Federal Reserve Bank of Cleveland
Press Release

For Release: October 3, 1997
Contact: June Gates, 216/579-2048

Price Stability: Is Close Enough Good Enough?

When the inflation rate hit double digits in the late 1970s, few questioned the Federal Reserve’s decision to take strong measures against it. But today, with inflationary pressures scant, the Federal Reserve’s continuing focus on price stability is often criticized as unnecessary. However, in a recent Economic Commentary, Federal Reserve Bank of Cleveland Senior Vice President and Director of Research Mark Sniderman argues not only that a continued focus on price stability is appropriate, but also that it is the critics’ relaxed view about inflation that is misguided.

Sniderman points out that inflation increases the effective tax rate on capital income, which discourages capital formation and long-term economic growth. In addition, people devote time and real resources to avoiding the costs of uncertain inflation. In the 1970s, for example, many people bought houses as an inflation hedge, and the resulting housing boom diverted land, labor, and financial capital from other, more productive, uses.

The author acknowledges that economists have had difficulty quantifying large social losses in low-inflation circumstances. But even if the costs of low inflation are small, Sniderman advocates being intolerant of even a little inflation, for two reasons. The first is that tolerance of low inflation risks unbounded expectations -- the notion that if 3 percent inflation is thought to cause little harm, then neither will 4 percent; and after a while, 5 percent becomes only a small differential from 4 percent, and so on. The second is that there exists a widespread but false notion that inflation can be traded off permanently for something of value, such as faster economic growth or lower unemployment rates, and tolerance of any inflation increases the temptation to seek such trade-offs.

Sniderman concludes that price stability will not be achieved until the public supports the principle that monetary policy best contributes to national prosperity by eliminating both inflation and the expectation that it will reemerge.

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