Views on Monetary Policy During My Four Years with Them

W. Lee Hoskins

W. Lee Hoskins is president and chief executive officer of The Huntington National Bank in Columbus, Ohio. This paper is given in honor of Ted Ba/bach and his service to the Federal Reserve Bank of St. Louis. His resolute pursuit of sound economics as the bedrock of monetary policymaking and his indomitable spirit, even when the policy process ran amok, has served us all welt I thank John Davis, Sandra Pianalto and members of the Research Department of the Federal Reserve Bank of Cleveland for helping to shape and advance my views on monetary policy during my four years with them.

Views on Monetary Policy

HE IDEAL MONETARY POLICY requires a efforts to coordinate monetary policies are credible and predictable commitment to main- likely to conflict with that objective. tain the long-term purchasing power of a currency. The performance of central banks, WHY CENTRAL BANKS? which have traditionally been entrusted with monetary policymaking, is far from this ideal What is the justification for a central bank? simply because a clear mandate for price-level Can some configuration of private institutions in stability—zero inflation—is absent. In practice, a so-called free-banking environment perform central banks serve as instruments that govern- the functions of a government-sponsored mone- ments use to pursue multiple objectives that they believe serve their interests. Therefore tary authority? Are central banks necessary? central banks pursue monetary policies that at In his 1959 Millar Lectures at Fordham best have only a fragile commitment to price University, Milton Friedman provided a classic stability. Governments are currently pursuing statement of the economic rationale for central policy coordination or monetary union strate- banks.’ Friedman’s argument appealed funda- gies that are little more than attempts to implement mentally to the costs inherent in a pure commodity- a regime of monetary protectionism, in the standard system, for example, a gold-standard global economy. The future of monetary policy system. These costs arise both from pure resource rests on the continuing struggle between politi- costs and perhaps more significantly from sub- cians seeking policies that serve their short-term stantial short-run price variability resulting from agendas and global financial markets that limit inertia in the adjustment of commodity-money the actions of an individual central bank. supply to changes in demand. The inefficiencies these costs represent are a significant disadvan- In my remarks I discuss why central banks tage of commodity-money exchange systems. have been established, their bias toward inflation and the importance of independence and As a consequence there is a natural tendency, accountability to their effectiveness. 1 also argue borne out by history, for pure commodity standards that zero inflation should be the dominant to be superseded by fiat money. But particular objective of a central bank and that current aspects of fiat money systems—such as fraudulent

‘These lectures were subsequently published as A Program for Monetary Stability.

MARCH/APRIL 1993 44 banking practices, natural monopoly characteristics sider the advantages of improving the perform- and tendencies for localized banking failures to ance of central banks. The benefits of a properly spread to the financial system as a whole—resulted managed fiat currency are considerable, and the in the active participation of government. We have issue is or should be how to provide the central come to know this active participation as cen- bank with a proper charter to ensure policy tral banking. action that generates price-level stability in the long term. If such efforts fail, market alterna- Rationales for establishing central banks have tives should be sought. not gone unchallenged, not even by Friedman.’ Disruptions in payments can be costly, but so Because I am most familiar with the Federal are the instabilities and inefficiencies caused by Reserve, let me use it as an example. Before the the lack of an effective anchor for the price creation of the Federal Reserve in 1913, the level in fiat money systems. Moreover, ‘theoretical country prospered without a central batik. discoveries in finance and monetary economics, Broadly speaking, the impetus for creating the closer attention to the lessons of lustorical bank- Federal Reserve was a series of banking panics ing arrangements and advances in infot-mation that led to contractions in money and credit and financial technologies have contributed to a that in turn caused serious disruptions in eco- healthy skepticism about the supeiiority of central nomic activity. The nation sought to improve its banks and government regulation to alternative banking system by establishing a means for market arrangements. For example, some of the providing an elastic money in the context of a financial-backstop functions performed by central monetary standard based on full convertibility banks and banking regulators may have weakened to gold. The gold link was severely weakened private market incentives to control and protect by the Gold Reserve Act of 1934. against risk.’ The Federal Reserve was the result of a com- Stilt, those who argue for alternative monetary promise between those who would have kept structures must at least recognize that their the banking system entirely private and those case rests on untested propositions. Yes, it would who wanted government to assume a prominent be wrong to accept unthinkingly our current role in a rapidly growing economy. Other nations central banking system as the best alternative have grappled with the same problems and created for performing the monetary functions of advanced similar institutions. Today many republics of economies, but it would also be wiong to claim the former Soviet Union and several eastern Euro- that the current central banking system does pean nations are facing these same issues. We not reflect society’s choice of an institutional now have a world monetary system in which arrangement to perform those functions. governments, through central banks, monopolize It is not sufficient to argue that market- the supply and management of inconvertible oriented alternatives to oui current central fiat monies. banking systems functioned better in other times and places, for example, in 18th-century The displacement of the commodity standard Scotland.4 This begs the question of why such a that prevailed at the time the Federal Reserve was founded has exposed problems not other- system did not prove to be sustainable. Nor is it wise envisioned in 1913. For example, the price sufficient to argue that this system would have level has no anchor except fot that provided by prevailed if not for government intervention arid interference. This line of debate fails to the resolve of Federal Reserve policymakers. consider whether a political equilibrium that The quadrupling of prices since 1950 dramati- cally demonstrates the failure of Federal Reserve would support a market-oriented system in an advanced economy exists anywhere. policymakeis to provide such an anchor for the monetary exchange system. Fed policymakers’ It is premature to claim that some hypothetical commitment to price stability is neither as explicit monetary system can or should dominate institu- nor as strong as necessary for the successful tional arrangements that have already evolved management of a fiat currency. The gradual from extended political and economic experience. demise of our convertible monetary standard I believe that the prudent first course is to con- has brought us to a point that requires a basic 4 ‘See Friedman and Schwartz (1986) For a discussion of the free banking era in Great Britain, see White (1984). ‘See Goodhart (1988).

