Full text of Statements and Speeches of W. Lee Hoskins : The Importance of Committing to a Zero Inflation Policy : Pittsburgh Association for Financial Planning, Pittsburgh Financial Planning Symposium, Pittsburgh, Pennsylvania

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FEDERAL

For release on delivery
8:00 a.m., E.S.T.
October

27,

1

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989

RESERVE
GD

BANK oF
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CLEv ELA

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THE IMPORTANCE OF COMMITTING TO

A

ZERO

INFLATION POLICY

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GD

N. Lee Hosklns, President
Federal Reserve Bank of Cleveland

Plttsburgh Assoclatlon for Flnanclal Planning
Plttsburgh Flnanclal Planning Symposium
Pi ttsburgh, Pennsyl vanl a
0ctober 27, I 989

PO Box 63A7
CLEvELAND

oH 44101

ïhe Importance of Committing to a Zero Infìation Policy

It is a pleasure to have the opportunlty to speak to the Pittsburgh
Association

for FinancÍal

Planning.

Charìie Parker, the famous jazz musician, once said,

"Romance without

ain't got no chance." Although Charlie's statement is insightful
its own right, I think that there is also some insight if we apply the

finance

statement

to our current econom'ic

in

si tuation.

for the past seven years -- a lengthy
economic recovery by some standards. l4hat is responsible for the ìongevity?
Ne have had

Good

a business

fortune has played a

romance

part.

climate and a stable suppìy

strength.

Many

of

Factors such as a relatively stable po'litlcal

of naturaì

resources has encouraged ìongevlty

these forces are considered beyond the control

makers. Nonetheless,

I

and

of poìicy

belleve that the Federal Reserve is responsible for

part of the successful romance.

of price stablìity has allowed
people like you -- participants in the financial markets -- to perform
effectively and facllitate the tmportant resource allocation process.
An environment

Recentìy, some have argued that the Federal Reserve's adherence to

policy of price stablllty
recession.

wlll

eventually end the recovery, or cause

a

I think that this is a fallacy. Ultimately, infìation itself

causes recession and

lnflation results in less than optimum economic

performance. In the long run, there
recession.

a

ls no trade-off

between

ìnflatlon

and

-2-

A Fal'lacious Tradeoff

:

Inf I ation For Recession

Unfortunately, over the years we have
expansion,

come

to believe that

or avold the pain of recession, with

recent history reminds us that there

recession. Although

we

is

more

we can prolong

inflation. A look at

no tradeoff between

inflation

don't understand recessions completely,

we have seen

that they can be caused by monetary policy actions as well as by
fac tor

s

whi

nonmonetary

.

In the early 1980s we had recessions
The

and

caused by monetary pol'icy mistakes.

policy mistakes were the excessÍve monetary growth rates of the

1970s,

ch aì lowed accel erati ng i nfì ation and ri si ng i nterest rates and ul timately

led to the need for distnflationary monetary policies. The disinflationary
po'licies were necessary to get our economies back on acceptable real growth

trends. Yet even today,

we

are apt to blame the policies which reduced

inflatlon for the recessìon instead of
i

nfl ation to begi n
l^lhy

wi

blamfng those which created the

th.

is lt that inflationary policies

cause recessions? As managers in the

financial services ìndustry, you face a great
surrounding any lnvestment

many sources

of

uncertainty

decision. Flrst, you must know your market

and

offer a product that people want. Next, you have to monltor costs and buìld

in the htghest possible quallty. Implicit in this task is a whole host of
decisions that require guessing future rates
Generally, hlgh and varlable rates

of interest

of inflation

and

inflation.

cause mistakes

in these

decisions, mlstakes which may lead to incorrect investments or products.
For some, costs due to inflation and interest rates may not

for

example, those with low

wages and

rates

prices

will

be

critical;

flxed costs and those that are able to adiust

for inflatlon.

crltlcal.

seem

For most, though, inflation and interest

Otherwise capable managers who made lnvestments in

-3the ìate 1970s in inflation sensitlve areas
estate --

--

farming, timberland,

fell ìnto bankruptcy when high inflation

oil,

real

rates failed to continue

into the next decade. However, the people who made this bet in the 1960s
became very wealthy. The history of the business cycle is a history of
gyrations in

money and prìces.

