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March 15, 1990

Federal Reserve Bank of Cleveland

The Case for Price Stability
by W. Lee Hoskins


Lr. Chairman, I am pleased to appear before this Subcommittee to testify
on House Joint Resolution 409.1 strongly support your resolution directing the
Federal Reserve System to make price
stability the main goal of monetary
policy. Ultimately, the price level is
determined by monetary policy. While
economic growth and the level of
employment depend on our resources
and the efficiency with which they are
used, the aggregate price level is determined uniquely by the Federal Reserve.
Efficient utilization of our nation's
resources requires a sound and predictable monetary policy. H.J. Res. 409
wisely directs the Federal Reserve to
place price stability above other economic goals because price stability is
the most important contribution the
Federal Reserve can make to achieve
full employment and maximum sustainable growth.

The Benefits of Price Stability

Price Stability Leads to Economic
Stability An important benefit of
price stability is that it would stabilize
the economy. High and variable inflation has always been one of the prime
causes of financial crises and economic
recessions. Certainly U.S. experience
since World War II reaffirms the notion
that inflation is a leading cause of recessions. Every recession in our recent history has been preceded by an outburst
of cost and price pressures and the associated imbalances and distortions.

ISSN 0428-1276

A monetary policy that strives for price
stability, or zero inflation, as mandated
by H.J. Res. 409 would help markets
avoid distortions and imbalances, stabilize the business cycle, and promote
the highest sustainable growth in our
Price Stability Maximizes Economic
Efficiency and Output A market
economy achieves maximum production and growth by allowing market
prices to allocate resources. Money
helps make markets work more efficiently by reducing information and
transactions costs, allowing for better
decisions and improved productivity in
resource use. Stabilizing the price level
would make the monetary system
operate more efficiently and would
result in a higher standard of living for
all Americans. Money is a standard of
value. Much of our wealth is held
either in the form of money or in
claims denominated in and payable in
money. Money represents a claim on a
share of society's output. Stabilizing
the price level protects the value of that
claim, while inflation reduces it.
When we borrow, we promise to pay
back the same amount with interest.
When we allow unpredictable inflation,
we arbitrarily take from the lender and
give to the borrower. When this condition persists, we create an environment
in which interest rates rise once to accommodate expected inflation and

In recent testimony before the U.S.
House of Representatives' Subcommittee on Domestic Monetary Policy,
Federal Reserve Bank of Cleveland
President W. Lee Hoskins presented
this statement of his support for a
Congressional mandate making price
stability the Federal Reserve's
primary policy goal. House Joint
Resolution 409, by committing the
central bank to create an explicit
plan for price stability, would allow
the Federal Reserve to achieve maximum output and employment
without incurring the detrimental
effects of inflation.

again to accommodate the increased
risk involved in dealing with an uncertain inflation. When inflation rises and
becomes uncertain, people are forced
to develop elaborate, complicated, and
expensive mechanisms to protect their
wealth and income, such as new accounting systems, markets for trading
financial futures and options, and cash
managers who spend all their time
trying to keep cash balances at zero. It
would be inefficient to allow the length
of a yardstick to vary over time, and it
is inefficient to allow inflation to
change the yardstick for economic
While the evidence that price stability
maximizes production and employment is not as direct or as extensive as
I would like, it is persuasive to me.
One source of evidence can be found
in the comparison of inflation and real
growth across countries. A number of
studies find that higher inflation or
higher uncertainty about inflation is associated with lower real growth.
Inflation adds risk to decision-making
and retards long-term investments.
Inflation causes people to invest scarce
resources in activities that have the sole
purpose of hedging against inflation.
Inflation interacts with the tax structure
to stifle investment incentives.
More evidence comes from the extreme cases, the cases of hyperinflation. There we see that economic performance clearly deteriorates with high
inflation. Both specialization and trade
decline as small firms go bankrupt and
people return to home production for a
larger share of goods and services.
Even a relatively predictable and
moderate rate of inflation can be quite
harmful. During the seven years of our
economic expansion since 1982, inflation has averaged between 3 and 4 percent. While that is low by the standards
of the 1970s, the purchasing power of
the dollar has been reduced by about
25 percent. Interest rates continue to
include a premium for expected inflation and a premium for uncertainty
about inflation.