FEDERAL RESERVE BANK OF ST. LOUIS 45 change to the framework within which the over time, the choice of targets or operating Federal Reserve functions if the benefits of a procedures probably only influences the variabil- fiat currency are to be achieved without large ity of inflation rates around a zero mean. In short, offsetting costs. a central bank that truly wants to achieve price- level stability can do it with any number of The evolution of the global monetary system operating techniques, as long as they control reflects a common, though unstated, acknowledg- money growth over time. ment that the benefits of a fiat monetary standard are substantial. Wise administration of that Perhaps a simple, and less elegant, explanation standard requires a central bank in some capacity. for persistent inflation is that central bankers are In this context, the essential issue is this: How can suffering from a Keynesian hangover. Centi-al nations achieve the benefits of a fiat money hankers, politicians and the public are merely standard and simultaneously consti-ain the exercise reflecting the prevailing economic dogma that of that power to the service of the public good? government has the responsibility and ability to Put another way: How can a nation prevent its manage aggregate output and employment, as central bank from debasing the monetary standard well as inflation. I have argued and continue to it is charged to protect? believe that a major source of price-level insta- bility comes from multiple objectives assigned to INFLATIONARY BIAS OF CENTRAL central banks—economic growth, employment, price stability and exchange rates. It is true that BANKS politicians pressure central banks to achieve different objectives at different times. Such politi- The answer to these questions seems to elude us. cal pressure can produce inappropriate policy Witness the universal debasement of currencies actions; however, the responsibility for assign- by central banks since the loss of a commodity standard as a price-level anchor. To find the ing multiple objectives to central banks rests as much with the economics professions as it does answer, we must review central bank charters with politicians. For the last 50 years, many and the incentives provided to those who con- economists have supported various theories of trol monetary printing presses. public-choice business-cycle management, which required that economists have focused on this issue and developed a rich literature; however, I feel they central banks shift from one objective to another. Today businessmen, politicians and most econormusts fail to provide a satisfactory explanation of the continue to believe that if the economy is weak, secular bias toward inflation among central the central batik should respond regardless of banks (with different charters and varying the cause of the weakness. And so it does. degrees of independence from political influence). Moreover, this approach fails to explain why in Some of the current discussions about mone- earlier periods governments did not consistently tary policy and the Federal Reserve suggest that exploit the opportunities to inflate by realigning the lessons of the 1970s may he fading from their currencies against gold or dropping their out- memories. Calls for lower interest rates or more convertibility - rapid money growth are not at all unusual. Another explanation br persistent inflation More often than not, those suggestions seem that iìas some appeal is policy mistakes, or inap- impelled by desires for growth or desires to off- propriate tat-gets or operating procedures of set the problems of particular sectors of the economy. They seem based on the notion that central banks. This explanation also leaves some there is a trade-off between inflation arid output unanswered questions. Why aren’t policy mistakes symmetrical? That is, why don’t they cause defia- or between inflation and employment that can be exploited by the central bank. Some of us tions as well as inflations, leaving the average learned from the experience of the 1970s that pt-ice level unchanged over time? Perhaps policy such a trade-off does not occur over time. mistakes are biased toward inflation because of Instead, higher inflation only added to uncer- the operating procedures employed, such as taints’, distorted resource allocation and reduced interest rate targeting. Yet the Bundesbank, which economic performance below the maximum sus- uses monetary aggregate targets, produces a rising tamable level with price stability. price level. The Bank of Japan uses interest rate targets and has generated a similar increase in Members of a central batik policy committee its price level during the past two decades. If a such as the Federal Open Market Committee central batik is dedicated to price-level stability (FOMC) reflect what is believed by the mainstream.