Nonmonetary

"surprises" also can cause disruptions in resource use that

may be widespread enough

sources. They

i ncl

to be a recessìon.

ude technologi

These surprises have many

cal i nnovations

such as

rr',e

have seen in

computers, information processing, and.management techniques. Ihey also
from economic disturbances
poì i

tÍ cal change. For

like droughts, strikes, lrars, cartel actlons,

exampl

e,

pol i ti

to learn how to reorganize

institutions that use the market. Recessions can also

the combined effects of many particular disturbances
and i ndustri

es

if
would still

we could elimlnate

Even

and

cal reforms I n countri es I i ke Pol and and

China may produce recession because people have

develop

come

and

emanate from

to lndivlduals, firms,

.

all the influences from monetary policy,

be recessions and expansions because of these

surprises.

there

Changes

in the economy that economists and pollcymakers do not
understand -- for example, technology and the changÍng tastes of

are occurring
completely

consumers and

uncontrollable

investors. Other changes occur which are considered to

-- like

droughts and

operate, these changes

oil spills. If

let market forces

wilì be accommodated or corrected in a natural and

gradual fashion. Market forces work best
l^lithout a doubt, there

we

in a stable policy

environment.

will always be short-term dlfflculties, but it is to

our long-term advantage to allow the world to experlence fundamental
Let

me emphasize,

I

be

am

not in favor of recessions. 0n the contrary, I

bel I eve

that vari abl e and uncertai n monetary pol i ci es exacerbate the

cycle.

l,,le

must remember

change.

that recessions

w'il

I

bus i ness

occur even under an ldeal

-4monetary

poìicy, but they wiìì not be as frequent or as Severe.

ideal policy
persi

we would

Under

an

not have recessions induced by inflation and the

stent need to el i mi nate i t .

ses: l,lhv Don't Ne Use Pol i cv to Thwart Them?
There is a blt of irony in the idea of forecasting recessions; that is, if
we could forecast recessions, we probably wouldn't have to vJorry about a
Nonnonetarv Surpri

policy to eliminate them. A recession is one kind of economic fluctuation.

of fluctuation -- seasonal fluctuations due to
tax laws, and cultural events like holldays. There is a fundamental

Consider another kind

weather,

difference in the way bre treat seasonal and business cycle fluctuations.
Seasonal downturns can be

larger than cyclical downturns, yet the

government

adjusts the data to account for seasonal downturns. Seasona'lity can be
adjusted because seasonal fluctuations are predictable based on past

experience. People can anticÍpate and prepare for seasonal downturns.
People have developed a

variety of

ways

to deal with

seasonal variatiöns

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

employment and

relatively high

incomes during

the

summer must

carry them through the winter

months. Successful retailers know that near'ly one-third

of their sales come

in the winter holiday season. Consequently, thelr budget plans and bankÌng
relationshlps reflect this cash fìow probìem.
People survive buslness cycles in many of the same ways that they survive
seasonal cycles. Firms build up a reserve of profÍts in good times to survlve
the bad times. Households save during good tlmes

--

and postpone ìarge

like unempìoyment insurance
the graduated income tax operate automatically to even out or stabilize

purchases

in

bad

times.

Government programs

spending over the buslness cycle.

and

-5-

condition

is that if business cycles were predictable -- a necessary
to justify a stabilizat'ion policy -- adjustments by people would

make such

a poìicy unnecessary.

'The point

Even

if

we thought

that eliminating the

healthy long-term goal,

I

believe

business cycle tras a desirable

and

it is impossible to do so. There are

several reasons that prevent us from using monetary policy to offset
nonmonetary

surprìses. First,

does not work ìmmediateìy

we cannot

predict recessions. Second, poìlcy

or predictably; 'it

works with

a

lag.

The

effects of

monetary poìicy on the economy are highly variable and poorly understood.
The

Crvstal Ball

Svndrome:

The

llmitations of

economic forecasting are

well-known. Analysis of forecast errors has shown that
when

a recession has begun unttl

there

we

often don't

know

it is well underway. At any point in time

is such a wide band of uncertainty

around economlsts'forecasts

that

the

pìausible outcome ranges from expansion to recession.
The people who make forecasts and those who use them
sense

of

often get a false

confidence because forecast errors are not distrlbuted evenly over

the business cycle.

Nhen

the

economy

is

doing well, forecasts that prosperity

will contlnue are usually correct. And when the economy is performing poorly,
forecasts that the slump wilì continue are also usually correct. The problem
lies ìn predicting the turning points. However, the turnlng polnts are the
things

we must

Monetarv

forecast to prevent recessions.