Research at the Federal Reserve Bank
of Cleveland indicates that a fully anticipated inflation, with no uncertainty
about future inflation, would reduce the
capital stock through taxes on capital income. Using 1985 as a benchmark and
using conservative assumptions, we
have estimated that the interaction of an
expected 4 percent inflation rate with
the tax on capital income leads to a
present value income loss in the American economy of $600 billion or more.
This is an amount much greater than the
output loss typically associated with
recessions. This estimate is from a
policy of a perfectly anticipated 4 percent inflation and includes only the welfare loss associated with the failure to
fully index taxes on capital income. It
ignores the greater damage done to
market efficiency by making our
monetary yardstick variable.
Even beyond these costs, I believe that
inflation diminishes productivity
growth. Because the worldwide slowdown in productivity growth occurred
simultaneously with the acceleration in
inflation and the oil price shocks, the
evidence is very difficult to sort out
satisfactorily. But if I am correct in
believing that inflation inhibits productivity growth, the present value of lost
output from even a very small reduction in the trend of productivity growth
would far exceed the adjustment costs
associated with the transition to price
• The Limitations
of Monetary Policy
A Fallacious Trade-Off: Inflation
for Prosperity Unfortunately, over
the years we have come to believe that
we can prolong expansion, or avoid
recession, with more inflation. A look
at recent history reminds us that there
is no trade-off between inflation and
recession. Although we don't 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 we had recessions
caused by monetary policy mistakes.

The policy mistake was the excessive
monetary growth of the 1970s, which allowed accelerating inflation and rising
interest rates and ultimately led to the
need for disinflationary monetary policies. The disinflationary policies were
necessary to get our economy back to
an acceptable level of real activity. Yet
even today, we are apt to blame the
recessions on policies that reduced inflation instead of blaming the policies that
created the inflation to begin with.
While recessions will occur even under
an ideal monetary policy, they will not
be as frequent or as severe. With price
stability, we would not have recessions
induced by inflation and the subsequent
need to eliminate it.
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. There are several
reasons that prevent us from using
monetary policy to offset nonmonetary
surprises. First, we cannot predict recessions. Second, monetary policy does
not work immediately or predictably;
it works with a lag, and the lag is 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 don't know
that a recession has begun until it is
well under way. At any point in time,
the range of uncertainty around
economic forecasts of business activity
for one quarter in the future is wide
enough that both expansion and recession are plausible outcomes.
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
business cycle. When the economy is
doing well, forecasts that prosperity
will continue are usually correct.
And when the economy is performing
poorly, forecasts that the slump will
continue are also usually correct. The
problem lies in predicting the turning
points. However, the turning points are
the things we must forecast to prevent

Monetary Policy's Long and Variable Lags We don't know exactly
how a particular policy action will affect the economy. Macroeconomic
ideas about monetary policy and its effect on real output have changed
profoundly in the last decade as we
have recognized that the effect of
monetary policy depends importantly
on how economic agents form and alter
expectations about policy.
Even if we could predict recessions
and wanted to vary monetary policy to
alleviate them, we still face an almost
insurmountable problem — monetary
policy operates with a lag. Moreover,
the length of the lag varies over time,
depending on conditions in the
economy and on public perception 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
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
future recession — via an inflation —
where otherwise there would not have
been one.
Economic agents, businessmen and
consumers alike, do not act in a
vacuum. The political forces operating
on a central bank make inflation always a possibility. Uncertainty about
future inflation adds risk to future investments. Uncertainty about future
inflation will raise real interest rates,
drive investors away from long-term
markets, and delay the very adjustments 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
Lessons We Should Have Learned
If we have learned anything about
economic policymaking in the last 20
years, we ought to have learned to
think about policy as a dynamic

process. To claim that "in order to
reduce inflation, we must have a recession," is a wrongheaded notion that
completely ignores the ability of
humans to adapt their expectations as
the environment changes.

H.J. Res. 409 satisfies the key requirements of sound policy: it is clear, it is
verifiable, and it has consistent rules.
Unlike other rates of inflation, zero inflation is a policy goal that will be understood by everyone.

People do their best to forecast
economic policies when they make
decisions. 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 acceleration of inflation and misallocation of resources
that will lead to a recession.

Responding to Multiple Goals The
Federal Reserve Reform Act of 1977
amended the Federal Reserve Act so
that it now requires the Federal
Reserve " promote effectively the
goals of maximum employment, stable
prices, and moderate long-term interest
rates." However, it is the Federal
Reserve's responsibility to decide how
best to pursue those goals.

