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'l

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I 989

BREAKING THE INFLATION-RECESSION CYCLE

I'1. Lee Hosklns, President
Federal Reserve Bank of Cleveland

The Fraser

Instltute

Ftfteenth AnniversarY Luncheon
Canada
Toronto, .l9,
1989
September

Breaking the Inflation-Recession Cycle

The Canadian and United States economies are approaching

a critical

Juncture. As the current expanslon strains agaÌnst capacity I lmits, some
forecasters warn that ne will soon have to make a choÍce between inflation
recession. Unfortunately, over the years
prolong expansion, or avoid the paln

we have come to believe

that

and

we can

of a recession, wÌth more inflation.

this cholce, as rlsk takers in the buslness world, you may view
inflation as a reasonable gamble and, perhaps, the lesser of the two evils.

Given

today 1s that these are false choices.
A.:Iook,at:recent.hlstory.reminds 'us vividlV of' the,reconomic pain ,resuìting

My message

:from :inf

lation.

,'Every'economici.recesslon

'ln'the recent'ht story of

Canada and

of cost and price pressures. Let us
not forget the miserable economlc situation at the turn of this decade when
unemployment and inflatlon were at double digit levels and production vras

the U.S. has been preceded by an outburst

declinlng. If

we learned anythlng from those dismal times, surely

it

was that

the harm caused by inflatlon takes years to undo, and usually at the cost of
permanent losses

Today,

in

lncome and economlc wel 1-being.

in both Canada and the United States,

people seem

to

be more aware

,than ever that the proper,role of.the central bank.ls to prevent these losses
by stabi ì izing ,the prlce.level
Freedman

of the Bank of

stabtlize the price

Both'Governor,Crow and Deputy Governor

Canada have

publicìy committed to monetary policies to

level. In the U.S., Federal Reserve Chairman Greenspan

has repeatedly stated

hlghest standard

.

that the

way

to attain

maxlmum

ìong-run growth and the

of llvlng ls to stabilize the price level.

-2-

ls slmple. In the long run, there is no trade-off between
inflation and recession. Ultimateìy, inflation itself causes recession and,
inflation results in less than optimum economic performance. A monetary
policy that strives for price stability, or zero inflation, is a pro-growth
The message

pol i cy.

Recessions: !,lhv Do l,le Have Them?

is a slowdown in the economy that is widespread across enough
industries or regions to make the slowdown general for the economy. Although
A recession

we

don't understand recessions comp'leteìy,

caused by monetary

we have seen

that they can be

poltcy actions as we'll as by nonmonetary factors.

In :the,'early',.1 980s,we: had,'recess ì ons caused, by :monetary' pol i cy
The:policy:mistakes'trere. the,',excessive monetary growth rates

mi

stakes

.

of the 1970s.

This excesslve growth of money in both Canada and the United States allowed
accelerating inflatlon and rlsing interest rates that led to the need for

disinflatlonary monetary policies.

The

disinfìatlonary policies

were

to get our economies back on acceptable real growth trends. Yet
even todaJ, we are apt to blame the policies which reduced inflation for the
necessary

recesslon instead
l.lhy

of

blamlng those whlch created the

is it that tnflationary

poì

lcles

cause recessions? As managers of

buslnesses, you face a great.many sources
investment

declslon..,First, you must

inflation to begin with.

of uncertalnty surrounding

know your market and

any

offer a.product

that people want. Next, Jou have to monìtor costs and build in the highest
possible quality. Impllcit ln this task is a whole host of decisions that
requi

re

guessi ng

variable rates
may I ead

future rates of i nterest and i nfl

of tnflatlon

to I ncorrect

I

cause mistakes

nvestment

atlon. General ly,

in these decisìons,

or i nventory deci sions.

hl gh and

mistakes which

-3For some, costs due

for

exampìe, those

to inflation

and

interest rates may not

seem

critical;

with low fixed costs and those that are able to adjust

inflation. For most, though, inflation and interest
rates will be crltical. Otherwise capable managers who made investments in
the late 1970s in inflation sensitive areas -- farmÌng, timberland, oil, real
estate -- fell into bankruptcy when high inflation rates failed to continue

wages and

prices for

into the next decade.
became

However, the people who made

very wealthy. The history

gyrations in

money and

Nonmonetary

this bet ln the 1960s

of the business cycle is a history of

prÍces.

"surprises" also can cause disruptions in resource use that

may be widespread enough

to be a recession.