Policv's

Lonq and Variable Laqs:

Even

if

we could predict

recessions and wanted to vary monetary policy to allevlate them, we still face
an almost insurmountabìe problem

--

monetary policy operates with

a lag.

of the lag varies over time, depending upon conditions in
the economy and the pub'lic's perception of the poìicy process. The effect of

Moreover, the length

6-

today's monetary policy actions

wlll

probably not be

felt for at least six to

nine months, wìth the main influence perhaps two to three years

future.
may

The

act of trying to prevent a recession

may not

only

in the

fail, but it

also create a recession where there was not going 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

central bank. You know that a return to inflation is always a possibility.
Uncertainty about future policy makes you cautious about future investments.
Uncertainty about future inflation

will raise real interest rates, drive

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

to

end the

recession.

The more

future monetary poìfcy, the

needed

certain people are about the stabìlity of

more

easily and quickly inflatlon can be reduced

and the economy recover.
Ne

don't

know

exactly

of
today.

how

a particular pollcy actlon will affect the

poltcy is the topic of great debate underway

economy. The effects

monetary

among economists

Macroeconomic ideas about monetary po'licy and

effect on real output

have changed profoundly i n

learned that the effect

of

monetary

policy

the last decade.

its

þ'le have

depends on peoples'expectatlons

about pol ì cy.

Lessons !,le Shoul

If

d

Have Learned

we have ìearned anything about economic policymaking

in the last

twenty

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

that, "lrì order to

wrongheaded notion

reduce

ìnflation,

tre must have a recession,"

that completely ignores the ablìity of

their expectations as the environment

changes.

humans

to

adapt

is

a

7People do

decisions.
attempts

setting

If

their best to forecast

economic

when they make

the central bank has a record of expanding the

to prevent recessions, people wiII

off

policies

an acceleration

of Ínflation

come

money supply in

to anticipate the policy,

and misallocation

of

resources that

will lead to the need for a correction -- a recession. Suppose for a moment
that the recession followed a period of excessive monetary expansion -- a
common

occurrence

economy

in the United States over the last three decades.

often goes into recession following an unexpected burst of inflation

because peopìe have made decisions

course

An

of asset prices

that

and economic

were based on an incorrect view

activity.

The

of

the

central bank can do little

to cure the situation except to provide a stable price environment. This will
be the optima'l setting in which you can adjust your business pìans to work off
i nventorl

long

es and bad debts generated duri ng the 'i nfl ati onary

this takes depends

on many

factors,

some

of

expans i on

.

How

whìch are outslde the control

of the central bank.
A Zero Inflation Policv
The

Is a Pro-Growth Pollcv

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

It is no coìncidence that these expansions
have proceeded in the presence of reduced inflation. I think it is because

extraordinarily long expansions.

of, not ìn spite of, restrictive monetary policies that we have done so well.
of proìonged growth and relatively'low, stable inflation wlll
make it easier for central banks to continue fighting lnflation. It is very
important that we not return to the inflationary po]icies of the past. Doing
so w'ill almost certainly cause a repeat of the terrible recessions we suffered
The combination

i

n the ear'ly

I 980s

.

-8-

that the U.S. economy is currently operating weìl below levels

l^le know

that could

be achieved

if

we

eliminate

inflation.

Zero

inflation

lvould

make

our monetary system more efficlent, contribute to better decisions, and result

in

more

efficient

use

of our resources. Achieving zero inflation will allow

the economy to perform at a higher level.

Infl ation adds ri sK to
changes the nature

deci

sions and retards long-term i nvestments.

of the economic environment

so that random inflation

outcomes overwhelm otherwise prudent managers.

start up businesses
purpose

of

and use

hedging against

costly accountlng

It

Inflatìon causes people to

methods

that

have

the sole

inflation. In the absence of inflatlon,

the

in these areas could be devoted to produclng more goods and
servlces. Inflation interacts with the tax structure to stifle lncentives and
limit investment. Inflation undermines peoples'trust in government. hlhy do

resources working

we

allow thfs sand to clog the wheels of our

Primarv Goal

In

of

economy?

Monetarv Policv Should Be Price

my vìevl, monetary

Stabllitv

policy has onìy one goa'l -- price stability. Price

stability over the long run is the maJor contribution that monetary policy can
make to the attai nment of sustai nabl e prosperi ty. Pri ce stabi I t ty woul d
ellminate the dlstortlons that inflation induces ln the economic decisions of
househol

of

ds,

busi nesses

unnecessary

risk

, and workers. It

woul

d reduce the

dampeni

ng i nfl uences

and uncertainty on longer-term planning and investment.

dlfflcult to measure, are likely to be substantial over
time. And, although tt is necessary to think about the short-term costs of
eliminatlng inflation, it is also important to recognize the accumulation of
These

benefits, though

costs assoclated wìth the current inflation trend.

-9-

is to achìeve price stability and enjoy its benefits,
the Fed must have price stabiìity as its monetary poìicy goal. The Fed's

If

the United States

control of

time.

