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January 15, 1992

Federal Reserve Bank of Cleveland

Uncertain Inflation
and Price-Level Rules
by Jeffrey J. Hallman


Nearly all economists believe that the
sole cause of long-run inflation is excessive money growth. In analyzing the
economy, it has long been standard practice to employ models in which only unexpected variations in the quantity of
money affect real activities and decisions, while anticipated variations affect only the price level. This property is
known as neutrality.' If inflation comes
from money, and money is neutral, there
may be little to gain by pursuing policies
that reduce inflation.
On the other hand, the depth of the recession in the early 1980s reaffirmed the
widely held belief that lowering inflation
is quite costly in terms of reduced output
and increased social distress. The inflation rate has been close to 4 percent for
several years now. If this is what the
public expects, why make any effort to
reduce inflation further?
There are at least two ways to answer
this. One is to deny that anticipated inflation is costless. The public finance
approach points out the inefficiencies
that result from both depreciation inflicted on money holders and the interaction of inflation with the tax code.
Measurements of these inefficiencies
range from fairly simple money-demand
calculations ("shoe-leather" costs) to
more elaborate models incorporating
such rigidities as bracket creep and the
taxation of nominal capital gains. Some
recent estimates of money-demand
costs range from 3 to 29 percent of one
year's GNP, while costs stemming

ISSN 0428-1276

from our unindexed tax code may reach
3 to 5 percent of output per year.2
This article presents a second rebuttal to
the "leave well enough alone" argument. To the extent that anticipated inflation is costless, it is also costless to
eliminate. Reducing inflation has not
been costless in the past, because the
price level under the existing monetary
regime has been highly unpredictable.
While the inflation costs derived from
the public finance perspective generally
depend on the rate of inflation, the present system imposes additional costs due
to the unpredictability of future prices.
This uncertainty could be largely eliminated and macroeconomic performance
improved by requiring the central bank
to announce a long-run target path for
the price level and to take actions as
necessary to keep actual prices on course.
• Leijonhufvud's Blueback Scheme
In what sort of world would inflation
be both predictable and neutral? Imagine an economy in which the inflation
rate has hovered around 4 percent per
year for a long time. The central bank
is required, as a matter of law, to do
whatever is necessary to maintain that
rate forever. For all practical purposes,
there is no price-level uncertainty. Inflation always was, is now, and forever
shall be 4 percent. Furthermore, the tax
code and all contracts are fully indexed, and the entire population is
highly proficient at multiplying and
dividing by powers of 1.04. Although
some of these conditions sound a bit

Some of the adverse effects of inflation
stem from the long-run unpredictability of the price level engendered by
our current monetary policy process.
Merely bringing inflation down to an
"acceptable" level will not eliminate
these costs. One simple way to reduce
both inflation and the uncertainty associated with it would be for the Federal
Reserve to target a long-run path for
the price level, to announce this goal
publicly, and to take whatever steps are
required to ensure that actual prices
remain on course.

silly, they are all needed to ensure that
inflation is truly neutral.
Now suppose that, for whatever reason,
the denizens of this economy decide
they want an inflation rate of zero. The
central bank is directed to pursue this
goal as assiduously as it previously
strove to maintain 4 percent. How
should the bank react?
It may elect to cut the monetary growth
rate by 4 percent, thus creating money
at a rate consistent with no inflation.
Even if the central bank is fully credible
and the reduction is phased in gradually,
however, the disinflation will create
problems. People who borrowed money
under the old regime will see a 4 percent increase in the effective rate of interest on their old contracts. They may
default as a result. Also in distress will
be employers who previously agreed to
muln'year labor contracts calling for annual 4 percent wage increases. Some
workers will have to be let go. Throughout the economy, expectations will be
upset and resources redirected; a recession of several quarters' duration may
ensue. Eventually, the economy will adjust to the new inflation rate and grow as
before, but the transition will be costly.
There is no need for all this pain. Axel
Leijonhufvud has described a scheme that
can eliminate inflation with no transition
costs at all. The central bank creates a
new currency, the blueback, to circulate
alongside the existing currency, known as
greenbacks. The bank has absolute control over the blueback-greenback exchange rate by virtue of its willingness to
trade unlimited quantities of one for the
other. It uses this control to appreciate the
blueback against the greenback continuously at a 4 percent annual rate. Since the
inflation rate in greenbacks is 4 percent,
inflation in terms of bluebacks is zero.
The courts cooperate by interpreting dollar amounts as referring to greenbacks in
existing contracts and to bluebacks in new
contracts, so people continue to receive the
real value they bargained for. Eventually,
the greater convenience and lower opportunity costs of dealing in bluebacks result