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 future course of asset
prices and economic activity. The
central bank can help prevent the need
for such adjustments by providing a
stable price environment. Moreover,
price stability will be the optimal setting for adjustments in business inventories and bad debts, should such adjustments be necessary.
• The Importance of Adopting
House Joint Resolution 409
Sound Policies Minimize Uncertainty
Economic policies must have clear objectives, verifiable outcomes, and rules
that are consistently adhered to in order
to minimize uncertainty. Predictable,
verifiable policies ensure that longterm planning and resource allocation
decisions will be efficient. Sound
policy thus requires a resolute focus on
the long term and resistance to policies
that, while expedient in the short run,
introduce more uncertainty into an already unpredictable world. If enacted,
H. J. Res. 409 would make a valuable
contribution to this important objective.
In the long run, inflation is the one
economic variable for which monetary
policy is unambiguously responsible.
The zero inflation policy called for in

Because of the multiplicity of goals established by Congress for the Federal
Reserve, the Federal Reserve can
choose which goal it emphasizes at any
moment. Such discretion increases the
likelihood that political and specialinterest groups could try to influence
the Federal Reserve to pursue the
policy that is currently important to
that group.
In this respect, the Federal Reserve's
situation is different from that of West
Germany's central bank, which is also
independent. More than one goal is
specified by law for that bank, but
West German law states that the goal
of price stability is to be given highest
priority whenever another goal might
conflict with maintaining price
stability. This is a major reason why
West Germany's price level only
doubled between 1950 and 1988, while
the U.S. price level quadrupled.
Since current law requires the Federal
Reserve to promote maximum employment, stable prices, and moderate longterm interest rates, the Federal Reserve
must choose a viable strategy to accomplish this mission. Two approaches
seem plausible.
One approach would be for the central
bank to try to achieve a balance among

its three Congressionally mandated objectives. The Federal Reserve could use
its own judgment about what balance
among the objectives to pursue, and
could change that balance from time to
time, depending on its view of how the
economy works and what course is
broadly acceptable to the public.
In essence, this is the practice that the
Federal Reserve has followed. It has
strived to balance desirable economic
conditions such as full employment,
economic growth, and low long-term
interest rates with low rates of inflation. But the major drawback to this
approach is its feasibility. To strike a
balance among the mandated goals
requires that they be reliably linked to
one another. Furthermore, monetary
policy would need to be capable of
influencing simultaneously all these
economic dimensions in the desired
directions and quantities.
While monetary policy is capable of influencing the economy in the short to
intermediate run, over long periods of
time monetary policy can only affect
the rate of inflation. The rate of inflation, in turn, affects all dimensions of
economic performance, including output, employment, and interest rates.
Maximum production and employment
and low interest rates can be achieved
only with price stability.
By its very nature, a balancing act
among complex economic goals causes
substantial confusion about the Federal
Reserve's intentions. Such confusion
could be avoided to a large degree if
Congress or the Federal Reserve assigned priorities to the goals.
A more promising approach is to select
one objective — the only one that the
Federal Reserve can influence directly.
Under the provisions of H.J. Res. 409,
the Federal Reserve would seek to
maintain a stable price level over time.
Price stability is defined as an inflation
rate so small that it does not systematically affect economic decisions. The
definition may appear less specific than
some would like, but I believe that the
decisions of economic agents will be

very important in monitoring success
in achieving price stability.
In practice, the size of the inflation
premium estimated to be found in longterm interest rates, surveys of the
public's inflation expectations, and
other market-generated measures of inflation expectations can be very useful.
If policy is credible, both the inflation
component and the inflation uncertainty risk premium would be eliminated
from interest rates. Temporary and unforeseen factors will cause the price
level to deviate from the desired
course. It would be a mistake to try to
keep some inflation index on target
each and every quarter, or even each
and every year.
Price stability can be achieved by holding the money supply (as measured by
M2) on or close to a path which is consistent with price stability over long periods. The relationship between money
and the price level over long periods of
time is stable and strong. However, the
link between money and the economy
over periods perhaps as short as a year
is loose enough to afford the Federal
Reserve considerable leeway in responding to problems and crises — as
long as economic agents believe that
the future value of money will be stable. Clearly, this resolution would not
prevent the Federal Reserve from providing liquidity in times of financial crises, such as the stock market crash in
Announcing a Commitment to Price
Stability Announcement of a commitment to price stability, as embodied in
H.J. Res. 409, would enhance the
ability of Congress to hold the Federal
Reserve accountable for achieving the
goal. Central-bank accountability is appropriate in a democracy and, in fact,
Congress has the ultimate authority to
change the Federal Reserve's goal.
A legislative commitment to price
stability would also enhance the
Federal Reserve's independence from
political pressures as it pursued that
goal. A commitment by Congress to

