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Number 95-02, January 13, 1995

A Look Back at Monetary Policy in 1994
The following is adapted from a series of recent
speeches given by Robert T. Parry, President and
Chief Executive Officer of the Federal Reserve
Bank of San Francisco, in the Twelfth Federal
Reserve District.
In February of 1994, monetary policy began shifting into another gear. After four years of grad ually
lowering short-term interest rates to stimulate the
economy's recovery from recession, the Fed began raising rates. All told, since February, the
federal funds rate has been raised from 3 percent
to 5112 percent. The Fed took these actions to
contain the buildup of inflationary pressures,
which is key to fostering sustainable economic
These moves have been met with controversy in
some quarters. For example, in early 1994, the
California economy was pretty weak. This has led
some critics to ask, "Why not help the parts of
the country that are not yet strong before worrying about inflationary pressures?"
Others have argued that the Fed moved too soon,
before there was much evidence of increases in
the inflation statistics. They ask, "Why not wait
until we clearly see the problem before trying to
solve it?"
From a third point of view, some have argued
that the Fed was ignoring the fact that the u.s.
operates in an increasingly global environment.
Their question is, "Why worry about constraints
on U.s. capacity when what matters is world
Finally, some think a little more inflation might
not be so bad anyway. In other words, they ask,
"If the benefit from a little more inflation is
higher employment, then what's wrong with it?"
This Weekly Letter addresses these questions in order to explain the rationale for Fed policy in 1994.

Question 1.
Shouldn't the Fed help the weak areas of the
economy before worrying about inflationary

There are two main reasons why the Fed's emphasis has to be on the nation as a whole, and
not on any particular state or region. First, U.S.
credit markets are very efficient, so they quickly
channel funds to the most productive uses.
Therefore, the Fed has no way to direct stimulus
. to any particular part of the country that needs
help. That is why the effects of monetary policy
are often referred to as "blunt."
Second, beyond this praCtical difficulty, there is
a real danger in focusing too much on anyone
region of the economy that is having a hard time.
Often enough, some state or region is going
through a recession of its own while the national
economy is humming along. For example, the
Twelfth Federal Reserve District, which covers
nine western states, currently includes the nation's
three fastest growing states-Utah, Nevada, and
Idaho-as well as two of its weaker performersHawaii and California. If the Fed stimulated
whenever any state had economiC hard times, it
would be stimulating most of the time. And the
upshot would be avery pro-inflationary environment. (See Cogley and Schaan 1994.)
Does this focus on the well-being of the national
economy mean that the Fed ignores regional economic conditions? Not by a long shot. The Fed
places great importance on understanding regional economies. We do this by analyzing
regional data and by talking with people who
have insights on current economic developments
in their areas of the country. This information is
the subject of a good portion of each Federal
Open Market Committee meeting, and it is used
to fit together a picture of how the whole economy is doing.

Question 2.
Since the overall economy was growing at a
robust pace in February 1994, without clear
signs of rising inflation, what was the problem?
The problem was-and is-that monetary policy
effects are not just "blunt"-they also involve
"delayed reactions." It takes a long time for a
policy action to produce results on inflationprobably from 1V2 to 2 years. This kind of lag


times means that it is dangerous to wait until the
problems show up in the inflation data-by then
it would be too late. Instead, the Fed has to anticipate problems.
In 1994, there were good reasons to think that inflation would be a problem in the future unless
the Fed raised rates. The economy has grown at a
3% percent rate on average since the beginning
of 1992. As a result, much of the unused capacity
that had built up in the 1990 recession was employed. The unemployment rate has fallen from a
peak of about 7% percent to just over SY2 percent. Furthermore, manufacturing capacity utilization rates have risen from under 77 percent to
over 84 percent.
Now, the Fed likes to see strong growth just as
much as anybody else does. But what gets the
Fed concerned is a strain on the economy's capacity to produce goods and services. In the
past, when we've been at or near so-called "full
utiiization," higher inflation hasn't been far
This is not to suggest that the Fed has some
magic number labeled "full utilization." On the
contrary, precise estimates simply are not available. For example, justabout everybody accepts
the concept of a so-called "natural rate of unemployment"-that is, the rate that is sustainable
in the long run, given current technology, labor
market size and composition, and so forth. But
not everybody agrees on precisely what that rate
is in the
economy today.


