rise, which led to the
need for dis inflationary monetary
policies in order to get our economies
back on acceptable real growth trends.
Yet even today, we are apt to blame a
recession on policies that reduced inflation instead of those that created the inflation to begin with.

-

In a recent speech to a Toronto business group, Federal Reserve Bank of
Cleveland President W. Lee Hoskins
presented his prescription for attain-

ing maximum sustainable economic
growth in the coming decade: a
policy of price stability that will
thwart the damaging cycle of inflation and recession.

Why is it that inflationary policies
cause recessions? Business leaders face
a great many sources of uncertainty surrounding any investment decision.
First, they must know their market and
offer a product that people want. Next,
they must monitor costs while providing the highest possible quality. Implicit in this task is a host of decisions
that require guessing future rates of interest and inflation. Generally, high and
variable rates of inflation cause mistakes in these decisions, mistakes that
may lead to incorrect investment or inventory decisions.
For some businesses, costs arising
from inflation and interest rates may
not seem critical; for example, those
with low fixed costs and those that are
able to adjust wages and prices for inflation. For most, though, inflation and
interest rates will be critical. Otherwise
capable managers who made investments in the late 1970s in inflationsensitive areas-farming,
timberland,
oil, or real estate-fell
into bankruptcy

when high inflation rates failed to con-

fashion. Without a doubt, there will al-

People survive business cycles in many

Monetary Policy's Long and Variable

celeration of inflation and misallocation

economy. Proponents of a countercycli-

tinue into the next decade. The people
who made this bet in the 1960s, however, became very wealthy. The history
of the business cycle is a history of

ways be short-term difficulties, but it is
to our long-term advantage to allow for
some shift in the economic "plates" as
the world changes.

of the same ways that they survive
seasonal cycles. Firms build up a
reserve of profits in good times to survive the bad times. Households save

Lags: Even if we could predict recessions and wanted to vary monetary
policy to alleviate them, we still face
an almost insurmountable problem:

of resources that will lead to the need for
a correction-a recession.

during good times and postpone large
purchases in bad times. Government
programs like unemployment insurance and the graduated income tax

monetary policy operates with a lag.
Moreover, the length of the lag varies
over time, depending on conditions in
the economy and the public's percep-

cal policy assume that the trend or overall average growth rate of the money
supply will be unaffected by policy.
They assume that excessive money
growth today will be offset by less
growth in the future. Because this is
usually not the case, there is no benchmark or anchor for the monetary sys-

operate automatically to stabilize
spending over the business cycle.

tion of the policy process. The effect of
today's monetary policy actions will
probably not be felt for at least six to
nine months, with the main influence

gyrations in money and prices.
Nonmonetary "surprises" also can
cause disruptions in resource use that
may be widespread enough to result in
a recession. These surprises often arise
from technological innovations such as
those we have seen in computers, information processing, and management
techniques. They also come from such
economic disturbances as droughts,
strikes, wars, cartel actions, and political change. For example, political
reforms in countries like Poland and
China may produce recessions because
people have to leam how to reorganize
and develop institutions that use the
market. Recessions can also emanate
from the combined effects of many particular disturbances to individuals,
firms, and industries.
Even if we could eliminate all the influences from monetary policy, there
would still be recessions and expansions because of these surprises. Consider an analogy between recessions
and earthquakes. Earthquakes occur
when the plates of the earth shift. Although scientists do not completely understand this shifting, they believe that
it may result in either many small
quakes or a few large ones. We have no
reason to believe that it would be beneficial if geologists were able to delay the
next earthquake, however. In fact, if the
earth's plates must shift, we may only
be causing a much worse quake if we

Perhaps the earthquake analogy seems
a bit extreme, but it is no more extreme
than the idea that monetary policy can
or should be used to eliminate the business cycle. Let me emphasize that I am
not in favor of recessions. On the contrary, I believe that variable and uncertain monetary policies exacerbate the
business cycle. We must remember that
recessions will occur even under an
ideal monetary policy, but they will not
be as frequent or as severe. Under an
ideal policy, we would not have recessions induced by inflation and the persistent need to eliminate it.
• Nonmonetary Surprises:
Why Don't We Use Policy to
Thwart Them?
There is a bit of irony in the idea of
forecasting recessions: if we could
forecast them, we probably would not
need a policy to eliminate them. A
recession is one kind of economic fluctuation. Others include seasonal fluctuations due to weather, tax laws, and
cultural events like holidays.
There is a fundamental difference in the
way we treat seasonal and business
cycle fluctuations. Seasonal downturns
can be larger than cyclical downturns,
yet the government adjusts its economic
data to account for seasonal downturns,
Seasonality can be adjusted because
seasonal fluctuations are predictable
based on past experience.