price stability would reduce the effectiveness of political pressure to deviate
from that goal. Thus, a distinction can
be made between a central bank that is
accountable for long-run performance
and a central bank that can be influenced to pursue short-run goals that
might be incompatible with desirable
long-term economic performance.
The commitment to price stability supported by a legislative mandate would
foster the credibility of the Federal
Reserve. Improving the Federal
Reserve's credibility would strengthen
the expectation that prices will be
stable, and would contribute to price
and wage decisions that would make
price stability easier to achieve and
• Arguments Against
Adopting House Joint
Resolution 409 Are Weak
What About the Transition Costs?
A commitment by Congress and the
Federal Reserve to achieve price
stability would entail adjustment costs.
Adjustment costs would arise from two
sources: contractual obligations and the
credibility problem, or uncertainty
about whether price stability would be
achieved and maintained. The contractual costs can be alleviated with an
appropriate adjustment period. H. J.
Res. 409 recognizes that abrupt policy
changes can be disruptive and provides
a phase-in period to help reduce adjustment costs.
Much of our day-to-day economic activity is conducted under contracts and
commitments that extend over longer
periods of time and that embody the expectations of a continuing moderate inflation rate. Most of these contracts
will expire in the next few years. The
disruption to business and the arbitrary
wealth redistribution of an abrupt adjustment to price stability would be
greatly reduced by an appropriate
phase-in period. H. J. Res. 409 gives us
five years to get to price stability — a
period long enough to reduce substantially the transition costs.

The second set of adjustment costs
emanates from the expectations of
economic agents. As the Congressional
Budget Office points out in its recent
Economic and Budget Outlook, if
everyone believed that inflation would
be reduced to zero, and planned accordingly, these costs would be very low.
The Federal Reserve has stated that it
intends to reduce inflation to zero or to
low levels, but it has not committed to a
specific timetable for eliminating inflation, or to a plan for doing so. The result
is that the public in general and the
markets in particular wonder just how
serious we are in those intentions, or
whether we will switch our priorities to
some other goal, as we have in the past.
Large-Scale Econometric Model
Estimates of the Transition Cost
Economists have not made much
progress in estimating the transition
costs of eliminating inflation. Frequently, econometric models that embody a
large number of complex relationships
and variables are used to estimate the
adjustment costs.
For manageability, econometric models
are built with many simplifying assumptions, one of which is the
presumption that economic agents are
backward-looking in the way they
form and change expectations. In these
models, expectations, which in effect
determine adjustment costs, are formed
from past experience, and are changed
only slowly as the future unfolds.
The presumption that expectations
change only slowly inevitably generates
estimates of high transition costs. The
real question about a change in policy
as specified by H. J. Res. 409 is how
forward-looking economic agents
would behave under a fully credible and
fully understood policy change.
Backward-looking models are relatively
useless in answering this question.
In almost every case, such models are
constructed to display the effects that
are consistent with the model builder's

theories and biases. Almost all of the
large models are based on the dual
notion that the only way to eliminate
inflation is to raise the unemployment
rate. Naturally, these models will find
that eliminating inflation is very costly.
These exercises have been conducted
many times in the past, and they have
consistently overestimated the costs of
eliminating inflation and ignored the
benefits of doing so. I might also observe that those who really believe the
analytical structures contained in these
models logically should advocate an acceleration of inflation because the
models would predict great benefits
from doing so.
One member of the Council of
Economic Advisers, an expert on such
matters, has developed large
econometric models with sluggish
resource adjustment induced by labor
contracts. Even in these models, there
is almost no short-run cost to eliminating inflation with a credible policy
change. The reason is simply that, in
these models, people are assumed to
change their behavior in response to
the policy change.
As the CBO study states, "... inflation
could be reduced relatively painlessly
by lowering inflationary expectations."
A commitment by the Congress and the
Federal Reserve would enhance
credibility and convince economic
agents to begin to base decisions on
gradual elimination of inflation over a
five-year period. The transitional costs
presented elsewhere in the CBO study
then would be grossly overestimated.
A consistent commitment to a long-run
policy goal of price stability is important. One of the worst things we could
do is to eliminate inflation for a while
and then return to high inflation later.
H.J. Res. 409 would contribute to an
important change in the policy process,
focusing it toward consistent long-run
goals and away from reactions to each
new report of economic activity. Each
policy action would become part of a
policy process that is consistent with
long-run price stability.