These surprises have many

'sources., ,They.;include technologf ca1 innovations such.as ìwe have.seen in
.::

computers;.'information''processing, and'management technlques. They also

come

like droughts, strlkes, wars, cartel actions, and
political change. For example, political reforms in countries llke Poland and
China may produce recesslon because peopìe have to learn how to reorganize and

from economic disturbances

develop

lnstitutions that use the market.

the combined effects of
and i ndustri

if
. would still

partlcuìar disturbances to lndlviduals, firms,

.

we could

Even

'an analogy

es

many

Recessions can also emanate from

ellminate

all the influences from monetary policy,

be recesslons,'and expanslons because

there

of these.surprises. Consider

between recessions and earthquakes. 'Earthquakes occur when the

don't compìetely understand the shiftlng of the
plates, but scientlsts believe that this shifting may resu'lt in many small
quakes or a few large ones. Ne have no reason to believe that, if geologists

plates of the earth

shift.

suddenly discovered a vray

l.le

to delay the next earthquake, then it

to do so. In fact, if the plates must shift,
worse quake

if

we

we may

try to prevent the small ones.

would be good

only be causlng a much

-4-

I thlnk that the same is true of recessions. Shifts are occurrlng in the
economy that economists and policymakers do not completely understand -- for
example, technology and the changing tastes

of

consumers and fnvestors.

Shifts occur which are considered to be uncontrollable

spills, etc. If
accommodated

we

let market forces

--

droughts, oil

operate, these changes will

or corrected in a natural

and gradual

be

fashion. Market forces

in a stabìe policy envìronment. I'lithout a doubt, there will always
be short-term difficulties, but it is to our long-term advantage to allow for

work best

shift in the economic "plates" as the world changes.
Perhaps the earthquake analogy seems a bit extreme, but it is no more

some

extreme than

the idea that monetary policy can or should be used to e'liminate

',the,..business,cyc'le. 'Let.me emphasize,

I

am

not ìn:favor of,'recessions.

0n

,the contrary; .I believe,that.variable and uncertain monetary policies
exacerbate the business
even under an

severe.

Ne must remember

ideal monetary poltcy, but they

Under an

ìnflation

cycle.

ideal policy

that recessions will

will

occur

not be as frequent or

as

we would not have recessions induced by

and the persistent need

to eliminate lt.

ses: l,lhv Don't l^le Use Pol i cv to Thwart Them?
There is a bit of irony in the idea of forecasting recessions; that is, if

Nonmonetarv Surprl

we could forecast,recesslons, we probably wouldn't have

pollcy to ellmlnate them.,".A recession'is one kind of

to worry about

economic

a

fluctuation.

of fluctuation -- seasonal fluctuations due to weather,
tax laws, and cultural events lìke holidays. There is a fundamental
difference in the way we treat seasonal and business cycle fluctuations.

Consider another kind

Seasonal downturns can be

larger than cyclical downturns, yet the government

adjusts the data to account

for

seasonal downturns. Seasonâlity can

be

adJusted because seasonal fluctuations are predlctable based on past

experience. People can anticlpate and prepare for seasonal

downturns.

5-

people have developed a varlety

of

ways

to deal with seasonal variations

output. Farmers know that a single fall's harvest has to
feed the family for a whole year. Construction workers know that thelr
in

employment and

relatively high

incomes during

the

must carry them through the winter

summer

months. Successful retailers know that nearly one-third

of thelr sales come

in the winter hoìiday season. Consequently, their budget plans and banking
relationships reflect thi s cash flow problem.
peopìe survive business cycles in many of the same vJays that they survive
seasonal cycles. Flrms butld up a reserve of profits in good times to survive
the bad times. Households save during good tlmes
purchases

in

bad

times.

Government programs

like

--

and postpone large

unemployment lnsurance and

'the,graduatedr:income.tax:operate.automatically to,'even out'or stabilize
,spendi rì9'over. the..busi ness

The

point ls that

if

cycle.

business cycles were predlctable

condition to Justify a stabilization policy
make such

--

--

a necessary

adjustments by people would

a policY unnecessary.

that ellmÍnating the business cycle was a desirable
healthy long-term goal, I belleve it ls impossible to do so. There are
several reasons that prevent us from using monetary policy to offset
Even

if

nonmonetary

we thought

surprises. First,

vte cannot

and

predict recessions. Second, pollcy

.does'not work lmmediately or predictably;

it

works with a

lag.-

The

effects of

monetary'policy on the economy are highly variable and poorly understood.

