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December 1, 1992

eCONOMIC
GOMMeNTORY
Federal Reserve Bank of Cleveland

Skepticism about the Direction of
Inflation: Causes, Costs, and Cures
by Jerry L. Jordan

'umper stickers sometimes convey
important ideas. In the 1980s, a familiar
one on America's highways read
"VISUALIZE WORLD PEACE." The
underlying idea was that visualizing
helps people behave in ways that tend to
bring the vision to reality.
In the 1990s, I would like to see a
bumper sticker that says "VISUALIZE
PRICE STABILITY." If everyone
today acted on the belief that the
dollar's purchasing power would
remain constant, households and businesses would make decisions quite differently, with overwhelmingly beneficial effects for the economy. But many
Americans are skeptical about the
government's ability — as well as its
resolve — to keep the price level
stable, and this skepticism is hampering the nation's economic performance.
• The Current Situation
During the 1992 presidential campaign, the performance of the economy
was the No. 1 issue. With the election
over and a new administration soon to
be in place, White House efforts to
foster more rapid economic growth
than seen in the last few years will undoubtedly receive top priority.
A number of factors, including the glut
of commercial office space, the reduction in national defense spending, and
the adaptation of business practices to
information processing technology,
have certainly contributed to the
economy's sluggishness. Adjusting to

ISSN 0428-1276

such fundamental changes will require
time, patience, and an economic environment in which households and
firms can make sensible long-run
decisions about consumption, savings,
and investment.
Inflation currently is low, but unfortunately, the public does not expect that
to be the case in the years ahead. This
skepticism is evidenced by the disparity between what people see and
what they foresee. Over the last several
years, inflation has been trending down
(now hovering around 3 percent), and
there is evidence that it is likely to stay
low for the next year or two. Furthermore, the avowed intent of the Federal
Reserve's key policymaking body, the
Federal Open Market Committee
(FOMC), is to keep a tight rein on
prices. Domestic policy directives issued by the FOMC in recent years all
state that the Committee seeks monetary and financial conditions that will
foster price stability.
Nevertheless, the public continues to
expect inflation to heat up. Long-term
interest rates have remained stubbornly
high — the yield curve is the steepest
in history — and people seem to
believe that when the curve flattens, it
will be the result of short rates rising
rather than long rates falling. Surveys
show that consumers are anticipating
inflation of about 4 percent over the
next 12 months and 5 percent on
average over the next five to ten years.
The consensus Blue Chip forecast is

Even though the Federal Reserve has
been successful in keeping inflation in
check over the last several years, and
despite its avowal to continue targeting
price-level stability as its top priority,
most Americans are still making financial decisions conditioned on the belief
that inflation is likely to be higher in the
future than it is today. Here, Cleveland
Federal Reserve Bank President Jerry
L. Jordan discusses the reasons for this
public skepticism about price stability,
the real economic costs entailed, and
the ways in which Congress, the Federal
Reserve, and the new administration
can help.

for the 30-year Treasury bond rate to
hit 7.5 percent next year and 7.7 percent in 1997. Such rates would be extremely high in a stable price environment. Furthermore, consumers have
been refinancing their mortgages and
corporations have been borrowing longterm money in record volumes at fixed
interest rates that are quite high, unless
one believes inflation will once again
reach the 4 to 5 percent range.

It has also been argued (again, I think,
incorrectly) that a little inflation is
good for the economy. Indeed, several
recent articles in Business Week, The
New York Times, and Investors Business Daily draw on both this belief and
the unemployment/inflation trade-off
argument to suggest that the Federal
Reserve should again forsake price stability in order to get the economy moving at a faster pace in the near term.

Such behavior by millions of Americans
reflects a general skepticism about the
prospects for achieving and maintaining
price stability. In view of what caused the
skepticism, it may be justified, but the
result entails substantial real economic
costs. Fortunately, cures are available for
the Federal Reserve, the Administration,
and the Congress to pursue.

Unfortunately, the timing of the Fed's actions over the past two years has falsely
led some observers to conclude that the
central bank is already targeting real
growth at the expense of inflation. By cutting interest rates immediately following
reports of a weak labor market on numerous occasions, the Federal Reserve has
fostered the impression that its primary
concern is near-term employment growth,
not price stability. This interpretation is
incorrect. In fact, policymakers know that
the only sustainable pro-growth monetary
policy is one that achieves and maintains
price stability. Federal Reserve policy
during the past decade has been based on
recognition of this tenet.

