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continue to reduce the annual
targets a little more each year. We
realize that either nominal GNP or
prices would not precisely follow
the steadily declining trend implied
by such a policy. Indeed, even the
monetary aggregates would not
decelerate so smoothly. We would
continue to have cyclical troughs
and peaks, but we expect each cyclicallevel of inflation to be well
below the one reached before.
The Federal Reserve has clearly
established and acknowledged that
its primary responsibility is to
end inflation, and we have made
much progress. The trend rate of
inflation has been halved in less
than four years, and some believe
that this is progress enough.
However, our goal has not been

achieved. We cannot contain inflation in the 4 percent to 5 percent
range. The late economist Arthur M.
Okun wrote
I would emphasize that such a state
[of steady inflation] has never existed
and can never be attained. The adoption of a public policy designed to
yield steady, fully anticipated inflation would commit the government to
an impossible goal. Economic policy
making is a highly imperfect art and
it cannot produce steady inflation
any more than it can produce steady
unemployment or a steady price level.
Moreover, the very acceptance by
government of a higher, though hopefully steady, inflation rate would
influence expectations in such a way
as to make prices rise more rapidly
and less steadily. 1

In my view, this statement turned
out to be, unfortunately, an accurate prophecy of the events of
the 1970s.

••

When the United States experienced double-digit inflation rates,
there was general agreement among
the public and among policy makers
that spiraling inflation had to be
stopped. In an improved environment with a lower rate of inflation,
it would be more difficult to retain
the consensus needed to eliminate
inflation. It is critical to our future
economic well-being to do so. The
economic hardships that we have
endured in the past decade should
remind us of the dangers of tolerating even a little inflation. If we
want to steer clear of such hardships in this decade and in the next
several decades, it is imperative
that we adopt zero inflation as our
goal-and that we achieve it. The
best way to do that is to continue
to reduce the growth ranges for the
monetary targets.

Federal Reserve Bank of Cleveland

February 27, 1984

Monetary Policy
in the 1980s
by Karen N. Horn

1. See Arthur M. Okun, "The Mirage of Steady
Inflation;' in Joseph A. Pechman, Ed., Economics
lor Policymaking, Cambridge, Mass.: MIT Press,
1983, p. 37.

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

••

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Permit No. 385

••

Karen N. Horn is president 0/ the Federal Reserve
Bank 0/ Cleveland. An earlier version 0/ this essay
appeared in the Conference Board's Economic
Policy Issues, No.1, 1984.
The views expressed herein are those 0/ Mrs. Horn
and not necessarily those 0/ the Board 0/ Governors 0/ the Federal Reserve System.

Twenty years ago policymakers
were optimistic that monetary and
fiscal policies were capable of
maintaining both full employment
and price stability. With longer lags
involved in deciding on and implementing tax and budget policies,
fiscal policy became a more complicated process, less able to respond
quickly to adverse shifts in employment and output. Consequently,
the responsibility for stabilizing the
economy fell more and more to the
nation's central bank, and monetary policy objectives alternated
between fighting inflation and
fighting unemployment. At the
peak of the business cycle, monetary policy was aimed primarily at
subduing inflation; at the trough of
the business cycle, monetary policy
was directed at spurring business
activity. By switching objectives
between inflation and unemployment, both battles were lost. Experience shows that the Federal
Reserve cannot, for very long, trade
off a little more inflation for a little
less unemployment. Indeed, our
experience in the past 20 years has
been the opposite, as inflation rose
to higher levels in each expansion
period and unemployment rose to
new heights in each recession (see
chart 1). To the extent that any
trade-off exists, it is only temporary.