Crystal Ball Syndrome: The limitations of economic forecasting are
well-known. Analysis of forecast errors has shown that we often don't know
The

until it is well underway. At any point in tìme
there is such a wide band of uncertainty around economists'forecasts that the

when

a recesslon has begun

plausible outcome ranges from expansion to recesslon'

-6The people who make forecasts and those who use them
sense

of

often get a faìse

confidence because forecast errors are not distributed evenly over

is doing weì.l, forecasts that prosperity
will continue are usually correct. And when the economy is performing poorly,
forecasts that the slump will continue are also usually correct. The problem
lies in predlcting the turnlng polnts. However, the turning points are the
the busÍness

cycle.

hlhen

the economy

thÍngs we must forecast to prevent recessions.
Monetarv

Pollcv's

recessions and wanted

Lonq and Variable

Even

if

we cou'ld predict

to vary monetary pollcy to alleviate them, we still

an almost insurmountable problem
Môreover, the length

Laqs:

--

monetary

face

policy operates wlth a lag.

of the lag varles over time, depending upon conditions

the.,economy and,'the pub'l'ic's;perception

in

of' the.policy process. . The effect of

be.felt:for at least'six to
two to three years in the

.:today,s.:monetaryrpolicy actlons'.úl1l'probably not

nine months, with the main lnfluence perhaps

future.
may

The

act of trying to prevent a recession

may

not only

fall, but it

also create a recession where there was not golng to be one.
The

other reason for a lag

is that you, as the operators of businesses,

not act in a vacuum. You understand the political forces operating on

do

a

that a return to inflation ls always a possibillty.
Uncertaìnty about future pollcy makes you cautious about future investments.
UncertaÍnty about,future lnflation will raise real interest rates, drive
central bank.

You know

investors'away from long-term markets, and delay the very investments

needed

to end the recession. The more certain people are about the stability of
future monetary pollcy, the more easily and quickly inflation can be reduced
and the economy recover.
Poorl

actlon

v Understood

Ll nkaqes:

wllì affect the economY.

of great debate underway among

l,le

don't

The

know

exactly

how

a partl

effects of monetary po'ltcy

economists

today.

cul

ar

pol i cy

is the topic

Macroeconomic ldeas about

-7-

policy and its effect on real output have changed profoundly in the
last decade. l,,le have learned that the effect of monetary policy depends on

monetary

peop'les' expectations about pol icy.

If

we have learned anything about economic policymaking

in the last

twenty

years, we ought to have learned to think about policy as a dynamic process.
To claim

that, "irì order to

wrongheaded

reduce

inflation,

l'le must have

notion that completely ignores the abiìity of

their expectations as the environment changes.
people do their best to forecast economic policies
decisions.

If

humans

will

come

to

adapt

when they make

the central bank has a record of expanding the

attempts to prevent recessions, peop'le

is a

a recession,"

money supply in

to antlcipate the policy,

setting'off Ìan,:acceleration,of .inf lation 'and',mì sal locatlon 'of '.resources that
,.wtll:lead to,the:need for a'correction -- a .:recesslon. .Suppose for a'moment

',

that the recesslon followed a period of excessive
common

occurrence

monetary expansion

ln the Untted States and Canada over the last

--

a

three

decades. An economy often goes into recession followlng an unexpected burst

of inflation because people have made dec'isions that were based on an
lncorrect vlew of the course of asset prices and economic activity. The
central bank can do
prlce environment.

little to cure the situation except to provide a stable
Thls wlll be the optimal setting in which you can adjust

,your buslness.plans to work.off inventories and"bad debts generated during the
', lnflationary expanslon. How,long thls takes depends on many factors, some of
whlch are outside the control
Canada, the

of the central

bank.

U.S., and many other western countries are experiencing

It i s no col ncl dence that these expansions
have proceeded in the presence of reduced inflatlon. I think it is because

extraordl nari ly long expansions.

of, not fn spite of, restrictive
The combination

of

monetary

prolonged growth and

policies that

we have done so well.

relatlvely low, stable lnflation will

-8make

it

easier

for central

banks

to contlnue fighting lnflation. It is

important that we not return to the inflatlonary policies
so
i

wfll

n the

almost certainly cause a repeat

ear'l

y

I 980s

of the terrible

Dolng

recessions we suffered

.

Central Bank Credibilitv and the Need for an

I

of the past.

very

Anchor

believe the way to achieve prolonged growth and

policy that seeks to stabilize the price

level.

The

stability is a monetary

first,

necessary step ìs

to anchor the prlce level, to create a worìd where people expect the average
ìong-run inflation rate to be zero.
Advocates
i nfll

of a countercycllcal

monetary

policy dlsregard the long-term

ation rconsequences. .iTo mai ntai n the val ue'of 'money, 'monetary expansions

must'be:kept,ln line with thercapacity of oureconomy'to grow. Proponents of

that the trend or overall

a countercycllcal pollcy

assume

of the money supply wlll

be unaffected by the

policy.

average growth rate

They assume that

wtll be offset by a lesser money supply growth
tomorrow. Because thls ls usuaìly not the case, there is no benchmark or

excessive money growth today

for the monetary system and the economy's partìcipants. Instead,
inflation is allowed to change randomly with the fortunes of the economy and

anchor

uncertai nti es are i nduced by tryi ng

to fol low thi s

countercycl i ca'l pol i cy.