• The Causes of Skepticism
There are several reasons why Americans are so skeptical about the future
course of inflation and monetary
policy. Once one has lived through a
period of ever-rising prices, it is not unreasonable to question policymakers'
determination to avoid a repeat. The
Federal Reserve lost much of its credibility as a champion of price stability
when it allowed inflation to accelerate
out of control in the 1970s. Although it
regained some ground in the early
1980s, assertions of a price stability
goal again began to ring hollow as inflation was allowed to remain in the 4
to 5 percent range throughout most of
the decade. At 5 percent inflation, the
price level doubles in about 15 years.
Another factor contributing to the prevailing skepticism is that many people
believe (incorrectly, in my view) that a
long-run trade-off exists between unemployment and inflation. As they see it,
monetary policymakers will choose — or
be forced to adopt — an inflationary policy aimed at reducing the jobless rate.

Another reason for Americans' skepticism is the lack of support for price
stability from Congress and the Bush
Administration. Congress was unreceptive to the proposed Neal Resolution
mandating price-level stability as the
Federal Reserve's primary responsibility, while the Administration did little
to promote either that goal or Federal
Reserve System independence. Indeed,
Treasury Secretary Brady frequently
criticized the Fed for keeping the reins
of policy too tight.
Finally, despite the huge budget deficit,
neither the Administration nor Congress has demonstrated the political
will necessary to constrain the growth
of government spending. This failure is
important in light of the widespread
belief that, in the long run in a democractic society, the same political forces

that produced the fiscal deficits will ultimately force the Federal Reserve to
monetize the government's debt, resulting in inflation. To the extent that financial market participants believe in this
long-run "fiscal dominance" theory,
large budget deficits will prevent longterm interest rates from falling.
Skepticism about the outlook for price
stability is a reasonable response to
past experience. In the post-World War
II period, inflation has fallen during
recessions or periods of slow growth,
only to accelerate to even higher levels
as subsequent expansions have gained
momentum. Such experience apparently has caused many people to believe
that growth per se causes inflation,
while in fact it is inflation that necessitates the policies that bring growth to
a temporary halt.
• The Costs of Skepticism
The economy pays dearly for Americans' skepticism about Washington's
willingness to hold the line on inflation. Since taxes are based on nominal
rather than real income, long-term investment is discouraged: High expected
inflation means high effective taxes on
real capital income. Long-term investment is also reduced as managers, incorporating an inflation risk premium
into their bottom-line calculations, establish higher hurdle rates for proposed
projects. The result is that shorter-lived,
"quick payback" projects are favored
over long-lived additions to the nation's
capital stock.
What's more, many projects that would
be viable in a low-inflation environment are not undertaken at all. Among
other things, reduced investment slows
the structural adjustments necessary to
foster economic growth, such as the
conversion of defense industry plants
and workers to peacetime pursuits.

Expectations of higher inflation also
cause valuable resources to be expended in designing, marketing, and
seeking out financial instruments to
serve as inflation hedges. In addition,
some physical assets are used to protect
against inflation, leading to overinvestment in such things as inventories and
houses, at the expense of investment in
other physical assets that would be
more productive for the economy.
Expecting inflation to be higher than
what actually occurs can result in
nominal wages and other contractual
costs rising faster than business revenues, in turn lowering profits and
prompting managers to slash costs by
cutting payrolls. That is, if inflation
turns out to be lower than was anticipated when wage contracts were signed
and other costs were agreed to, companies will end up paying more than
they bargained for in real terms. This
puts pressure on managers to pare their
work forces and to reduce other production costs.
Finally, when borrowers and lenders act
on the belief that inflation will be higher
than what emerges, ex post real interest
rates rise and wealth is transferred from
debtors to creditors. For businesses, the
higher real debt-servicing burden (and
lower profits) increases the probability of
default, dampens credit demand, and reduces confidence about the future. For
households, the same debt-servicing burden cuts into the amount of discretionary
income available for consumption spending. It is unlikely that the prosperitylowering responses of businesses and
households to their losses will be fully
offset by creditors' responses to their
windfall gains.

