Price Stability: Issues and Challenges
Central banks have done a very impressive job of achieving low and stable rates of inflation in recent years. But despite past successes, they must always be ready to deal with new challenges that might arise. Sandra Pianalto, president and CEO of the Federal Reserve Bank of Cleveland, discusses some of those challenges and how central banks might best prepare for them (from a speech she gave at a conference sponsored by the Deutsche Bundesbank and the Cleveland Fed in Frankfurt, Germany, on June 6, 2007).
I think we would all agree that price stability is a top priority for central bankers around the world. For the European Central Bank, price stability is the sole objective. For the Federal Reserve, it is one pillar of our dual mandate, the other being maximum sustainable economic growth.
Central banks have done a very impressive job of achieving low and stable rates of inflation in recent years. Despite our past successes, however, we must always stand ready to deal with challenges that could eventually confront us. I will discuss some of those challenges and how central banks might best prepare for them.
First, I will explain why maintaining price stability requires more than just keeping inflation low—it also requires keeping inflation expectations low and secure in the face of potential inflationary risks. Second, I will describe some of those inflationary risks that may become significant down the road. Finally, I will discuss why, in the face of these risks, the ability of central banks to maintain price stability will depend on the clarity and transparency of their communications.
Please note that my comments are my own; I do not presume to speak for any of my colleagues on the Federal Open Market Committee.
Maintaining Price Stability Requires More than Just Keeping Inflation Low
A few years ago, former Federal Reserve Chairman Alan Greenspan stated that “price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms.”1 This is a fairly common definition of price stability, and it has two essential characteristics. First, actual inflation must remain low and stable and, second, people must have every confidence that inflation will remain low and stable. This second characteristic may not get as much emphasis as it deserves. Price stability is more than keeping inflation in check—it also means keeping inflation expectations in check.
Of course, actions speak louder than words, and ultimately, the public will judge the central bank’s resolve to keep inflation low and stable by whether it actually delivers low and stable inflation. But can inflation expectations come unglued in the face of some as-yet-unrealized threat?
I think most of us recognize that under some circumstances, expectations can become unglued even if the current inflation measures appear contained. From time to time, there are pressures on a central bank to “buy” relief from economic troubles with artificially low short-term interest rates. The public understands these pressures, of course, and if it believes that the central bank will yield to the pressures, inflation expectations can rise. Also problematic is that inflation uncertainty can rise. Both of these outcomes impose costs on the economy by misdirecting the way resources are allocated. Most notably, long-term interest rates may move higher than they otherwise would, interfering with saving and investment decisions.
Central bankers face an unpleasant dilemma when inflation expectations become unanchored. Central banks could validate these rising expectations by actually delivering higher inflation, but that outcome would be contrary to our policy objective. Alternatively, central banks could pursue policies that generate lower inflation than the public expected. This, in my opinion, is the correct course, but there can be costs in terms of lower short-term growth—costs that would not be incurred if expectations had remained aligned with the central bank’s inflation goal in the first place.
The past quarter-century has brought relatively good times for central banks. But the credibility test comes when the economic currents are not so favorable. History has not always been kind to central bankers, so if we are prudent, we must prepare for the challenges to price stability that may still lie ahead of us.
Potential Inflationary Risks Down the Road
Let me describe some potential inflationary risks that I believe could challenge central banks down the road. Although there are many such risks, I will focus here on three familiar ones: relative price shocks, extraordinary liquidity crises, and the deficit problem.
The first inflationary risk occurs from time to time when large and persistent relative price shocks temporarily ripple through the inflation data. The obvious example is energy prices, although we see such changes in commodity prices more generally. These price pressures are temporary and so do not represent changes in the inflation trend. Still, a central bank cannot ignore them if it hopes to maintain credibility for delivering low and stable inflation.
Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3 percent.2 This is above where I would like to see the trend settle in the longer run. The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear about our belief that the impact of these influences will dissipate over time. But until our beliefs are validated by the data, there is a risk that the public’s trust could erode and inflation expectations could move higher.
The second inflationary risk that central banks should be prepared for is what could come about when responding to extraordinary liquidity crises. This is an important lesson learned from experience. Just consider a few examples of what the world’s central banks have dealt with in the past few decades: the U.S. stock-market crash of 1987, the Asian currency crisis in 1997, and the collapse of the Brazilian real in 1999.
The Federal Reserve was largely created to act as a lender of last resort, and central banks have often provided liquidity in times of large-scale financial stress. I think this is the appropriate response to financial market turmoil, but in any given case there are still questions of how much to intervene, and for how long. How those questions are answered can have longer-term consequences for inflation expectations.
