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July 1, 1991

Federal Reserve Bank of Cleveland

Price Stability and
World Economic Recovery
by W. Lee Hoskins

"uring the past decade, we have enjoyed considerable success in reducing
inflation. Despite an unusually long
economic expansion, rates of inflation
did not accelerate much during the
1980s. While this is heartening, I do not
mark our success solely by the numbers;
indeed, inflation remains unacceptably
high. Instead, I find encouragement in
changing attitudes, in both the United
States and Europe, about the proper role
of monetary policy. Policymakers and
academic economists increasingly accept
the view that monetary policy can promote stable economic growth only by
focusing on long-term price stability.
We now stand at an important juncture.
We face a rare opportunity to make further gains against inflation in the 1990s,
but the commitment to this goal, while
growing, remains fragile. With the economy struggling to edge out of recession
and with credit demands looming large
on the economic horizon, some observers are calling for a further easing of
monetary policies. They wrongheadedly
cling to once-fashionable illusions that
nations can fine-tune economic activity
and that the costs of achieving price
stability are prohibitively high. To cloak
these ideas in modern garb, they now
stress the global nature of world markets
and call for a coordinated worldwide
easing of monetary policies.
In the weeks ahead, leaders of the
major industrialized countries will once
again consider the merits of the global
fine-tuners' creed. They must distinguish the role that monetary policy and

ISSN 0428-1276

central banks can truly play from the
role that many wish these forces could
play. My intent in this Economic Commentary is to highlight this important
distinction. Central banks can neither
smooth short-term fluctuations in business conditions nor guarantee an abundance of credit at low interest rates.
Monetary policy, however, can promote long-term investment and stable
growth at the economy's long-run
potential by guaranteeing price stability.
• The Current
Economic Environment
Our efforts to pursue price stability will
confront two challenges, one cyclical
and the other structural. Current business conditions present the most immediate obstacle. Over the past year, the
U.S. economy has experienced a recession. As downturns go, this one has
been relatively mild. We now seem
poised for a recovery, but the upturn
may be modest by historical standards,
at least during the year ahead.
In response to the weakening economic
activity of the past year, monetary policy has been gradually eased. The Federal Reserve Board lowered the discount
rate in three steps from 7 percent in late
1990 to 5.5 percent at present, and the
Federal Open Market Committee
(FOMC) has promoted a reduction in
the federal funds rate. Responding both
to these policy initiatives and to the
sluggish economy, money market rates
in the United States have declined significantly. Capital market rates, as is typ-

The challenges of weak economic activity and heavy credit demands have led
some observers to advocate a coordinated global easing of monetary policies. This economic fine-tuning could
jeopardize our recent gains against
inflation and would damage centralbank credibility. Central banks contribute to long-term economic growth
only by guaranteeing the stable purchasing power of money.

ical, have been much less responsive to
our monetary policy initiatives.
Economic activity among the other
major industrialized countries also has
weakened, but with somewhat greater
variation than we have come to expect.
The United Kingdom and Canada have
experienced relatively sharp economic
declines since the middle of last year.
Other countries, notably France and
Italy, may have only recently begun to
experience declining economic activity.
As in the United States, most of these
countries have eased monetary policies
through reductions in official centralbank lending rates.
Although many expect economic
growth in Germany and Japan to slow,
it recently has remained strong, with
productive capacity at high rates of
utilization. Inflationary pressures, as
reflected in both rising prices and growing wage demands, remain a primary
policy concern, especially in Germany,