in the withering away of greenbacks.
Unlike the first disinflation scenario,
however, the transition is costless.
It may be argued that a blueback scheme
could not be implemented so easily in a
complex, real-world economy like our
own. Indeed it could not, but the reasons
why are grounds for doubting that our
current 4 percent inflation is costless. We
have not indexed contracts, the tax code,
or the legal system. And, most important,
the constraints on monetary policy that
would be needed to give people confidence in a stable inflation rate have not
been implemented.
• Peppermint Patty
Price Prognostication
The monetary policy process we actually
have makes it virtually impossible to predict the price level several years hence.
Leijonhufvud makes this point with a
mischievous metaphor:
In a memorable Peanuts cartoon of quite
some years ago, Peppermint Patty was
shown in school struggling with a truefalse examination. Her efforts to divine
the malicious intent of capricious authority went something like this: "Let's
see, last time he had the first one False,
so this time it should be True." "He
wouldn't have just one False, after a
single true, so False, False." "Ok, now
we've got True, False, False, True,...."
"Looks reasonable so far," she says with
a contented smile.
If this sounds vaguely familiar, it may be
because you read the business and financial pages. "This quarter should be Go,
because they want interest rates down
before the election." "Next quarter will
be Stop again, though, because otherwise
we risk a revival of inflationary psychology." "Quarter after that is probably Stop
too, but then it is bound to be Go because something will have to be done
about unemployment." "So, now we've
got Go, Stop, Stop, Go." "Looks reasonable so far."
But not much further. It is possible sometimes to muster considerable confidence
in Peppermint Patty divination for the
first few steps into the future. But a few
more steps and it falters and then disappears altogether. You cannot build up a
firm expectation of the price level three
years hence this way.

... The price level 10 years into the future
is a subject for joking, not for rational
discussion. Yet, of course, in an economy
such as ours people are forced to bet on
it all the time.4

To get a feel for how unpredictable the
price level has been, try the following
experiment. Using a sheet of paper,
cover everything in figure 1 to the right
of the vertical line at 1920, so that only
the data from 1913 to 1920 are visible.
Based on this information, guess where
the price level will be 10 years later
and mark it on the figure. Repeat this
for each decade. Believe it or not, your
decade-ahead forecasts are probably
very similar to the ones made by professional forecasters operating in real
time. When it comes to long-range economic forecasts, it's hard to beat simple
trend extrapolation.
To help assess how far you were off,
figure 1 also contains horizontal lines
spaced 25 percent apart. Thus, if one of
your guesses missed by the space of
two lines (as my forecast of the 1980
price level did), it was off by 56 percent (1.25 x 1.25 = 1.5625). When I
tried this experiment, only once (in
forecasting the 1940 price level) did I
err by less than 25 percent. My average
error appears to be about 40 percent.
• The Costs of
Price-Level Uncertainty
It is widely believed that uncertainty
about the future path of prices adversely affects the economy, although there
is no consensus on the extent of the
harm. Arguments about the detrimental
effects are handicapped by the lack of a
direct measure of how unsure the public
really is. Indirect indicators have been
derived from surveys that ask people to
forecast inflation over the coming year,
but to the extent that longer-run uncertainty is also important, studies using
these measures may be expected to understate the impact of price-level unpredictability.
Despite this and other limitations, investigators have found substantial initial effects on employment and output
that are partially offset over time. For


Finally, price-level uncertainty is a contributing factor to the growth of government. As Leijonhufvud explains:


Log scale

In [this] environment, the real outcome of



private contractual agreements becomes
more uncertain. Contracting becomes a
less effective, less reliable method for
reducing the risks particularly of longterm ventures to manageable proportions.
When contracting increasingly fails, political lobbying becomes a substitute strategy
for many groups.... Monetary mismanagement will bring in its wake efforts by all
sorts of groups to obtain by public compulsion what private cooperation failed to
