By

focusing on a stable prlce level, the central bank would automatically reslst

inflationary pressures that occur when aggregate spending is
Likewi

the

se, i t

economy

hlhat

would automatical

turns

ly

resl

st deflationary

excessìve.

pressures

that occur when

down.

Is a Zero Inflation

Pollcv?

A successful zero ìnflation pol icy would completely el lminate long-run

inflation or any upward trends tn the genenal level of prices.
phrase "zero i nfì atlon pol I cy,

"

I

mean

a two-part pollcy.

The

þ{hen

I

use the

first part ls a

-9-

to long-term price stability. The second part is a firm
commitment to an expliclt timetable.
A successful zero inflation policy does not mean that actuaì price indexes

flrm

commitment

would remaln

constant. Central

banks cannot

control the price leveì over

short horizons such as one quarter or even one year. No matter how much
people may wish otherwise, there

factors that

will

cause the

price level to deviate from the desired pollcy

target of no change in the price
some

inflation

will always be temporary and unforeseen
level. It

would be a mistake

index on tar.get each and every quarter,

or

to try to

keep

even each and every

year.
By

price stabi'lity,

make ,decj

I

mean an economlc environment

sions about,the'future;:wi thout

hav.i

in which people can

to worry about long-run

ng

'inf.lation. ' In: practlce,: non-policy.aspects of.the'economy that affect
inflation have to be partially accommodated. The price level mìght remain

or below the target path for a year or two, but during that
time the public would know the Fed's goal. They would expect to see a poìicy
slightly

above

stance dlrected toward returnlng the price

level to the target

path.

inflation policy would require a transition period in
whÌch we get to zero lnflatlon gradually. This transitlon should be stated as
a path for the prlce level. Adopting a zero inflation pollcy today would mean
that the price level.would continue to rise for the next three to fìve years,
.for example, but at a lower.'rate each year., Eventually, the target would
A complete zero

become

a constant price level.

A Zero Inflation Policv
l^le know

ls a Pro-Growth Policv

that both the U.S. and Canadian

wel'l below levels that couìd be achieved

inflatìon would make our

if

economies are
we

monetary system more

ellminate

currently operating

inflation.

Zero

efficient, contrlbute to better

_t 0_

decisions, and result in more efficient use of our resources. Adopting zero

lnflation will allow the

economy

to perform at a higher level. During the

transìtion to this higher ìevel of performance, the

economy

Eventually, we would expect the economy to return to

trend, but at a level of output that is
we continue

to operate with this

Inflation
changes

adds ri sk

to

deci

much

grow faster.

"normal" growth

higher than will be possible

unnecessary "sand"

in our economic

It

the nature of the economic environment so that random inflation

start up businesses

of

and use

hedglng against

costly accountìng

Inflation

methods

causes people to

that

have

the sole

inflation. In the absence of infìation,

the

resources working"in .these;areas:could be devoted:to producing'more goods

services.,'Inflatloni'interacts rwith the tax :structure
I

imit fnvestment. Inflation

we

if

machìnery.

sions and retards long-term ì nvestments.

outcomes overwhelm otherwise prudent managers.

purpose

some

will

undermines peoples'

allow this sand to clog the wheels of our

to'stifle

and

lncentives

and

trust ln government. lihy do

economy?

Conclusion

Monetary

policy fs being tested today. Although

we have enJoyed high

levels of economic growth, recent slowing in economic activìty ìn
the U.S. has prompted calls

for easier

monetary

policy

--

Canada and

lower interest rates

.and more rapid monetary growth.: Yet, such a policy would not only support the

current inflatlon rate,'but would also lay the foundatlon for accelerating

inflation.

The

result would be an economy operating

even

further below its

long-run potential, with growing vulnerability to frequent and severe

recesslons. A monetary policy that leads to zero lnflatìon, even ìf
a recesslon, ls our best opportunity for long-term growth.

it

risks

-l l Fears

of

ty.

recesslon create an apparently lnsurmountable barrier to price

s t s unfortunate. The percel ved trade-off between I nfl ati on
and recesslon ls an illusion. In the end, tnflation itself is the cause of
most recesslons. In the end, continued inflatlon will reduce economic
stabl

II

Tht

growth. To achleve

maxlmum

sustainable growth

in the economy in the

1990s,

central banks should commit today to achievlng zero inflation.
Fortunately

for

Canada and

a publlc commitment.

carry

i

t

out

the U.S., thelr central bankers have made

such

It is now up to us to have the resolve and the wiìl

to