where reunification has resulted in a
recent surge in money growth and a
sharper-than-expected rise in the budget
deficit. Not wishing to accommodate
these price pressures, both Germany
and Japan have been reluctant to ease
their monetary policies significantly. In
fact, Germany has increased its official
interest rates this year.
Beyond the immediate cyclical problems lies a structural challenge that
central banks will inevitably face. As
recovery proceeds, demands for credit
will rise. In addition to the normal increases in business investment, credit
demands will reflect an amalgam of unusual circumstances, including capital
necessary to rebuild Eastern Europe,
the Soviet Union, and Kuwait; hefty
governmental borrowing; developingcountry credit needs; and funds to
restructure business. Although many
expect private savings to rise worldwide, the increase is unlikely to satisfy
these credit requirements without a rise
in real interest rates.
Faced with these prospects, many contend that central banks should suspend
their commitment to long-term price
stability. Proponents of this view maintain that faster monetary growth among
the largest industrialized countries
would lower worldwide interest rates,
encourage global investment, and stimulate real economic growth. Should
such a policy later intensify inflationary
pressures, a little ratcheting back on
money growth could then hold inflation
in check, they assert.
Last April and again in June, the British,
Germans, and Japanese, among others,
promptly rebuffed a proposal to undertake a coordinated expansion of their
monetary policies. Many reports cited
inflationary pressures in some countries
as the primary cause of the rejection. Although this undoubtedly is partially true,
it is not a full explanation. The European
response fundamentally reflects these
countries' changing attitudes about monetary policy. Whereas proponents of
fine-tuning espouse a monetary policy
to foster "low inflationary growth," the
Europeans seek a monetary policy con-

sistent with "noninflationary growth."
The differences envisioned by the two
sides are substantially greater than
these adjectives suggest.

observers, monetary policy cannot finetune the business cycle, and it cannot
increase the real supply of savings
available for investment.

• Price Stability and the
Role of Central Banks
Economic policy should strive to maximize the standard of living. This is best
accomplished in competitive markets
that encourage private initiative and that
clearly define the role of government. A
properly functioning price mechanism
is central to such a system, because it
relays vital information about relative
scarcities across all markets, thereby ensuring allocative efficiency. The recent
experiences of Eastern Europe and the
Soviet Union dramatically illustrate the
plight of economies that do not allocate
resources through price systems.

• Monetary Policy and Fine-Tuning
The belief that global monetary-policy
coordination can fine-tune the world
economy rests on assumptions and conditions that either do not hold in actuality or that central banks cannot successfully exploit. It assumes, for example,
that monetary policy has a stable relationship with real economic growth over
all phases of the business cycle. This
simply is not the case. Economists continue to debate the relative importance
of the various channels through which
monetary policy might affect real economic activity and prices. The mechanisms are even more complicated when
one affords proper consideration to international interactions. The greatest
disagreements among competing large
econometric models typically center on
the global interactions of monetary

In market economies, the province of
central banks is to ensure the allocative
efficiency of the price mechanism by
guaranteeing the purchasing power of
money. To do so, central banks must
focus monetary policy on long-term
price stability, and gain credibility
either through a statutory mandate for
this objective or through a steadfast
focus on the goal. Deviations from
price stability erode central-bank
credibility and impede the efficacy of
the price mechanism. Inflation, even if
fully anticipated, transfers wealth from
the private sector to the government
sector via taxes on inflated values of
nominal wealth. Individuals will
naturally attempt to protect their real
wealth from higher taxes and the uncertainty associated with price instability.
Such attempts direct resources away
from more productive uses, especially
those that require risky, long-term investments. Empirical studies indicate
that countries with high, variable inflation rates typically experience slower
real economic growth than countries
with lower, more stable inflation rates.
As this discussion illustrates, monetary
policy can influence real growth and investment by creating a stable environment that encourages individuals to
make long-term economic commitments. Despite the contentions of many

In addition, monetary fine-tuning requires that central banks have an accurate economic forecast, particularly
for the period before monetary policies
influence economic activity and prices.
Forecasts of real economic activity
have often proved inaccurate, with the
result that ill-timed policies can actually
accentuate the business-cycle fluctuations they sought to moderate.
The Bonn Summit of 1978 provides a
good example of this problem, one that
recent advocates of coordinated monetary expansions might well consider. At
that meeting, the major developed countries agreed to a joint expansion of their
fiscal policies. The primary objective
was to stimulate real economic growth
and to reduce unemployment throughout
the industrialized countries. Inflation
was already high in many countries, but
trading off a little more inflation for
lower unemployment seemed a good
bargain. Unfortunately, policymakers
misjudged the world's ability to absorb
additional workers and incorrectly interpreted the inflationary pressures in
world markets. These forecast errors,