NOTE: The distance between two dotted horizontal lines represents a 25 percent change in the price level.
SOURCES: Board of Governors of the Federal Reserve System; and U.S. Department of Commerce, Bureau
of Economic Analysis.

example, the average level of inflation
uncertainty approximately doubled
over the 1973-83 period from the level
prevailing in 1961-72. A permanent
change of this magnitude is estimated to
increase the unemployment rate by 2 to
3 percent during the first five years, but
by only VA to 1 VA percent after 20 years
have passed.

taxation, first as corporate income, then
as dividend income or capital gains.
Given these alternatives, some otherwise worthwhile projects—perhaps
many—will not be undertaken. Further
difficulties will result from the fact that
many of the projects that are pursued
will have been based on incorrect pricelevel predictions.

Investment may be a primary channel
through which inflation uncertainty
harms the economy. Imagine that you
are considering a million-dollar investment in a new plant, technology, or research effort whose major benefits will
not be felt for 10 years. You may borrow the million for 10 years, but the experiment above shows that this is a
risky proposition. The best guesses of
borrowers and lenders about the real
value of the loan principal a decade
later may be off by 40 percent or more.
The lender can demand a higher interest rate to cover his risk, but this does
nothing to cover your exposure. Instead, you are left with price-level risk
and a higher cost of capital to boot.
These risks can be avoided if the investment is financed by incorporating and
selling equity in the project, but then
any profits will be subject to double

The effects of inflation uncertainty on
investment are only part of the story.
The mix of goods and services the economy produces can also be affected. It
may be impossible to measure how many
resources are devoted to protecting individuals and businesses against unexpected price-level changes. What is clear
is that such hedging can become more
important to firms' survival than other
managerial skills. This increases the
demand for the specialized financial skills
of lawyers, accountants, and economists,
and leads some bright young people to
make careers in these professions rather
than in engineering or production management. Inflation hedging is a diversion
of valuable human resources that would
be unnecessary if long-run inflation were
highly predictable.

The miserable economic performances of
the former Soviet Union and the Eastern
European states are clear demonstrations
of the futility of replacing market mechanisms with political ones.
Though the costs of inflation uncertainty
are hard, perhaps impossible, to measure,
that does not make them any less real.
• Inflation Uncertainty
and Price-Level Targets
Besides demonstrating the magnitude
of price-level uncertainty, the forecasting experiment above also shows that
erratic inflation is not new. This fact,
coupled with the costs of unpredictable
inflation, raises the question of why we
have so much uncertainty. The length
of the record suggests that the instability is due less to the individuals who
have filled Federal Reserve policymaking positions than to the process by
which policy is made. This view holds
that unstable prices are endemic to the
current regime due to the lack of appropriate constraints on monetary policy.
The notion that imposing constraints on
policymakers enables them to achieve
superior outcomes may seem counterintuitive; it is most easily understood by
way of example. Consider the classic
case of a flood control agency that warns
people not to build houses in a floodplain, though it lacks the legal authority to keep them from doing so. The
best outcome for society is that houses are
built on high ground. But suppose people
do build in the low-lying area. Once

houses are in place, preventing floods is
less costly than cleaning up afterward.
Now, the agency will find it optimal to
undertake the costly flood control measures necessary to protect the homeowners.
Realizing that the agency will have to protect them, people ignore the warnings and
build in the floodplain.
Under current arrangements, the Federal Open Market Committee (FOMC)
often finds itself in a position similar to
that of the flood control agency. The
Committee meets approximately every
six weeks. At any meeting, it can modify or reverse decisions made at previous sessions. For instance, suppose
that in January of a particular year the
FOMC sets its policy instruments in a
manner it believes will yield 3 percent
inflation over the coming year. Between January and July, events unfold
in an unexpectedly inflationary manner, so that by the time of the July meeting, inflation for the year to date is running at a 5 percent annual rate.
The Committee is faced with a difficult
decision. It can try to achieve the 3 percent goal by drastically tightening policy.
At the other extreme, it can accommodate the shock (the surprise inflation) by
not changing policy at all, in effect deciding to live with 5 percent inflation. The
first course of action is likely to increase
unemployment, at least for a time. The
second option will not only cause inflation to rise, but will also increase uncertainty about the future price level. Balancing these costs, the FOMC is likely to
find that the optimal response is a partial
accommodation. Policy will be tightened
a little, and the Committee will hope for
better luck next year.
This is not the end of the story, however.
If the public has some understanding of
the FOMC's decisionmaking process, it
realizes that the Committee will often
partially accommodate unexpected
changes in the price level. The mere
fact that the central bank can do so results in heightened uncertainty. Because uncertainty already exists, accommodating a particular shock will
not increase it by much. Furthermore,
standard economic theory predicts that