Even though economists don't agree on precisely
what that rate is, most do agree that the current
figure is in the ballpark. If the past is any guide to
the future, then inflation will be on the rise unless
things slow down a bit. I should point out that
these estimates are not the Fed's idea of what the
rate ought to be, or what anyone at the Fed or
anywhere else would like it to be.

Second, even when we consider goods that are
traded internationally, the effect on U.S. prices is
offset to a large extent by flexible exchange rates.
This offset can be illustrated with a very simplified example. Suppose the price of steel, or
some other good, is lower in japan than in the
manufacturers buy japanese
steel, they have to pay for it in yen, which they
buy on the foreign exchange market. Since that
will mean additional bidders for yen, its value
will climb relative to the dollar. As the yen appreciates, the cost of japanese steel to u.s. firms
goes up-even though the japanese have not
changed the (yen) price they charge!



Of course, in the real world, a few of our trading
partners do fix their exchange rates to the dollar,
and some others do not let their currencies float
with complete freedom. In addition, it may take
time for exchange rates to adjust. However, that
does not change the basic point that we cannot
depend on foreign capacity to keep u.S. inflation
in check. This helps explain why the historical
relationship between domestic capacity in labor
and product markets and inflation has held up
throughout the 1980s and so far in the 1990s.

Question 4.
"What's wrong with a little more inflation if the
benefit we get is more employment?"
The answer to what's wrong with a Iittle more inflation ties back to the issue of the natural rate of
unemployment. A little more inflation may get us
more employment, but it would only be temporary. The Fed simply does not have the power to
push the economy beyond its capacity to produce goods and services for very long, because
the things that influence capacity-such as current technology, labor market size and composition-are well beyond the Fed's control. If the
Fed tried to push the economy beyond its capacity, we might get a short-term rise in output and
employment. But in the long run, unemployment
and capacity utilization would return to their natural rates, and we'd be left with accelerating
inflation and financial instability.

Question 3.
"/sn't it the amount of worldwide capacity-:-not
just u.s. capacity-that determines our inflation


The answer largely is "no"-for a couple of reasons. First, a large proportion of what we consume in the u.s. is not affected by foreign trade
at all. For example, health care is not traded internationally, and it amounts to about 14 percent
of GDP. There are plenty of other examples, as
well, like most services, construction, and so on.

To sum up, the Fed's actions this year have been
warranted to guard against an increase in future
inflation. Maintaining low inflation is important
in providing a firm foundation for sustainable
economic growth. Since there is much less slack
in labor and product markets, it would have
been a mistake to keep real short-term interest
rates at the stimulative levels of late 1992 through

1993. The last time these rates stayed at low levels for a long period was in the 1970s. It made
the economy "go" for a· while, but eventually it
led to the run-up in inflation in the late 1970s
and early 1980s. Putting on the "economic
brakes" to fight that inflation flare-up led to a
major recession. Although the recent situation
was not as dire as that one was, we did not want
to risk even a small part of that kind of problem
As a consequence, I think the steps the Fed has
taken this year to raise rates are appropriate:
They should help to foster stable, sustainable
economic growth with low inflation. Such forward-looking monetary policy helps avoid the

"go-stop" economic environment of the late
1970s and early 1980s, and it is much more
likely to produce a lasting economic expansion.

Robert T. Parry
President and
Chief Executive Officer
Federal Reserve Bank
of San Francisco

Cogley, Timothy, and Desiree Schaan. 1994. "Should
the Central Bank Be Responsible for Regional Stabilization?" FRBSF Weekly Letter 94-25 Ouly 15).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Aeseorch Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

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Index to Recent Issues of FRBSF Weekly Letter




An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targetsand Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in Japan?
Measuring the Cost of "Financial Repression"
The Recent Behavior of Interest Rates
Risk-Based Capital Requirements and Loan Growth
Growth and Government Policy: Lessons from Hong Kong and Singapore
Bank Business Lending Bounces Back
Explaining Asia's Low Inflation
Crises in the Thrift Industry and the Cost of Mortgage Credit
International Trade and U.S. Labor Market Trends
EU + Austria + Finland + Sweden + ?
The Development of Stock Markets in China
Effects of California Migration
Gradualism and Chinese Financial Reforms
The Credibility of Inflation Targets


The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.