try to prevent the small ones.
The same is true of recessions. Shifts
are occurring in the economy that
economists and policymakers do not
completely understand-for
example,
technology and the changing tastes of
consumers and investors. Other shifts
that are considered to be uncontrollable,
such as droughts and oil spills, also
occur. If we let market forces operate,
these changes wi II be accommodated
or corrected in a natural and gradual

People have developed a variety of
ways to deal with seasonal variations in
employment and output. Farmers know
that a single fall's harvest has to feed
the family for a whole year. Construction workers know that their relatively
high incomes during the summer must
carry them through the winter months.
Successful retailers know that nearly
one-third of their sales come in the
winter holiday season. Consequently,
their budget plans and banking relationships reflect this cash-flow problem.

The point is that if business cycles
were predictable-a
necessary condition to justify a stabilization policyadjustments by people would make
such a policy unnecessary.

perhaps two to three years in the future.
The act of trying to prevent a recession
may not only fail, but may also create a
recession where there was not going to
be one.

Even if we thought that eliminating
the business cycle was a desirable and
healthy long-term goal, I believe it is
impossible to do so. Several reasons
prevent us from using monetary policy
to offset nonmonetary surprises. First,
we cannot predict recessions. Second,
policy does not work immediately or
predictably; it works with a lag. The
effects of monetary policy on the
economy are highly variable and
poorly understood.
The Crystal Ball Syndrome: The limitations of economic forecasting are well
known. Analysis of forecast errors has
shown that we often fail to recognize a
recession until it is well under way.
Economic forecasts at any point in time
entail such a wide band of uncertainty
that the plausible outcomes range from
expansion to recession.
The people who make forecasts and
those who use them often get a false
sense of confidence because forecast
errors are not distributed evenly over

The other reason for a lag is that
businesspeople do not act in a vacuum.
They understand the political forces
operating on a central bank and know
that a return to inflation is always a possibility. If they are uncertain about future policy, they will be cautious about
future investments. Uncertainty about
future inflation will raise real interest
rates, drive investors away from longterm markets, and delay the very investments needed to end the recession. The
more certain people are about the
stability of future monetary policy, the
more easily and quickly inflation can be
reduced and the economy can recover.
Macroeconomic ideas about monetary
policy and its effect on real output have
changed profoundly in the last decade.
Economists have learned that the effect
of monetary policy depends largely on
expectations about policy.

Suppose that the recession followed a
period of excessive monetary expansion, which has been a common occurrence in the United States and Canada
over the last three decades. An economy often goes into recession following
an unexpected burst of inflation because people have made decisions that
were based on an incorrect view of the
course of asset prices and economic activity. The central bank can do little to
cure the situation except to provide a
stable price environment in which adjustments can be made to work off inventories and bad debts generated
during the inflationary expansion.
How long this takes depends on many
factors, some of which are outside the

makers try to follow this countercyclical policy. By focusing on a stable
price level, the central bank would
automatically resist inflationary pressures that occur when aggregate spending is excessive. Likewise, it would
automatically resist deflationary pressures that occur when the economy
turns down.

control of the central bank.
•
The United States, Canada, and many
other western countries are experiencing extraordinarily

long expansions. It

is no coincidence that these expansions
have proceeded in the presence of
reduced inflation. We have fared well
in the mid- to late 1980s because of,
and not in spite of, restrictive monetary
policies. The combination of prolonged
growth and relatively low, stable inflation will make it easier for central

What Is a Zero Inflation Policy?