Focusing on Inflation
The experience of the past 20 years
prompts two observations. First,
the Federal Reserve does not have
the tools or the knowledge to manipulate the economy in the short
run to achieve full employment.
Second, full employment cannot be
achieved on an enduring basis in
an inflationary environment. The
difficulty, if not the impossibility,
of achieving short-term goals,
coupled with the growing awareness of the overriding importance
of an inflation-free environment,
has led to a consensus that price
stability over the long run should
be the central bank's primary
goal. What do we mean by price
stability? In theory, it can be
argued that it does not matter
whether the inflation rate is 0 or
5 percent, as long as it is predictable. In practice, we have found that
some inflation soon becomes more,
and that inflation becomes even
less predictable at higher levels.
Adjusting to high levels of inflation in the real world is not costless, even when those levels are
predictable. Repeated failure to deal
with inflation on a long-term basis
all but forced consumers, businessmen, savers, and borrowers to expect
future inflation to be worse than
current inflation. Eventually, the
expectation of future inflation
became entrenched in financial
markets, and investors built a substantial inflation premium into

Unemployment Rate
Annual percent change
14

12
10
8
6

SOURCE: Bureau of Labor Statistics.

interest rates. Accelerating inflation led to more uncertainties and
risks in financial markets as well
as to distortions in savings and
investment. These distortions
eroded the stock of productive capital, lowered worker productivity,
and contributed to even higher unemployment rates. Although there
are certainly many who would disagree, economists increasingly
have come to realize that the central
bank can do little to promote full
employment except provide an economic environment that includes a
sound financial system and a stable
price level.
Suppose we were to accept
the objective of price stability as
the principal goal of the central
bank. What would this mean for
monetary policy? We are now in
the midst of, or perhaps half way
through, a program to end inflation
by gradually slowing the growth
of money and credit. When this
program began, it was informally
defined as a policy to red uce the

annual growth targets for the
money supply gradually each year
until inflation was eliminated.
Because there are times when our
daily open market operations do
not conform to our inflation objective, the Federal Reserve needs
intermediate targets that allow it
to react correctly to unfolding
events and incoming information.
Perhaps at this time, when so
many are calling for an end to
monetary targeting, it might be
worthwhile to review the reasons
why the Federal Reserve has
chosen to pursue intermediate
targets on an annual basis.
Choosing a Target
At first, it may seem more appropriate for the central bank to react
to incoming information about
prices-if, after all, our objective
is stable prices. But the objective is
to achieve stable prices, or zero
inflation, over several years. The
central bank has neither the ability
nor the desire to prevent shortrun fluctuations in the price
indexes-fluctuations
that result
from myriad adjustments in supply
and demand in many different
sectors of the economy. If there
were no inflationary bias in monetary growth, then all the shocks to
aggregate demand and aggregate
supply would cancel out. On the
other hand, the inflationary
impulse from excessive monetary
growth shows up in reported price
indexes only after many quartersperhaps years.
The central bank probably
would contribute to instability in
the economy if it tried to react on a
daily or weekly basis to incoming
information about specific price
indexes. We might go even further
and suggest why policymakers
should not react to price movements on a quarterly basis. There
is cyclical movement of prices
around the secular trend. Prices

tend to rise least in the early years
of a recovery. It is during this
period, when the momentum of the
economy is upward but before
inflationary expectations begin to
rise, that a disinflation policy
designed to prevent future inflation
would be least disruptive. Prices
tend to rise fastest around the peak
of the business cycle. At that point,
inflation is already entrenched in
the economy, becoming increasingly difficult for the central bank
to control.
Today, if the Federal Reserve
were to react only to incoming
information about price indexes,
it would have little reason to
contain monetary growth. Rather,
the Fed would wait to tighten
monetary policy until the current
recovery was well documented and
prices began to rise. By then, however, inflationary expectations
might become embedded in labor
contracts and investment decisions. Tightening monetary policy
at that point would tend to cause
hardships as firms and individuals
would be forced to revise their
expectations and their contracts.
Another policy approach currently getting much attention is
for the Federal Reserve to target
nominal GNP. This choice has an
advantage over a price target in
that the lags from monetary policy
to GNP are shorter than those to
prices. However, the time horizon
over which the Federal Reserve
may expect to control nominal GNP
is highly variable and still measured in years-not quarters.
Under the Full Employment and
Balanced Growth Act of 1978, the
Federal Reserve is required to operate on an annual reporting cycle. It
is not clear that the potential
benefit derived from switching to
a multi-year planning cycle would

