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November 23, 1990

Credibility, Commitment
and Inflation Policy
Most economists now accept the notion that
the success of a policy designed to maintain low
rates of inflation can depend importantly on the
public's beliefs about the government's commitment to the policy. This point was made recently
by Alan Greenspan, Chairman of the Board of
Governors of the Federal Reserve System when,
in testimony before Congress he stated "One key
element that would minimize the transition (to
price stability) would be a conviction of participants in the economy that the anti-inflation
policy is credible, that is, likely to be effective
and unlikely to be reversed:'
Less agreement exists concerning the means
by which policy can achieve credibility. Some
argue that a reputation for following credible and
effective policies must be earned, whereas others
argue for institutionalizing policy goals to
increase their credibility.
The Federal Reserve's willingness to maintain its
anti-inflationary stance in the early 1980s, despite the rise in unemployment from 5.8 percent
in 1979 to 9.5 percent in 1982 and 1983, was
viewed by many as critical in giving credibility
to the Fed's stated goal of reducing the rate of
inflation. Some, however, continue to support
moves to amend the Fed's Charter to require
explicitly that the Fed achieve and maintain
price stability. Legislation has been proposed
requiring the Federal Reserve to establish zero
inflation explicitly as its goal. Such a change, its
proponents argue, would increase the credibility
of policy by limiting the ability of the Fed to
engage in short-run discretionary policy actions
that might be inconsistent with longer-term
price stability.
Although the future of legislatively establ ished
inflation goals is uncertain here, a recent act of
New Zealand's Parliament made price stability
the primary objective of that country's monetary
policy. In fact, the head of its central bank has
signed an employment contract that sets out an

explicit goal of 0 to 2 percent inflation by the
end of 1992. Using New Zealand's experience,
the arguments for and against the use of more
explicit inflation targets are reviewed in this


New Zealand's new policy
On February 1, 1990, The Reserve Bank of New
Zealand Act (1989) took effect. Designed to reflect the role of the Reserve Bank in New Zealand's newly deregulated financial sector, the Act
also changed the monetary policy objectives of
the central bank. According to the Act, "The
primary function of the Bank is to formulate and
implement monetary policy directed to the economic objective of achieving and maintaining
stability in the general level of prices:'
A major motivation for this single-minded focus
on price stability was New Zealand's poor inflation record. The chart shows the rate of inflation,
as measured by the Consumer Price Index,for
New Zealand and the U.S. Until early 1989, New
Zealand's inflation rate had fallen to the level of
the U.S. only during 1983 and 1984. That drop
reflected the impact of disinflationary policies in
New Zealand's major trading partners, and wage
and price controls in New Zealand from 1982
to 1984. As evident in the chart, New Zealand's
inflation slowdown based on wage and price
controls was only temporary.

Comparison of Consumer Price Inflation
New Zealand ,\









I \ I
I \ I
\ I

\ /'t





: V:


















To ensure that the country's Reserve Bank
pursued the legislative goal of price stability,
its Governor has signed a formal contract with
the Minister of Finance setting out a specific
inflation goal and a timetable for its achievement.
The Governor can be dismissed for not achieving
the target specified in the contract.
The contract states that /I ... the Reserve Bank
should formulate and implement monetary policy
with the intention of achieving price stability by
the year ending December 1992. An annual inflation rate in the range of 0 to 2 percent will be
taken to represent the achievement of price stability./I It also specifies a number of conditions
under which the policy target may be altered,
but /I... increases in wages or profit margins
that are inconsistent with these targets will not
be accommodated by the Bank and will not
give grounds for automatic renegotiation of
the policy targets:'

Arguments for a zero inflation target
Proponents of New Zealand's proposal to adopt
price stability as the sole goal of monetary policy
cited three issues: achievability, credibility, and
First, they argued that policy goals needed to
be stated in terms of macroeconomic variables
that could in fact be affected by monetary policy.
Since most economists accept that the long-run
effects of monetary policy fall entirely on the
price level and not on real variables such as the
economy's average unemployment rate or real
growth rate, the proponents believed that the
goals for monetary policy should reflect what
can be achieved by monetary policy.
Second, the proponents argued that a legislated
policy would provide the credibility needed to
prevent expectations of inflation from developing
their own momentum. According to macroeconomic theory, which emphasizes the importance
of expectations in the inflationary process, a
policy designed to maintain low rates of inflation
is likely to be more successful when the public
expects the policy to be consistently applied.
In contrast, a belief that authorities will abandon
an inflation fight would lead to an escalation in
wage increases, and force the monetary authority
to choose between ratifying wage and price increases, thereby sacrificing its inflation goals,

and generating unemployment in order to keep
inflation low.
Third, establishing a specific target for inflation
and making the Reserve Bank responsible for its
achievement was part of a broader reform of the
public sector designed to increase accountability.
Proponents of price stability as the sole goal of
monetary policy believed that the institution
entrusted with the responsibility to conduct
monetary pol icy must be accountable to elected
government officials and to the public. They argued that accountability is most easily achieved
when the performance of the monetary authority
is easily measured. Vague policy objectives involving potentially conflicting goals would make
accountability more difficult than a goal expressed simply, in terms of one easily measured