For example, let’s recall what happened with U.S. monetary policy beginning in the latter half of 1998. At this time, we were well into the turmoil that began in Southeast Asian economies the summer before. In September 1998, the Federal Open Market Committee informally convened via telephone for an unusual pre-FOMC meeting discussion regarding the unsettled nature of financial markets. At the formal FOMC meeting soon afterward, the Committee cut the federal funds rate target, followed by two additional cuts in October and November. In each case, the record makes clear that the Committee’s decisions were greatly influenced by the unusual strains in financial markets.
Throughout the spring of 1999, the Committee held the federal funds rate at the lower level, citing continuing downside risks associated with global financial conditions. In May 1999, the Committee signaled that inflation concerns were taking on greater weight in their policy deliberations, and in June the Committee raised its federal funds rate target. The Committee eventually raised the federal funds rate target to 6½ percent in May 2000—its highest level in a decade. The final step in that sequence was a 50-basis-point hike, and the minutes of that meeting indicate that at least one of the motivating factors was a concern about fragile inflation expectations.
The FOMC’s policy course was ultimately successful in containing inflation, but we now know that industrial production was reaching its peak just as the FOMC was ending its sequence of rate hikes. With the benefit of hindsight, it seems likely that the policy environment of the time was complicated by the fact that inflation expectations were on the rise.
As I mentioned earlier, I think the record of monetary policy for the past quarter-century in the United States, in Europe, and elsewhere—is a great success story. But we live in an era of rapid and dramatic financial innovation and increasingly integrated financial markets. We need to explore how best to meet those challenges effectively, and in ways that preserve the public’s confidence in our commitment to price stability.
The final inflationary risk is what I will simply call the “deficit problem.” By this I am, of course, referring to fiscal imbalances—in both the United States and Europe.
In the 1970s, economists Tom Sargent and Neil Wallace gave us a lesson in “unpleasant monetarist arithmetic.” They noted that fiscal imbalances provide a temptation to inflate away the value of the government’s outstanding debt, and this possibility may become embedded in inflation expectations. Those lessons are even more relevant when an important share of a nation’s debt is held abroad. The political cost of inflating away debt is lower when that debt is held predominantly by foreigners.
Unless the deficit problem is addressed through explicit fiscal policies or changes in national saving rates, creditors might reasonably conclude that debtor governments will resort to inflationary policies. Ultimately, however, central banks cannot control either fiscal policy adjustments or private consumption decisions. If fiscal dynamics don’t improve, central bankers could once again face the difficult challenge of maintaining price stability in a world where expectations are moving in the wrong direction.
The Importance of Clear Communications
So what assurances can central banks provide to secure inflation expectations in the face of these risks? Here, I believe, we are still learning. We actually know very little about how the public forms its expectations and the specifics about how best to secure them. In fact, just last month the Federal Reserve Bank of Cleveland held a joint conference with the Federal Reserve Bank of Dallas to better understand inflation expectations. Central banks from 22 countries were represented, underscoring the universal interest in this topic.
What seems clear enough is that without convincing guidance from the central bank, the public is left to guess about future inflation based only on the central bank’s history. Clearly, history alone could be insufficient to hold expectations stable in times of crisis.3 And so central banks are developing strategies to provide that guidance.
Suppose I asked you to describe the most important ways central banks have changed in the past quarter-century. What would you say? First, I think you would say we have shown a much greater vigilance against inflation. But second on that list, I think, would be that central banks today spend a lot more time communicating—about the economy, about their policy objectives, and about the risks to achieving those objectives.
In the United States, the Federal Open Market Committee issues press releases immediately following our meetings, with minutes of the meeting released only a few weeks afterward. I can assure you that every word and every nuance in our communications are carefully considered. It is essential that the public understands our interpretation of the economic situation and that it supports our policies. In a very real sense, our communications have become a part of the policy process, because we understand that influencing inflation expectations is an important dimension of monetary policy.
Some central banks hold regular press conferences. And, of course, some have established explicit numerical objectives—or inflation targets—and publish economic projections that clearly show what they are aiming at and how they expect to get there. Our different approaches are, in part, a result of our different histories and governance structures. But also, I think, central banks are still developing “best practices” for securing inflation expectations in the face of unknown future risks.
However, differences in tactics should not be confused with differences in intent. I believe that my colleagues—and indeed, most central bankers today—are working to achieve the same end. We are all trying to create an environment in which inflation is so low and stable that it does not influence the decisions that households and businesses would otherwise make.
I continue to be optimistic that central bankers will successfully meet the challenges that lie ahead. And indeed, inflation expectations appear to be well-anchored. But we cannot afford to be complacent, and that is why research activities like those represented at this conference are so important.