together with an unforeseen rise in oil
prices, swiftly translated the stimulus
package into a rapidly accelerating inflation. In the United States, for example, the inflation rate doubled from
approximately 6 percent in 1978 to
12 percent by 1980.
Perhaps most important, calls for finetuning economic activity assume that
central banks can consistently surprise
individuals about the nature of price
changes. Monetary policy can affect
real output and employment only when
prices do not adjust rapidly. Even if we
allow that prices are at times slow to
adjust, individuals will eventually
recognize attempts to exploit the situation—to trade higher inflation for additional growth—as a breach in the central bank's commitment to long-term
price stability. They will come to anticipate future inflation and will make
appropriate adjustments in their pricing
policies and investment decisions,
thereby misallocating resources.

• Monetary Policy,
Saving, and Investment
Besides being unable to fine-tune economic activity, monetary policy can
neither directly alter world credit supplies nor set interest rates that will
balance credit demands and supplies.
Savings depend on the willingness of
individuals to forgo current consumption for future consumption. Investment depends on the expected real
returns on capital. When savings and
investment decisions do not balance,
economic variables adjust to bring
them in line. Long-term real interest
rates play a central role in the process.
Given the expectations of large demands
for credit over the next five years, high
real interest rates may be necessary to
encourage saving and to discourage the
least-economical investments.
Those who believe faster money growth
lowers interest rates and provides additional resources for investment fail to
distinguish between nominal and real
economic variables. While monetary
policy can influence the former, it can
affect the latter only to the extent that it
creates confusion and uncertainty about

future expected inflation. As I have indicated, the market becomes adept at
forecasting inflation. The consequence
has been that nominal long-term interest rates often increase as a result of
monetary easing, while real interest
rates show little long-term trend. Monetary policy does not afford central
banks a channel through which they
can systematically influence decisions
about savings and capital accumulation.
• Should We Coordinate?
Many economists and policymakers argue that, in an increasingly interdependent world, central banks of the major
industrialized countries must coordinate
their monetary policies. Certain types
of international cooperation are indeed
beneficial to policymaking and to the
smooth functioning of markets. Empirical studies suggest, however, that most
of the benefits from international policy
coordination derive from the sharing
of information, not from the joint determination of policy instruments.
I have advocated, therefore, that countries adopt independent price-level targets based on their individual preferences for inflation. Nations might then
cooperate in the sense of providing
timely information about these pricelevel targets and about the nature of
any underlying economic disturbances.
Exchange markets would continue to
function freely, with exchange rates between currencies adjusting to individual
countries' preferences for inflation. Exchange rate depreciation in response to
trade and capital flows might exert its
own discipline in countries with inflationary biases, forcing an international
• Price Stability: The Progress
to Date, the Distance to Travel
Over the past few years, we have witnessed growing support for the objective
of focusing monetary policy solely on
long-term price stability. The performance of inflation in the United States
over the last business cycle reflects this
support. Throughout one of the longest
business expansions on record, inflation
held fairly steady in a 4 to 5 percent
range." Looking back over the 1970s,