New Zealand's new framework for monetary
policy has not been without its critics. A consideration of the impacts of aggregate demand and
supply shocks can help illustrate the potential
problems of a monetary pol icy focused solely
on price stability. Aggregate demand is the total
spending in an economy, and aggregate supply
is the total of that economy's production capacity.
An aggregate demand shock, such as a fall in
government expenditures, will act to temporarily
lower the level of economic activity. The resulting
rise in unemployment will tend to moderate
wage increases. Weak sales and moderated wage
costs tend to reduce prices relative to their initial
path. Under a policy of price stability, the monetary authority would respond with an expansionary policy designed to keep prices from falling.
This shift in policy would help maintain the level
of economic activity and moderate the rise in
unemployment. In this case, there is no conflict
between stabilizing employment and stabilizing
However, as national economies discovered
in the 1970s, a short-run conflict between inflation and unemployment does arise in the face of
aggregate supply shocks. An oil price increase,
for example, pushes up prices while tending to
depress real economic activity. A monetary authority with both unemployment and inflation
goals must then contend with the choice of a

contractionary policy to prevent prices from
rising but which will exacerbate the increase
in unemployment, or an expansionary policy
to moderate the rise in unemployment but at
the cost of further increasing the price level.
Monetary policy can temporarily delay the
output decline caused by a permanent adverse
supply shock, and it is for this reason that central
banks have recently focused, at least in principle,
on contributing to short-run real economic stability while ensuring that monetary policy remains consistent with longer-run price level
or inflation targets. Critics of strict price stabil ity
policies argue that a narrow focus on inflation
alone will produce costly and unnecessary fluctuations in real economic activity and inflation.

A current test
Iraq's invasion of Kuwait serves as a vivid reminder of the vulnerability of energy-importing
countries to oil price shocks. Central banks are
again facing the prospect of accepting temporarily higher rates of inflation in order to maintain current levels of economic activity, or
accepting an economic slowdown in order
to prevent inflation from accelerating.
The agreement between the Governor of New
Zealand's Reserve Bank and the government
does allow for a renegotiation of inflation targets
in response to a significant movement in the
country's terms of trade. The terms of trade, the
ratio of the price of New Zealand's exports to
the price of its imports, will fall as the price of
imported oil rises. In addition, New Zealand
is already experiencing a recession.
Whether New Zealand's Reserve Bank will raise
its inflation targets to accommodate the rise in oil
prices remains to be seen. As long as monetary
policy stays firm overall, the oil price rise should
have only a one-time effect that would dissipate,
according to some commentators, by 1991. Thus,
the Reserve Bank could still achieve its low inflation target for 1992, although with a higher price
level than originally planned.

Zero inflation target in the U.S.
In the United States, Representative Neal
(D-NC) has introduced legislation (HJ Res. 409)

that would establish zero inflation as the official
goal of the Fed. During hearings on the bill, Alan
Greenspan and four of the presidents of regional
Federal Reserve Banks, including Robert Parry,
President of the Federal Reserve Bank of San
Francisco, expressed strong support for this idea.
In his testimony, President Parry was quite explicit in arguing that the Fed should conduct
policy to maintain a constant price level. Under
this approach, if prices were to rise, the Fed
would tighten policy to force prices back down
to the target level. This approach contrasts with
one that would aim just to keep the price level
stable at the new higher level.
Although Neal's proposal would make price
stability the official goal of monetary policy,
unlike the New Zealand Act, his bill has no
formal mechanism for enforcement.

Acbievability, credibility, and accountability
are generally desirable qualities of any proposed
policy, but most would agree that they are not
sufficient to ensure desirable monetary policy
outcomes. In fact, policies that are unduly rigid
in the face of rising cyel ical unemployment may
undermine their own credibility.
New Zealand has gone farther than any other
country in designing an institutional framework
incorporating the three qualities, but that framework is already facing a test of its flexibility. New
Zealand's current recession is leading to pressures on the governmentto revise the timeframe
over which the Reserve Bank should achieve its
target rate of zero inflation. On October 26, the
National Party, which had promised to push back
the achievement of 0-2 percent inflation until
1993, gained a landslide victory over the governing Labor Party. New Zealand's experiment
must therefore still prove itself capable of providing the price stability that is widely accepted as
the ultimate goal of monetary policy.

Carl E. Walsh
Associate Professor,
University of California, Santa Cruz
Visiting Scholar, FRBSF
and Fulbright Fellow,
New Zealand Institute of Economic Research

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.

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Federal Reserve
Bank of
San Francisco
P.O. Box 7702
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