• The Possible Cures for Skepticism
There are several actions that the
Federal Reserve, the Clinton Administration, and the new Congress could
take to instill confidence in the future
course of inflation and monetary policy.
The United States could adopt a specific multiyear target for the price level
that reflects a gradual slowing and then
a cessation of inflation. The credibility
of such a program would be enhanced
by placing monetary policy actions
firmly within a longer-term perspective
pointed exclusively at achieving price
stability. Obviously, such a program requires judgment, but it is important that
judgment be exercised in the context of
the longer-term price stability objective.

fully explain any tactical changes in
policy implementation necessary to
keep policy consistent with the pricelevel objective. To some extent, this is
now being done in February and July
of each year, when target ranges for certain monetary aggregates are set and
are announced to Congress by the Federal Reserve Board Chairman in his
mandatory Humphrey-Hawkins testimony. However, that process does not
include a specific timetable for achieving price-level stability, nor does it require specification and explanation of
FOMC actions, judgments, and responses when monetary policy actions
do not appear to be consistent with the
longer-term goal of price stability.

Monitoring the growth rates of monetary aggregates that have a long history
of consistency with movements of the
price level would be an important part
of such a program. As policymakers,
we know that producing money faster
than people want to add to their money
balances creates an excess supply that
results in a rising price level. But from
time to time, as in the past few years,
these relationships may be disturbed
temporarily. On such occasions, the
necessary monetary policy judgments
and adjustments should be made within
the longer-term framework. Doing so
would be reassuring to financial market
participants who closely monitor
central bank actions.

There are several important contributions the new administration could
make as well. First, it could declare its
support for price-level stability and
then endorse the schedule adopted to
reach that goal. Publicly supporting
the Neal Resolution would be a clear
sign of the executive branch's intent.

The Fed could also improve the timing
of its actions. By associating policy
actions with the monetary aggregates
instead of with labor market data, monetary authorities would avoid the implication that they are shifting their focus
away from inflation and toward the attainment of some particular employment or output level that they cannot
systematically control anyway.
The Federal Reserve's credibility would
also be enhanced — and skepticism reduced — if it were to announce a target
path for the price level and then clearly
articulate to the public its plans for
achieving that goal. In addition, until the
central bank's credibility is secure, it
would also be helpful to promptly and

Second, to demonstrate its conviction,
the White House could use the Federal
Reserve's targeted price-level objectives (inflation rates) in its own budget
calculations. By law, the Administration
is required to project expenditures and
receipts for five years, based on inflation and other assumptions. Avoiding
the use of inflation forecasts that are
higher than targeted by the Fed would
add credibility to such objectives.
And finally, it is critically important
that the Administration work with Congress to keep the growth of government
spending in line with that of tax revenues so that budget policy will not
appear to be on a collision course with
monetary policy. The public always
worries that politicians will resort to an
unlegislated inflation tax when current
expenditures are not covered by explicit taxes.

Congress likewise has a role to play in
allaying inflation fears. First and foremost, it must work with the Administration to get federal finances under control. Second, legislators should resurrect
and pass the Neal Resolution. And
third, the Fed should be held accountable for achieving its targeted pricelevel trajectory.
By helping to reduce long-run inflation
expectations, these steps by the Fed,
Congress, and the Administration
would immediately reduce long-term
nominal interest rates. This in turn
would raise investment, thus speeding
economic expansion in the short term
and contributing to long-run growth.
• Conclusion
At current rates of inflation and
monetary growth, the adjustments that
would be required to achieve price
stability are quite small. There is no
time like the present to consolidate
hard-earned gains.

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

Address Correction Requested:
Please send corrected mailing label to
the above address.

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

In principle, the Federal Reserve can
achieve price stability regardless of the
fiscal policies hammered out on Capitol
Hill. But it is by no means certain that
a government permanently wedded to
massive budget deficits will refrain
from trying to change the Federal Reserve Act in ways that would force the
central bank to assist in financing
Washington's fiscal follies. Governments are always tempted to use
monetary policy to achieve short-run
employment objectives, believing that
any inflation by-product can be dealt
with at some later date.

This Economic Commentary is based on a
speech presented by President Jordan to the
Association of Bank Holding Companies in
Tucson, Arizona, on November 5,1992.

Instead of relying on luck, as some administrations have, the Clinton White
House should take a lesson from history. Tolerance of inflation creates
costs and complications. When the
pressure to try a little inflation builds,
as surely it will, we would all be wise
to remember a popular bumper sticker
of several years ago: JUST SAY NO.

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