the public's expectation of an accommodative policy will increase the costs
(in terms of unemployment and reduced
output) on those occasions when the
Committee unexpectedly takes a hard
line. In a vicious circle, then, the lessened costs of particular accommodations lead the public to expect more of
them, further lowering their costs, and
so on. The uncertainty is further compounded by the lack of any reliable
method for predicting to what degree
the FOMC will accommodate any
given shock. Under this system, Peppermint Patty price predictions are
about the best that one can hope for.
The decisions of both the flood control
agency and the FOMC are thus governed by what the public expects them
to do. Just as the agency is forced to
build dams and levees because the public expects that it will, the FOMC accommodates inflation shocks because
people expect that such action is forthcoming. The FOMC and the flood controllers could better serve the public interest if constraints on their actions led
to changed expectations. In the flood
control example, society would benefit
if the agency could be constrained in
advance from protecting the homes of
those who build in the floodplain. Without the guaranteed protection, people
would build elsewhere, making costly
flood control measures unnecessary.
Similarly, the costs of long-run inflation uncertainty outlined above could
be sharply reduced by imposing a pricelevel rule on the Federal Reserve System. How might this work? Initially,
say in 1992, Congress would decide on
a target path for the price level (as
measured by the Consumer Price Index
[CPI]) for each of the next 10 years;
that is, from 1992 until 2001. In 1993,
the legislature would extend the path
by adding a target for 2002, leaving unchanged the targets for 1993-2001. A
2003 target would be appended the
next year, and so on. The central bank
would be instructed to take whatever
action it deemed necessary to keep the
CPI within 5 percent of the target. If it
turned out that simply setting the target
and instructing the Federal Reserve to

achieve it was not restrictive enough,
Congress could then specify a specific
interest rate or monetary base rule to
further constrain the FOMC.
While operating with a price-level target would greatly reduce uncertainty
about future prices, it would have little
effect on the System's day-to-day
operations. In particular, it would not
prevent the Fed from responding to
concerns about financial market liquidity, as it did following the stock market
crash of October 1987. Nor would it
disallow partial accommodation of unexpected changes in the price level. It
would require, however, that any such
accommodations be temporary. Inflation
above the target rate in one year would
have to be offset in subsequent years by
inflating at less than the target rate.

• Conclusion
The point made by the blueback scheme
is that it takes just as much monetary
discipline to achieve a stable 4 percent
inflation rate as it does to achieve a
stable rate of zero. In principle, it is
possible to reduce the costs of inflation
greatly by indexing the tax code and
paying interest on currency and demand
deposits. But such reforms would do little
or nothing to alleviate the many harms
emanating from the long-run price-level
uncertainty inherent in a regime that
lacks appropriate constraints on the monetary authority. By making it possible to
predict the price level a decade ahead
with confidence, effective long-run targeting of a broad price index would sharply
reduce these costs.

