The question for this essay is: Critically discuss the following statement: ‘Price stability should be the primary target of central banks around the world in the next decade’.
The Federal Reserve Act as amended in 1977 directs the Federal Reserve to pursue monetary policy to achieve the goals of “maximum employment, stable prices and moderate long-term interest rates.” The Federal Reserve and all central banks have also long been expected to promote financial stability. Specifically, central banks have been expected since the 19th century to serve as lender of last resort to the banking system by providing liquidity to prevent financial crises and disruptions in the payments system.
Are the goals of maximum employment, stable prices, moderate interest rates and financial stability compatible with one another? Many people believe that they are not. Conventional wisdom holds that if monetary policy is too focused on controlling inflation, for example, then employment and output growth will likely fall below their potential, and financial markets will be less stable than they otherwise could be.
The idea of stepping on the monetary gas pedal to boost employment and output growth, or to protect against financial losses, may seem appealing. Indeed, until recently, many economists believed that moderate inflation makes the economy perform better. However, a growing number of economists today believe that monetary authorities can best promote financial stability and economic growth by making a firm commitment to maintaining price stability. There is little evidence that expansionary monetary policy can increase employment or economic growth, except perhaps for brief periods, and there is no evidence that inflation fosters financial stability. On the contrary, history is full of examples of how an unstable price level can wreck a financial system and harm the economy.
Two Views about Inflation
On the subject of inflation, most economists fall into one of two camps. One camp believes that moderate inflation helps promote full employment, economic growth and stable financial markets. Inflation is seen as enabling labor and product markets to function more smoothly in the face of shocks that could otherwise reduce employment or output. Some in this camp believe that central banks can boost employment and output growth more or less permanently by allowing the inflation rate to rise.
The first camp had its heyday in the 1960s. At that time, the data suggested the existence of an exploitable tradeoff between inflation and unemployment—the so-called Phillips Curve, named after the economist A.W. Phillips, who first documented that the unemployment rate and changes in wage rates moved in opposite directions in the United Kingdom.
The Phillips Curve made monetary policy-making seem beguilingly simple. Choose a little more inflation, and unemployment would fall; accept somewhat higher unemployment, on the other hand, and inflation would be a bit lower. Policymaking was viewed as simply a matter of selecting from among a menu of inflation and unemployment options.
Several influential economists argued that this menu could be improved upon if policymakers were willing to discard their old-fashioned obsession with price stability. Allow some inflation, these economists argued, and the labor market would operate more efficiently, employment would rise and the economy would grow faster.
There were some notable dissents from this view. Milton Friedman and Edmund Phelps, both of whom later were awarded the Nobel Prize, argued that inflationary policies do not boost employment or economic growth in the long run. Instead, attempts to use monetary policy to engineer higher employment or faster growth result in ever higher inflation but no more employment or growth than was possible with a stable price level, they said.
Events also put a dent in the arguments of the first camp. Inflation began to rise in the mid-1960s, and it climbed still higher and became more volatile in the 1970s. Higher inflation did not bring about higher employment or faster growth, however. On the contrary, as shown in Figure 1, the unemployment rate was higher on average during the 1970s than it had been during the 1950s and 1960s. The unemployment rate fell in the 1980s and 1990s, albeit slowly, as inflation came down.
The Benefits of Price Stability
Under the weight of persuasive reasoning and empirical evidence, many economists abandoned the first camp and joined a growing second camp of economists, who believe that central banks can best promote high employment and economic growth, as well as financial stability, by focusing on the goal of price stability.
“Price stability” is usually interpreted to mean a low and stable rate of inflation maintained over an extended period of time. In our view, the ideal rate of inflation is zero, properly measured. Biases in price indexes imply that, in practice, price stability will likely be consistent with a small positive rate of measured inflation, say 0.5 to 1 percent, depending on the specific price index one looks at.1 Further, price stability does not mean that the price index is constant. Monetary policy could never eliminate every wiggle in the inflation rate; nor should policymakers try to do so.
Price stability means that inflation is sufficiently low and stable so as not to influence the economic decisions of households and firms. When inflation is low and reasonably stable, people do not waste resources attempting to protect themselves from inflation. They save and invest with confidence that the value of money will be stable over time.
In a market economy, consumers and firms base their consumption and investment decisions on information derived from prices, including asset prices and returns. Efficient allocation of economic resources depends on the clarity of signals coming from the price system, as well as the clarity of signals from governments and central banks about economic policy.
Uncertainty about the price level makes it difficult for firms and households to determine whether changes in individual prices reflect fundamental shifts in supply and demand or merely changes in the overall rate of inflation. By eliminating this uncertainty, a monetary policy that maintains long-run price stability eliminates a potential drag on the efficient allocation of resources and, hence, on economic growth.
Long-run price stability contributes to financial stability in a similar fashion. An unstable price level can lead to bad forecasts of real returns to investment projects and, hence, to unprofitable borrowing and lending decisions. Unexpected bouts of inflation, for example, tend to encourage optimistic forecasts of real returns. Errors in distinguishing nominal and real returns result in misallocation of resources and eventually to financial distress that would not occur if the price level was stable. Business decisions based on expectations of continuing inflation often turn out badly when inflation falls, resulting in higher default rates and business failures. Outright deflation is particularly notorious because a falling price level increases the real cost of servicing outstanding debt.
Price stability is the most powerful tool the central bank has to promote economic growth, high employment and financial stability. Price stability also enables monetary authorities to pursue secondary objectives, including the reduction of fluctuations in real economic activity and the management of financial and/or liquidity crises. These are referred to as secondary goals because a central bank is unlikely to succeed at limiting fluctuations in economic activity or containing financial crises unless the price level is stable.