Fiscal Policy Is No Obstacle to Price
Stability Federal budget deficits
should not compromise either the
Federal Reserve's goal of price stability
or the adoption of a specific timetable
to achieve it. I do not mean to suggest
or imply that current fiscal policy is
ideal, appropriate, or the result of bad
monetary policy. Savings are too low, at
least partly because of budget deficits,
and measures to address our savings
shortfall must include measures to
reduce the deficit. However, while we
strive for better fiscal policy, we should
recognize that monetary policy cannot
offset whatever harm may result from
fiscal policy; indeed, it can only add to
those costs.
We are all familiar with the argument
that large federal budget deficits cause
high interest rates, forcing the Fed to
ease monetary policy in order to keep
interest rates at levels consistent with
full employment. This argument ignores the fact that both the federal
budget deficit and, more important,
government spending, at least
measured relative to the economy, have
been falling for the past several years
and should continue to do so.
There is, of course, legitimate concern
that the progress in deficit and expenditure reduction might cease or even be
reversed, for any number of reasons.
How should such a reversal influence
monetary policy? Even if fiscal policy
choices were to put upward pressure on
interest rates, and there is little consensus among economists that this is the
case, it is far from clear that the Federal
Reserve can do anything to alleviate the
economic consequences of that problem. Ultimately, it is real interest rates
that affect the consumption and production decisions of individuals and businesses and the allocation of resources
over time. Real rates of return are based
on the productivity of labor, capital, and
other real assets in a society, and have
very little, if any, connection with
monetary policy.

In an inflationary environment,
nominal rates of return include an inflation premium to compensate lenders
for being repaid in money of reduced
purchasing power. The correlation between monetary policy and nominal interest rates that dominates discussion in
the financial press tells us next to nothing about the relationship between
monetary policy and the real interest
rates that govern the allocation of
resources over time. Every movement
in the federal funds rate does not
produce equivalent changes in real interest rates, in the productivity of our
capital stock, or in any of the other important real variables that affect
economic activity. The fact that
monetary policy exerts relatively direct
control over the federal funds rate does
not imply that real interest rates can,
similarly, be controlled by monetary
It is unnecessary and undesirable for
sound monetary policy choices to
await sound fiscal policy choices.
Sound fiscal policy decisions, like
sound private economic decisions,
require the stable inflation environment
that H.J. Res. 409 would direct the
Federal Reserve to provide. The taxrelated distortions and economic complexities associated with even stable,
positive rates of inflation argue strongly for price stability.

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

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Material may be reprinted provided that
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• Conclusion
If H. J. Res. 409 is enacted and the
Federal Reserve commits to an explicit
plan for price stability, the transition
period will soon be over, and any costs
that arise because of this policy change
will be outweighed by the benefits.
These benefits will be large and permanent, and will far outweigh the costs
of getting there.

W. Lee Hoskins is president of the Federal
Resene Bank of Cleveland. This is the text of
a statement he presented on February 6,
1990, to the Subcommittee on Domestic
Monetary Policy of the Committee on Banking, Finance, and Urban Affairs, U.S. House
of Representatives, Washington. DC.

H. J. Res. 409, if enacted, would be a
milestone in economic policy legislation because it would shift the focus of
monetary policy away from short-term
fine-tuning to the long term, where it
belongs. It would enforce accountability for the one vital objective that
the Federal Reserve can achieve. It
would officially sanction those sometimes unpopular short-run policy
actions that most certainly are in our
nation's long-term interest. It would
make clear that the Federal Reserve
cannot achieve maximum output and
employment without achieving price
stability. I fully support House Joint
Resolution 409.


1. David Altig and Charles T. Carlstrom,
"Expected Inflation and the Welfare Losses
from Taxes on Capital Income," manuscript,
Federal Reserve Bank of Cleveland,
February 1990.

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