A successful zero inflation policy
would eliminate long-run inflation or
any upward trends in the general level
of prices. This policy comprises two
firm commitments: a commitment to
long-term price stability, and a commitment to an explicit timetable.
A successful zero inflation policy does
not mean that actual price indexes
would remain constant. Central banks

banks to continue fighting inflation in
the coming decade. We must not return
to the inflationary pol icies of the past.

cannot control the price level over
short horizons such as one quarter, or

Doing so will almost certainly cause a
repeat of the terri ble recessions we suffered in the early 1980s.

people may wish otherwise, there will
always be temporary and unforeseen
factors that will cause the price level to

The experience of the last 20 years has

• Central Bank Credibility
Need for an Anchor

shown us that we must think of policy
as a dynamic process. The philosophy
that a recession is inevitable in order to
reduce inflation completely ignores the

The first, necessary step for achieving
prolonged growth and stability is a
monetary policy that seeks to stabilize
the price level. The result will be a

ability of individuals to adapt their expectations as their environment changes.

world where people expect the average
long-run inflation rate to be zero.

lem lies in predicting the turning points
-the critical junctures that we must

People do their best to forecast economic policies when they make deci-

Advocates of a countercycl ical monetary policy disregard the long-term con-

forecast in order to prevent recessions.

sions. If the central bank has a record of
expanding the money supply in attempts
to prevent recessions, people will come
to anticipate the policy, setting off an ac-

sequences of inflation. They contend
that to maintain the value of money,
monetary expansions must be kept in
line with the growth capacity of our

the business cycle. When the economy
is doing well, forecasts that prosperity
will continue are usually correct.
When the economy is performing poorly, forecasts that the slump will continue are also usually correct. The prob-

tem and the economy's participants. Instead, inflation is allowed to change
randomly with the fortunes of the economy, causing uncertainties as decision-

and the

even one year. No matter how much

deviate from the desired policy target
of a stable price level. It would be a
mistake to try to keep some inflation
index on target for each quarter, or
even for each year.
By price stability, I mean an economic
environment in which people can make
decisions about the future without having to worry about long-run inflation.
In practice, nonpolicy aspects of the
economy that affect inflation have to
be partially accommodated. The price
level might remain slightly above or
below the target path for a year or two,
but during that time the public would

when high inflation rates failed to con-

fashion. Without a doubt, there will al-

People survive business cycles in many

Monetary Policy's Long and Variable

celeration of inflation and misallocation

economy. Proponents of a countercycli-

tinue into the next decade. The people
who made this bet in the 1960s, however, became very wealthy. The history
of the business cycle is a history of

ways be short-term difficulties, but it is
to our long-term advantage to allow for
some shift in the economic "plates" as
the world changes.

of the same ways that they survive
seasonal cycles. Firms build up a
reserve of profits in good times to survive the bad times. Households save

Lags: Even if we could predict recessions and wanted to vary monetary
policy to alleviate them, we still face
an almost insurmountable problem:

of resources that will lead to the need for
a correction-a recession.

during good times and postpone large
purchases in bad times. Government
programs like unemployment insurance and the graduated income tax

monetary policy operates with a lag.
Moreover, the length of the lag varies
over time, depending on conditions in
the economy and the public's percep-

cal policy assume that the trend or overall average growth rate of the money
supply will be unaffected by policy.
They assume that excessive money
growth today will be offset by less
growth in the future. Because this is
usually not the case, there is no benchmark or anchor for the monetary sys-

operate automatically to stabilize
spending over the business cycle.

tion of the policy process. The effect of
today's monetary policy actions will
probably not be felt for at least six to
nine months, with the main influence

gyrations in money and prices.
Nonmonetary "surprises" also can
cause disruptions in resource use that
may be widespread enough to result in
a recession. These surprises often arise
from technological innovations such as
those we have seen in computers, information processing, and management
techniques. They also come from such
economic disturbances as droughts,
strikes, wars, cartel actions, and political change. For example, political
reforms in countries like Poland and
China may produce recessions because
people have to leam how to reorganize
and develop institutions that use the
market. Recessions can also emanate
from the combined effects of many particular disturbances to individuals,
firms, and industries.
Even if we could eliminate all the influences from monetary policy, there
would still be recessions and expansions because of these surprises. Consider an analogy between recessions
and earthquakes. Earthquakes occur
when the plates of the earth shift. Although scientists do not completely understand this shifting, they believe that
it may result in either many small
quakes or a few large ones. We have no
reason to believe that it would be beneficial if geologists were able to delay the
next earthquake, however. In fact, if the
earth's plates must shift, we may only
be causing a much worse quake if we