one would not have predicted such an
outcome. Inflation accelerated dramatically over each business cycle, reaching
successively higher peaks and troughs.
Our improved inflation performance
reflects a changed pattern of money
growth over the business cycle. During
the 1970s, money growth (M2) rose dramatically when business activity weakened and grew rapidly through most of
the subsequent recovery periods. When
inflation accelerated sharply, and policy
objectives abruptly shifted focus, money
growth decelerated with equal drama.
Over the business expansion of the
1980s, we surely saw fluctuations in
money growth, but overall the Federal
Reserve managed to slow trend money
growth as the economy expanded.
Since the most recent recession began
in mid-1990, policymakers have not undertaken an excessive monetary expansion. In fact, moderate money growth
has helped to restrain price pressures,
unlike the early stages of both recoveries in the 1970s, when rapid money
growth caused inflation to surge. By
avoiding this past cyclical pattern, the
System has recouped much of the credibility that it lost in the 1970s. If we continue to moderate money growth as the
economy strengthens, inflation should
continue to slow.
Most other industrialized countries,
notably Germany, Japan, France, and
Canada, have also avoided an acceleration of inflation during the recent business recovery. Many have linked their
currency values with the German mark
through the European Monetary System
(EMS) to ensure greater monetary discipline and to gain credibility in their
pursuit of price stability. A big surprise
to many analysts has been the willingness of European participants in the
EMS to avoid currency realignments.
This has often come at the expense of
monetary policy independence. Moreover, those currency realignments that
did occur intentionally did not fully restore competitiveness. This has afforded
a further discipline against inflation.

Nevertheless, progress has been slow,
and we are still a long way from our
goal of price stability. Inflation rates as
high as 4 or 5 percent can still have important resource implications through
their interactions with the tax structure.
We have come to a critical juncture.
Our price performance to date provides
us with a unique opportunity for making further gains, but the closer we
come to approaching the objective, the
more difficult it becomes to make these
gains. As I have suggested, many
policymakers in the United States and
throughout the world maintain that the
adjustment costs of reducing inflation
further are simply too great. How, then,
do we proceed?
• Monetary Policy in
the Current Environment
The United States should reaffirm its
commitment to price stability over the
long run. To increase its credibility,
Congress should mandate this objective
as the overriding priority of the Federal
Reserve System. Germany, which has
consistently enjoyed a rate of inflation
below that of other industrialized countries, follows this approach. As mandated in the Deutsche Bundesbank Act,
the primary function of the German central bank is to "safeguard the currency,"
that is, to guarantee the stable purchasing power of the German mark.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
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We must also avoid an acceleration of
inflation as the recovery proceeds. The
System should continue to lower the
midpoint of its M2 target range and to
keep money growth well inside its
boundaries. Although the System uses
the federal funds rate as an indicator of
the direction of monetary policy, it is
important, particularly in light of growing capital needs, that monetary policy
not focus on interest rates, but continue
to concentrate on price stability. With
credit demands looming heavy, interest
rates are likely to remain high from a
historic perspective.
If the Federal Reserve fails to prevent a
further acceleration of inflation at this
juncture, the immediate, measurable
costs will be in terms of higher inflation, but the immeasurable and lasting
costs will be in terms of lost credibility.
Credibility is often slow and difficult to
build, but is quickly destroyed.
• Conclusion
Monetary policy can influence real
economic growth, but it does so only
indirectly, to the extent that it protects
the purchasing power of money and
fosters a stable environment in which
individuals can make long-term commitments. Those who advocate finetuning believe that central banks can
buy faster short-term economic growth

with higher inflation. The long-run
terms of trade, as the past has shown,
are much more costly. Any cyclical advantages that we might possibly gain
from monetary fine-tuning surely will
come at the expense of long-term
growth, economic stability, and centralbank credibility. Instead, I support
"noninflationary growth."


1. See, for example, David E. Lebow, John
M. Roberts, and David J. Stockton, "Economic Performance under Price Stability,"
unpublished manuscript, Board of Governors of the Federal Reserve System, December 1990; and Laurence Ball and Stephen G.
Cecchetti, "Inflation and Uncertainty at Long
and Short Horizons," Brookings Papers on
Economic Activity, vol. 1 (1990), pp. 215^-5.
2. See Owen F. Humpage, "A Hitchhiker's
Guide to International Macroeconomic
Policy Coordination," Federal Reserve Bank
of Cleveland, Economic Review, vol. 26, no.
1 (1990 Quarter 1), pp. 2-14.
3. Unless otherwise stated, I measure inflation by the Consumer Price Index less food
and energy.

W. Lee Hoskins is president of the Federal
Reserve Bank of Cleveland. The material in
this Economic Commentary is based on a
speech he presented in Dayton, Ohio, on
June 12,1991.

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