satisfy Congress' and the public's
desire to discuss policy on an
annual basis. Looseness in the
linkage between money and GNp,
together with the existence of the
business cycle, suggests that the
Federal Reserve would have almost
no chance of ever achieving an
annual target for GNP. Again, as
with the case of price indexes,
there are many short-run fluctuations in nominal GNP that are
transitory and need not induce a
change in monetary policy. This
does not mean that the Federal
Reserve should ignore current
information about GNP or prices.
Incoming information that leads us
to change our estimate of the
trends in these variables should be
and has been an important factor
in setting annual monetary targets
and in deciding either to change
those targets or permit deviation
from them.
Targeting the Money Supply
In 1982, our effort to lower the
money targets gradually each year
was set aside. A series of welldocumented events led to a sharp
shift in the linkages between the
money supply and total spending
in the economy. Massive shifts of
funds among the various measures
of the money supply-the
monetary
aggregates-distorted
the growth
of those aggregates, particularly
of M-l. Other factors, such as the
sudden decline in inflation and
improved expectations about the
future cost of holding money relative to other financial assets, also
played a role. The Federal Open
Market Committee agreed to deemphasize the M-1 policy target
and to place more emphasis on the
broader monetary aggregates. As
events since have proven, that
decision did not mean that the
battle against inflation was over.
It was merely an acknowledgment

that events had occurred that
made the preannounced targets
inappropriate-indeed
inconsistent-with
our policy to end
inflation gradually.
In retrospect, we believe that
the surge of M-1 in the first half of
1983 and the subsequent slowdown
resulted from the effects of the
ongoing deregulation of the financial markets and lower inflation
itself. These transition effects
appear to be ending. Barring
further substantial changes in
depository regulations, we expect
the linkage between money and
spending to be restored. This does
not mean that the money supply
would become perfectly predictable,
or even that the relationship
between the monetary aggregates
and nominal GNP would become
any more stable and predictable
than it was in earlier times. Nevertheless, the current dissatisfaction
with the M-1 target probably stems
from M-1's unusually rapid growth
throughout the last recession.
Although we cannot yet be totally
sure, this anomaly most likely
resulted from deregulation and the
decline of inflation expectations.
While we have no guarantee of how
M-1 will behave in the future, the
last three years have shown that
the Federal Reserve can achieve its
disinflation goal using annual
monetary targets, even in the presence of enormous distortions to the
aggregates. This success is predicated on the Federal Reserve's freedom to deviate from its targets
when appropriate. An analysis of
the last four years shows that the
Federal Reserve did not achieve its
original monetary targets; yet, in
each of those four years, the deviations from target can be most accurately interpreted as reflecting
offsetting deviations in the velocity
of money from trend (see chart 2).

1M-I

Percent
6

growth
Velocity growth

4
2

o
-2
-4
-6
-8
1980

1981

1982

1983

SOURCE: Derived from Federal Reserve data.

The progress that we have
made in reducing inflation in the
past three years has increased the
credibility of the Federal Reserve
System. With increased credibility,
we can afford to be more flexible
in implementing our monetary
policy. If we were to abandon the
monetary targets or choose targets
that are inconsistent with disinflation, however, we could quickly
erode that credibility. We need
targets, but we also need wide
ranges for those targets. We need
to move M-1 within the target
ranges to offset unexpected developments in pursuit of the ultimate
goal of zero inflation.
Toward Zero Inflation
The question then arises as to
which plan for monetary targets is
consistent with gradual but steady
progress toward zero inflation. One
plan, which is consistent with the
policy of the last four years, is to