Perhaps the earthquake analogy seems
a bit extreme, but it is no more extreme
than the idea that monetary policy can
or should be used to eliminate the business cycle. Let me emphasize that I am
not in favor of recessions. On the contrary, I believe that variable and uncertain monetary policies exacerbate the
business cycle. We must remember that
recessions will occur even under an
ideal monetary policy, but they will not
be as frequent or as severe. Under an
ideal policy, we would not have recessions induced by inflation and the persistent need to eliminate it.
• Nonmonetary Surprises:
Why Don't We Use Policy to
Thwart Them?
There is a bit of irony in the idea of
forecasting recessions: if we could
forecast them, we probably would not
need a policy to eliminate them. A
recession is one kind of economic fluctuation. Others include seasonal fluctuations due to weather, tax laws, and
cultural events like holidays.
There is a fundamental difference in the
way we treat seasonal and business
cycle fluctuations. Seasonal downturns
can be larger than cyclical downturns,
yet the government adjusts its economic
data to account for seasonal downturns,
Seasonality can be adjusted because
seasonal fluctuations are predictable
based on past experience.

try to prevent the small ones.
The same is true of recessions. Shifts
are occurring in the economy that
economists and policymakers do not
completely understand-for
example,
technology and the changing tastes of
consumers and investors. Other shifts
that are considered to be uncontrollable,
such as droughts and oil spills, also
occur. If we let market forces operate,
these changes wi II be accommodated
or corrected in a natural and gradual

People have developed a variety of
ways to deal with seasonal variations in
employment and output. Farmers know
that a single fall's harvest has to feed
the family for a whole year. Construction workers know that their relatively
high incomes during the summer must
carry them through the winter months.
Successful retailers know that nearly
one-third of their sales come in the
winter holiday season. Consequently,
their budget plans and banking relationships reflect this cash-flow problem.

The point is that if business cycles
were predictable-a
necessary condition to justify a stabilization policyadjustments by people would make
such a policy unnecessary.

perhaps two to three years in the future.
The act of trying to prevent a recession
may not only fail, but may also create a
recession where there was not going to
be one.

Even if we thought that eliminating
the business cycle was a desirable and
healthy long-term goal, I believe it is
impossible to do so. Several reasons
prevent us from using monetary policy
to offset nonmonetary surprises. First,
we cannot predict recessions. Second,
policy does not work immediately or
predictably; it works with a lag. The
effects of monetary policy on the
economy are highly variable and
poorly understood.
The Crystal Ball Syndrome: The limitations of economic forecasting are well
known. Analysis of forecast errors has
shown that we often fail to recognize a
recession until it is well under way.
Economic forecasts at any point in time
entail such a wide band of uncertainty
that the plausible outcomes range from
expansion to recession.
The people who make forecasts and
those who use them often get a false
sense of confidence because forecast
errors are not distributed evenly over

The other reason for a lag is that
businesspeople do not act in a vacuum.
They understand the political forces
operating on a central bank and know
that a return to inflation is always a possibility. If they are uncertain about future policy, they will be cautious about
future investments. Uncertainty about
future inflation will raise real interest
rates, drive investors away from longterm markets, and delay the very investments needed to end the recession. The
more certain people are about the
stability of future monetary policy, the
more easily and quickly inflation can be
reduced and the economy can recover.
Macroeconomic ideas about monetary
policy and its effect on real output have
changed profoundly in the last decade.
Economists have learned that the effect
of monetary policy depends largely on
expectations about policy.

Suppose that the recession followed a
period of excessive monetary expansion, which has been a common occurrence in the United States and Canada
over the last three decades. An economy often goes into recession following
an unexpected burst of inflation because people have made decisions that
were based on an incorrect view of the
course of asset prices and economic activity. The central bank can do little to
cure the situation except to provide a
stable price environment in which adjustments can be made to work off inventories and bad debts generated
during the inflationary expansion.
How long this takes depends on many
factors, some of which are outside the

makers try to follow this countercyclical policy. By focusing on a stable
price level, the central bank would
automatically resist inflationary pressures that occur when aggregate spending is excessive. Likewise, it would
automatically resist deflationary pressures that occur when the economy
turns down.

control of the central bank.
•
The United States, Canada, and many
other western countries are experiencing extraordinarily

long expansions. It

is no coincidence that these expansions
have proceeded in the presence of
reduced inflation. We have fared well
in the mid- to late 1980s because of,
and not in spite of, restrictive monetary
policies. The combination of prolonged
growth and relatively low, stable inflation will make it easier for central

What Is a Zero Inflation Policy?