No

Some

money

creation gives

it

the power to control the price level over

other agency of government

argue

that the nation

ls equipped to do that.

and government have other objectives such

as

high empìoyment, rapÍd economic growth, and a stable foreign exchange rate.
During the past two decades, rre learned that

of price stability in pursuit of
empìoyment,

high

if

Fed compromises

these other goals, the

rapid economic growth, and a stable

inflation. I

the

its

result is not

exchange

goal

high

rate; the result is

believe that achieving price stabiltty

is the greatest

contribution the Fed can make to achÍeving these other important national
economi

c

goal s.

for the need to coordinate monetary and fiscal
poìicies. I believe that the experlence of the past two decades has also
taught us that monetary policy cannot correct the failures of fiscal
poìicies. A bad monetary pollcy won't produce better fiscal poìicies. I am
not suggesting that fiscal poìicy is unimportant for monetary policy. The
Arguments.are also made

accumulation

of large amounts of government

debt could create an incentive for

adopting inflationary monetary policies.

Central Bank Credi bì I i tv

of a monetary policy that strìves for price stabiìity lies in
the pubìic's assessment of its credibillty. In the final analysis,
credibility accrues to those who vlsibly make choices in support of their
announced goals. Congressman Stephen Neal has introduced a joìnt resolution
The success

(House

Joint Resolution 409)

monetary pol

mandating the Federal Reserve

and pursue

inflation. I
that it is valuable in two ways. Flrst, it

lcies leadlng to,

H.J. Res. 409 and believe

to adopt

and then maintalning, zero

support

-t 0-

explicltly

mandates

stability.

Second,

the Federal Reserve to pursue a single objective

it

establishes a

--

price

five year time frame for eliminating

i nf I ati on gradua'l I y.

"Price stabiìity," as

in

I

have been

Representative Neal's resolution,

factor in

economic decision

making.

to achieve exactly zero inflation

referring to

it

and as

it is referred to

is an inflation rate which is not a

It

would be undesirable, even impossibìe

each and every

year. Central banks cannot

control the price level over short time horizons such as one quarter or
one

year.

No

matter

how much people may wish

mlstake

or

will

always

be

will cause the price level to deviate
policy target of no change in the prlce level. It would be a

temporary and unforeseen

from the desired

otherwlse, there

even

factors that

to try to keep some inflation index on target

even each and every

anchor the price level

year.

A

firm

commitment

or create a world

each and every quarter,

to price stability

would

where people expect the average

ìong-run inflation rate to be zero.

stabllity wilì require a transition period in which we
el iminate inflation gradua'lly. H.J. Res. 409 mandates that inf latìon be
reduced gradually in order to ellm'inate inflatlon by not later than five years
Achieving price

from the date

perlod

of

enactment

is appropriate.

of the legislation. I believe the five year time

Some

people believe

within five years would lnvolve quite slow

that achievìng price stability

economic

activlty

and empìoyment

for an extended period. The costs of achievfng price stabÌlity are a
matter of substantial debate. I persona'lly do not believe the costs are
I arge. l,lhatever the costs mi ght be, we do know that the costs wi I I be I ess if
we begin the process of achleving price stability when inflation is low. Ïhe
costs will be less lf the Federal Reserve has a high degree of credibi'lÍty,
growth

wlll be less if the Federal Reserve makes a commitment to
prlce stability. H.J. Res. 409 would enhance the credibiltty

and the costs

achleving
monetary

of

policy even further and reduce the costs of ellminating inflation.

-11-

Concl usfon

Monetary

policy is being tested today. Although we have enjoyed high

levels of economic growth, recent slowing in economic activ'ity in the U.S.
prompted

calls for easler

monetary poìicy

--

lower interest rates and

has

more

rapid monetary growth. Yet, such a policy wouìd not only support the current

inflation rate, but
The

result

would also

lay the foundatlon for accelerating inflation.

would be an economy operating even

further below its long-run

potential

, wf th growi ng vul nerabi I i ty to frequent

monetary

policy that leads to zero inflation, even if

and severe recessions.

A

it risks a recession, is

our best opportunity for long-term growth.
Fears

of

stability.

recession create an apparently lnsurmountable barrier to price

This

is unfortunate.

The perceived

trade-off

between

inflatlon

illusion. In the end, inflatlon itself is the cause of
most recessions. In the end, conti nued i nfl ation wi I I reduce economi c
and recesslon

growth.

is

an

in the economy in the 1990s,
commit today to achieving zero inflation.

To achieve maxÌmum sustainable growth

central banks around the world should