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For release on delivery l:00 p.m., E.S.T. September 'l 9, ¡(- 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