A successful zero inflation policy
would eliminate long-run inflation or
any upward trends in the general level
of prices. This policy comprises two
firm commitments: a commitment to
long-term price stability, and a commitment to an explicit timetable.
A successful zero inflation policy does
not mean that actual price indexes
would remain constant. Central banks

banks to continue fighting inflation in
the coming decade. We must not return
to the inflationary pol icies of the past.

cannot control the price level over
short horizons such as one quarter, or

Doing so will almost certainly cause a
repeat of the terri ble recessions we suffered in the early 1980s.

people may wish otherwise, there will
always be temporary and unforeseen
factors that will cause the price level to

The experience of the last 20 years has

• Central Bank Credibility
Need for an Anchor

shown us that we must think of policy
as a dynamic process. The philosophy
that a recession is inevitable in order to
reduce inflation completely ignores the

The first, necessary step for achieving
prolonged growth and stability is a
monetary policy that seeks to stabilize
the price level. The result will be a

ability of individuals to adapt their expectations as their environment changes.

world where people expect the average
long-run inflation rate to be zero.

lem lies in predicting the turning points
-the critical junctures that we must

People do their best to forecast economic policies when they make deci-

Advocates of a countercycl ical monetary policy disregard the long-term con-

forecast in order to prevent recessions.

sions. If the central bank has a record of
expanding the money supply in attempts
to prevent recessions, people will come
to anticipate the policy, setting off an ac-

sequences of inflation. They contend
that to maintain the value of money,
monetary expansions must be kept in
line with the growth capacity of our

the business cycle. When the economy
is doing well, forecasts that prosperity
will continue are usually correct.
When the economy is performing poorly, forecasts that the slump will continue are also usually correct. The prob-

tem and the economy's participants. Instead, inflation is allowed to change
randomly with the fortunes of the economy, causing uncertainties as decision-

and the

even one year. No matter how much

deviate from the desired policy target
of a stable price level. It would be a
mistake to try to keep some inflation
index on target for each quarter, or
even for each year.
By price stability, I mean an economic
environment in which people can make
decisions about the future without having to worry about long-run inflation.
In practice, nonpolicy aspects of the
economy that affect inflation have to
be partially accommodated. The price
level might remain slightly above or
below the target path for a year or two,
but during that time the public would

October 15,1989

know the Federal Reserve's goal. They

return to some "normal" growth trend,

would expect to see a policy stance
directed toward returning the price
level to its target path.

but at a higher level of output than will
be possible if we continue to operate
under the current system.

port the current inflation rate, but
would also lay the foundation for accelerating inflation. The result would
be an economy operating even further

A complete zero inflation policy would

Inflation adds risk to decisions and

require a transition period in which

retards long-term investments. It
changes the nature of the economic environment so that random inflation out-

eCONOMIC
COMMeNTORY

Yet, such a policy would not only sup-

below its long-run potential, with growing vulnerability to frequent and severe
recessions. A monetary policy that
leads to zero inflation, even if it risks a

zero inflation is approached gradually.
This transition should be stated as a
path for the price level. Adopting a
zero inflation policy today would mean
that the price level would continue to
rise for the next three to five years, for
example, but at a lower rate each year.
Eventually, the target would become a
constant price level.
• A Zero Inflation Policy Is a
Pro-Growth Policy
We know that both the U.S. and
Canadian economies are currently
operating at levels well below those that
could be achieved if we eliminate inflation. Zero inflation would make our
monetary system more efficient, contribute to better decisions, and result in
more efficient use of our resources.
During the transition to a higher level of
performance, the economy would grow
faster. Eventually, we would expect it to

comes overwhelm otherwise prudent
managers. Inflation causes people to
start up businesses and use costly accounting methods for the sole purpose
of hedging against it. In the absence of

Breaking the
Inflation-Recession Cycle

recession, is our best opportunity for
long-term growth.

inflation, the resources working in
these areas could be devoted to producing more goods and services. Inflation
interacts with the tax structure to stifle
incentives and limit investment, and it
undermines public trust in government.
Why do we allow inflation to clog the
wheels of our economy?

