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March 2, 1990

Price Level Stability
On September 25, 7989, Congressman Stephen
L. Neal introduced legislation requiring the
Federal Reserve to eliminate inflation within five
years. House Joint Resolution 409 states, in part:
the Federal Open Market Committee of the
Federal Reserve System shall adopt and pursue
monetary policies to reduce inflation gradually
in order to eliminate inflation by no later than
5 years from the date of the enactment of this
legislation and shall then adopt and pursue
monetary policies to maintain price stability;

(2) inflation will be deemed to be eliminated
when the expected rate of change of the general
level of prices ceases to be a factor in individual
and business decision making. .. "
This Letter is based upon testimony on the Neal
Resolution delivered by President Robert T.
Parry on February 6, 7990, before the House
Subcommittee on Domestic Monetary Policy.

By reducing uncertainty about the future level
of prices, the elimination of inflation would make
a significant contribution to higher standards of
living in the
and around the world. These
benefits are difficult to quantify, but they most
likely are substantial.


Price stability would lead to better long-term
planning and contracting by business and labor.
It also would reduce the risk premia in long"term
interest rates associated with uncertainty about
the future price level, thereby increasing capital
formation and productivity in this country. Moreover, it would avoid the many arbitrary transfers
of wealth and income that occur when the general price level changes unexpectedly, and thus
would reduce wasteful hedging activity designed
to protect against these transfers. Finally, price
stability would eliminate confusion between
absolute price changes and movements in relative prices, leading to improved decisions.

The costs of eliminating inflation
The central bank and inflation

Few would disagree that eliminating inflation
is a desirable goal for the Federal Reserve. The
debate centerson the costs of achieving that
goal and how large these costs are relative to the
benefits. Unfortunately, it is difficult to produce
precise estimates of the costs.

Inflation is a monetary phenomenon, in the sense
that excessive growth of money is the root cause
of sustained increases in the level of prices. Thus,
the central bank is uniquely suited to control
inflation in the long run. Monetary policy also
affects the production of goods and services in
the short run, until the price level adjusts to
changes in the supply of money and credit. As a
result, the central bank frequently must consider
the transitory effects of its actions on the business
cycle, even though its policies mainly should
focus on the single variable it can control in the
long run: the rate of inflation.

The so-called Phillips curve relationship provides
an upper bound estimate of the costs of eliminating inflation. The Phillips curve relates the rate of
wage inflation to the actual unemployment rate,
an estimate of the unemployment rate consistent
with the economy operating at full capacity, and
an estimate of expected inflation.

Federal Reserve officials consistently have made
it clear that achieving price stability is indeed the
long-term goal of the System. If enacted, House
Joint Resolution 409 would provide clear legislative support for the attainment of this goal within
a specified period and would minimize pressures
to focus only on short-run concerns.

The Phill ips curve suggests that the short-run
costs of reducing inflation are relatively high,
largely because this relationship incorporates
the assumption that the public's expectations
concerning future inflation adjust only gradually.
Thus, a disinflationary policy regime may have
to be in place for a relatively long period before

it has a measurable impact on inflation expectations and, therefore, on inflation.
Nonetheless. work at this Bank using comDuter
simulations of a Phillips curve-based~ model suggests that a recession is not necessary in order to
reduce inflation from four to 4% percent now to
around zero percent by 1994. The unemployment rate would need to rise by a maximum of
about 1% percentage points above an estimated
five to six percent "full-employment" rate. At the
same time, real GNP growth during the transition
period would need to be about one to two percentage points per year lower than the rate of
growth in productive capacity, which is currently
estimated at around 2Vz to three percent a year.
Two points about these estimates should be
emphasized. First, these costs are one-time, transitory costs only. In the long-run, there is no trade
off between inflation and unemployment. Once
inflation is eliminated, real GNP will go back to
its long-run potential path, and the unemployment rate to its "full-employment" level. The
benefits of price stability, however, continue
Second, the figures represent average historical
relationships over the past 25 years, and should
be taken only as rough indications of the costs of
implementing the Resolution if inflation expectations were to adjust only very gradually. However, the costs of achieving zero inflation within
five years probably would be smaller than these
estimates suggest. Presumably, the public's expectations of future inflation would decline more
rapidly than the historical Phillips curve relationship indicates if it were to become apparent that
the Federal Reserve was pursuing a steady disinflationary policy. There is general agreement
within the economics profession that the costs of
reducing inflation are closely tied to the degree
to which the public believes the central bank's
anti-inflation policy to be credible. In this regard,
the legislative support provided by the Neal Resolutionundoubtedly would hasten the decline in
inflation expectations, and would reduce the
costs of eliminating inflation.
Unfortunately, it is difficult to determine how
quickly expectations might respond in such an
environment. There is evidence that expectations
did not decline quickly in the period following
the Federal Reserve's implementation of a strong