• Footnotes
1. Some models go even further and feature
superneutrality, in which the growth rate of
money is also irrelevant.
2. See Charles T. Carlstrom and William T.
Gavin, "Zero Inflation: Transition Costs and
Shoe-Leather Benefits," Working Paper 9113,
Federal Reserve Bank of Cleveland, October
1991; and David Altig and Charles T. Carlstrom, "Inflation, Personal Taxes, and Real
Output: A Dynamic Analysis," Journal of
Money, Credit, and Banking vol. 23, no. 3,
part 2 (August 1991), pp. 547-71.
3. See Axel Leijonhufvud, "Inflation and
Economic Performance," in Barry N. Siegel,
ed., Money in Crisis: The Federal Reserve,
the Economy, and Monetary Reform. Cambridge, Mass.: Ballinger Publishing Company, 1984, pp. 19-36.
4. See Axel Leijonhufvud, "Constitutional
Constraints on the Monetary Powers of Government," in James A. Dom and Anna J.
Schwartz, eds., The Search for Stable Money.
Chicago: University of Chicago Press, 1987,
pp. 129-44.
5. See A. Steven Holland, "Wage Indexation
and the Effect of Inflation Uncertainty on
Employment: An Empirical Analysis," American Economic Review, vol. 76, no. 1 (March
1986), pp. 235-43. Holland measures inflation uncertainty as the standard deviation of
the inflation forecast errors made by survey
6. For example, both borrowers and lenders
at many savings and loan institutions in the
early 1980s expected the high inflation rates of
the previous decade to continue. The unexpected disinflation that followed played a large
part in creating the industry's current crisis.

7. See Leijonhufvud, "Constitutional Constraints on the Monetary Powers of Government."
8. The FOMC is the policymaking arm of the
Federal Reserve System. It consists of the seven members of the Board of Governors and five
of the 12 regional Reserve Bank presidents.
9. There is a substantial literature on the
problem of time consistency in monetary
policy. The flood control example appears in
the seminal article by Finn E. Kydland and
Edward C. Prescott, "Rules Rather than Discretion: The Inconsistency of Optimal Plans,"
Journal of Political Economy, vol. 85, no. 3
(June 1977), pp. 473-91. My argument is
novel in that it applies similar reasoning to
explain why inflation uncertainty is too high,
while the existing literature aims at explaining the level of inflation.
10. This is also the reason why comparisons
across countries show a high correlation between the level and the variability of inflation. Stable low inflation is better than stable
high inflation, so countries with the political
will to accomplish either invariably choose
the former.

Jeffrey J. Hallman is an economist at the
Federal Reserve Bank of Cleveland,
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

Price Stability Conference Proceedings Offered
The papers in this special issue of the Journal of Money. Credit, and Banking were presented and discussed at a conference on
"Price Stability" held at the Federal Reserve Bank of Cleveland on November 9-10, 1990. The purpose of the conference was to encourage research and discussion on the costs and benefits of adopting a policy to achieve and maintain price stability.
The Genesis of Inflation and the
Costs of Disinflation
by Laurence Ball
Comments: Dennis W. Carlton and
Peter Howitt

Seigniorage as a Tax:
A Quantitative Evaluation
by Ayse Imrohoroglu and
Edward C. Prescott
Comments: Stephen G. Cecchetti and
Herschel I. Grossman
The Welfare Costs of Moderate
by Thomas F. Cooley and
Gary D. Hansen
Comments: Roland Benabou and
Randall Wright
Optimal Fiscal and Monetary Policy:
Some Recent Results
by V.V. Chari, Lawrence J. Christiano,
and Patrick J. Kehoe
Comments: B. Douglas Bemheim and
R. Anton Braun

Panel Discussion on Monetary Policy: What Should the Fed Do?
The Goal of Price Stability:
The Debate in Canada
by C. Freedman
An Error-Correction Mechanism
for Long-Run Price Stability
by J. Huston McCulloch

To order a copy of the conference proceedings, please send $8.00 (U.S.) in a check or
money order drawn on a U.S. bank. Make checks payable to the Federal Reserve
Bank of Cleveland. Complete and detach the form below and mail to:
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, Ohio 44101



The Sustainability of Budget
Deficits with Lump-Sum and
with Income-Based Taxation
by Henning Bohn

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

Address Correction Requested:
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Material may be reprinted provided that
the source is credited. Please send copies
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Please send the Price Stability Conference Proceedings to:

Inflation, Personal Taxes, and Real
Output: A Dynamic Analysis
by David Altig and Charles T. Carlstrom
Comments: Alan J. Auerbach and
Finn E. Kydland

Comments: Timothy S. Fuerst and
James D. Hamilton

How Should Long-Term Monetary
Policy Be Determined?
by Lawrence Summers


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