Federal Reserve Bank of Cleveland

ity. This is unfortunate. The perceived
trade-off between inflation and reces-

Fears of recession create an apparently
insurmountable barrier to price stabil-

by W. Lee Hoskins

sion is an illusion. In the end, inflation
itself is the cause of most recessions,
and continued inflation will reduce economic growth. To achieve maximum
sustainable growth in the economy in
the I990s, central banks should com-

Over
the years, many people have
come to believe that nations can prolong an economic expansion, or avoid
the pain of a recession, with more inflation. Given this choice, some observers
may view inflation as a reasonable gamble and, perhaps, as the lesser of two
evils. These are false choices, however.

-

mit today to achieving zero inflation.

• Conclusion
Monetary policy is being tested today.
Although we have enjoyed high levels
of economic growth, recent slowing in
economic activity in Canada and the
United States has prompted calls for
easier monetary policy-lower
interest
rates and more rapid monetary growth.

W. Lee Hoskins is president of the Federal

A look at recent history reminds us
vividly of the economic pain resulting
from inflation. Every recession in the

Reserve Bank of Cleveland. The material in
this Economic Commentary is based on a
speech presented to The Fraser Institute,
Toronto, Canada, on September 19. 1989.

recent history of North America has
been preceded by an outburst of cost
and price pressures. Let us not forget
the miserable economic situation at the
tum of this decade, when unemployment and inflation were at double-digit
levels and production was declining. If
we learned anything from those dismal

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

times, surely it was that the harm
caused by inflation takes years to undo,
and usually comes at the cost of permanent losses in income and economic

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Permit No. 385

well-being.
Today, in both Canada and the United
States, people seem to be more aware
than ever that the proper role of the

Address Correction Requested:

central bank is to prevent these losses
by stabilizing the price level. Both Gov-

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the above address.

ernor Crow and Deputy Governor
Freedman of the Bank of Canada have
publicly committed to monetary policies designed to stabilize the price
level. In the United States, Federal
Reserve Chairman Greenspan has
repeatedly stated that the way to attain
maximum long-run growth and the

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the source is credited. Please send copies
of reprinted materials to the editor.
ISSN 0428-1276

highest standard of living is to stabilize
the price level.
The message is simple. In the long run,
there is no trade-off between inflation
and recession. Ultimately, inflation itself causes recessions and results in
less-than-optimum economic performance. A monetary policy that strives
for price stability, or zero inflation, is a
pro-growth policy.
• Recessions:
Why Do We Have Them?
A recession is an economic downturn
that is widespread across enough industries or regions to make the slowdown general for the economy. Although we do not understand recessions
completely, we have seen that they can
be caused by monetary policy actions as
well as by nonmonetary factors.
In the early 1980s, recessions were
caused by monetary policy mistakes,
namely the excessive monetary growth
rates of the 1970s. This excessive
growth of money in both Canada and
the United States allowed inflation and
interest rates to rise, which led to the
need for dis inflationary monetary
policies in order to get our economies
back on acceptable real growth trends.
Yet even today, we are apt to blame a
recession on policies that reduced inflation instead of those that created the inflation to begin with.

-

In a recent speech to a Toronto business group, Federal Reserve Bank of
Cleveland President W. Lee Hoskins
presented his prescription for attain-

ing maximum sustainable economic
growth in the coming decade: a
policy of price stability that will
thwart the damaging cycle of inflation and recession.

Why is it that inflationary policies
cause recessions? Business leaders face
a great many sources of uncertainty surrounding any investment decision.
First, they must know their market and
offer a product that people want. Next,
they must monitor costs while providing the highest possible quality. Implicit in this task is a host of decisions
that require guessing future rates of interest and inflation. Generally, high and
variable rates of inflation cause mistakes in these decisions, mistakes that
may lead to incorrect investment or inventory decisions.
For some businesses, costs arising
from inflation and interest rates may
not seem critical; for example, those
with low fixed costs and those that are
able to adjust wages and prices for inflation. For most, though, inflation and
interest rates will be critical. Otherwise
capable managers who made investments in the late 1970s in inflationsensitive areas-farming,
timberland,
oil, or real estate-fell
into bankruptcy