disinflationary policy in October 1979. In the
current situation, however, the Federal Reserve
has much more credibility as an inflation fighter
than it did in the Deriod of double-digit inflation
at the beginning of the 1980s. Thus, announcing
a policy to reduce inflation to zero within five
years may have more impact on expectations
today than it would have had earlier, particularly
if such a policy were mandated by the legislature. Moreover, inflation expectations would
decline even faster, and price stability could be
achieved even sooner if monetary policy were
supported by other policy actions, such as credible reductions in the federal budget deficit.
However, we cannot estimate the extent to which
inflation expectations will respond to such a
change in policy. Therefore, the possibility exists
that achieving zero inflation in five years might
involve the relatively high transitional costs outlined above. Only implementation of the Resolution will tell. Despite this uncertainty, a transition
period longer than the five years envisioned in
the Resolution does not seem advisable, as it
might reduce the credibility of the anti-inflation

Level or rate?
There is some ambiguity in the Resolution
concerning what the Federal Reserve would be
required to do once zero inflation is achieved:
should it aim at a constant price level over time
(price level stability) or at a zero inflation rate
over time (inflation rate stability)? Following an
unanticipated shock to prices, such as an oil
price shock, the objective of a stable price level
would require that a period of deflation (inflation)
follow a positive (negative) shock to bring prices
back to their pre-shock level. As a consequence,
this approach might imply a high level of volatility in the short- to intermediate-run inflation
Alternatively, a stable inflation rate objective
would keep prices at their post-shock level, and
monetary policy would be geared toward permitting no further change in prices. Byaccommodating past price level movements, this approach
would involve less short-term volatility in inflation, but would permit more long-run inflation or
deflation if the shocks tended to be one-sided.
Price level stability has a number of advantages
over inflation stability. First, the distortions

caused by inflation relate more closely to uncertainty about the long-run price level than to
short-run volatility in the inflation rate. Moreover,
a price level goal probably would be more credible than a zero inflation rate goal. Permitting the
price level to drift (as could happen under a zero
inflation rate goal) inevitably would raise questions whether the Federal Reserve were serious
about controlling inflation, particularly if the
source of the price level shocks were uncertain.
Finally, there is nothing to be gained, and a lot
to be lost, from permitting the price level to drift
over the long run. Even in the case of a shock
like the oil embargo of the mid-1970s, the appropriate response is to maintain price stability
in the long run. Following such a shock, real
GNP inevitably must fall to reflect the decline in
long-run potential output. This decline in output
will occur no matter where the price level eventually ends up, and thus there is nothing to gain
by allowing prices to rise in the long run.
However, there are short-run problems to consider.For example, a recession could result from
attempts by the Federal Reserve to return prices
to their original level tooquickly following a
large oil shock. Thus, it is important that the
Federal Reserve have some flexibility in implementing the requirements of the Resolution.
Monetary policies designed to produce a gradual
deflation (or inflation, depending on the nature of
the shock) following a price shock would minimize short-run dislocations, and yet still remove
the long-run uncertainty about the price level
that damages the performance of the economy.

What is price stability?
A flexible definition of price stability like the one
used in the Resolution is preferable to a specific
numerical target. Although a numerical target
would make it easier for the public to measure
the Federal Reserve's performance and, therefore,
might make the policy more credible, such a
standard might be counterproductive.

should be targeted, and all indexes most likely
will not exhibit zero rates of change when "price
stability" is achieved. Second, there may be upward biases in the price indexes because they
may not adequately adjust for improvements in
the quality of goods and services. This bias could
be addressed by allowing some upward drift in
the price index, but it is difficult to estimate the
appropriate magnitude of this adjustment. Third,
a numerical target would reduce the Fed's flexibility in responding to relative-price shocks,
leading to increased risk of undesirable effects
on economic activity.
Relying on a flexible definition of price stability
inevitably will lead to debate over how the Federal Reserve's performance stacks up against its
objective. This judgment will require evaluation
of a large number of different price indexes.
Other considerations also could playa role.
Does a recent supply shock justify the inflation
observed in a given year? Have there been significant biases in price indexes because of mismeasurement of quality change? These issues
can be discussed and evaluated in the context
of the Federal Reserve's semiannual policy report
to the Congress, as specified in the Resolution.
In any case, these issues likely will become less
worrisome over time, as it becomes clear that the
Federal Reserve's policies are indeed moving the
economy towards price stability.

An important step
Eliminating inflation would be the most significant contribution that the Federal Reserve could
make to the attainment of the highest possible
standards of living in the United States and
around the world. House Joint Resolution 409
would provide a legislative mandate for this goal
and a deadline for attaining it. Once this goal is
achieved, monetary policy should be geared
toward maintaining a stable price level over the
long run so that businesses and individuals do
not need to be concerned about long-run inflation in making their economic decisions.

For a number of reasons, itis difficult to define

in advance a specific numerical target that reasonably could be adhered to over a long period.
First, it is not clear which particular price index

Robert T. Parry
President and
Chief Executive Officer

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 (Barbara Bennett) 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.

Research Department

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