MARCH/APRIL 1993 46

In January 1990 the National Association of ence and the ability to achieve price stability. Business Economists surveyed its members and Recent studies show that countries that grant asked the following question: Is reducing the their central banks the greatest degree of inde- inflation rate to zero over the next five years pendence have had the lowest rates of inflation.8 the appropriate objective of monetary policy?” Even taking into account other sociopolitical More than 80 percent of the respondents factors that might cause inflationary pressures, answered no. Their responses indicate that they the degree of central-bank independence appears believe the FOMC should trade off inflation for to have an important effect on a country’s infla- some other objective, presumably economic tion rate. growth At about the same time, the House Sub- committee on Domestic Monetary Policy sur- However, with independence must come veyed 500 members of the American Economics accountability. Even the clearest objectives will Association who list monetary economics as either prove elusive without accountability; independence their first or second specialty. The unpublished without direct accountability is a dangerous survey shows that only a slight majority of those brew for those who drink it. Great harm has who responded favored zero inflation over the come from well-intentioned, independent cen- next five years. tral bankers with little or no accountability— witness the United States in the 1930s. Many I believe that much of the inflationary bias of mechanisms exist today to bring accountability central banks over the past 50 years reflects the to central banking; for example, the employ- prevailing view that output and employment ment contract of the governor of the central fluctuations can be smoothed with monetary bank of New Zealand contains a price-stability policy. Currently, before each FOMC meeting, requirement. members of the Committee are presented with the policy views of several prominent economists. The objectives, degree of independence, and Either explicitly or implicitly, these views invari- accountability of the central bank are substan- ably present the policy choice in terms of a tially determined by its legal structure. For Phillips curve trade-off. Staff projections at the example, a clear legislative directive to achieve FOMC meeting also imply such a trade-off, as price-stability goals above all others and the do the statements by some FOMC members. freedom to pursue price-stability initiatives Moreover, policy actions, such as a reduction in would all but eliminate potential conflict with the federal funds rate, often follow the release other objectives. The vexing question of what of employment or output statistics, further rein- extent, if any, a central bank should compromise forcing the notion that the F’ederal Reserve can the price-stability objective to pursue auxiliary manage real variables. To the extent that this goals, such as smoothing real output fluctua- explanation of central bank behavior is valid, tions or stabilizing exchange rates, should be inflationary bias will not be eliminated until resolved and dictated in the legislative charter. there is agreement within the profession on True independence and strict accountability can price-level stability as the dominant objective for be attained only legislatively. central banks. Compared with the central banks of other countries, the Federal Reserve System has a INDEPENDENCE AND better structure to execute monetary policy ACCOUNTABILITY effectively; however, the Fed is not as well posi- tioned as other central banks. The FederalReserve The problems that emanate ftom multiple, is charged with multiple objectives that are and often incompatible, objectives are well often incompatible but that at least include known. To conttibute to maximum economic price stability. It is functionally independent growth over time, central banks must achieve within government, but it faces intermittent price-level stability. Achieving this goal requires challenges to its autonomy. Its independence that central banks be free from political comes from both its charter and its practice. expediencies—that is, that they have independ- lndependence is essentially a delineation ence within government. Substantial evidence between the responsibilities of Congress and the indicates a link between central-bank independ- executive branch on one side and the monetary

6 ‘See NABE Policy Survey (1990). See Alessina (1988) and Banaian (1983).

FEDERAL RESERVE BANK OF ST. LOUIS 47 authority on the other to limit the motive and year, inflation measured by the consumer price means to debase the value of the nation’s money. index fell to 3.2 percent—a 16-year low. As the decade proceeded, the deficit relative to GNP ‘~“he~~sourceof tension between monetary and rose, fell, and rose again to its present level fiscal authorities is the central bank’s ability to above S percent. The inflation rate was impervi- create money. Because the creation of fiat money ous to these patterns. imposes an implicit tax on money balances, the monetary authority is one source of government Astute observers might question the melevance of revenues. For the most part, the long-run viability the early- and mid-1980s to the fiscal dominance of the government’s fiscal operations requires proposition, because deficits as they are conven- that its real current debt burden plus the present tionally measured do not necessarily reflect the value of its expenditures equal the present value government’s long-run fiscal operations. To name of revenues. Thus if the path of debt plus expendi- just a few of the problems, the value of long- tures diverges from the path of explicit tax rev- run government net liabilities is inherently enues, fiscal viability requires that the discrepancy ambiguous, the path of future revenues is un- he satisfied by seigniorage from monetary growth. certain and the appmopriate method of discounting This scenario is typically referred to as fiscal future tax and expenditure flows is problematic. dominance over the monetary authority. Although sympathetic to this view, I am still left with the strong suspicion that if any period in The original Federal Reserve charter left recent history was ripe for the emergence of many doors open for the executive branch to fiscal dominance, it was the last 10 years. influence monetary policy. These were partially closed when the Banking Act of 1935 removed Indeed, as the decade progressed and the the Secretary of the Treasury and the Comp- predictions of the fiscal-dominance theory failed troller of Cvrrency from the Board of Gover- to materialize, more sophisticated variants of nors of the Federal Reserve System. In addition, the relationship between fiscal and monetary the law established the FOMC, with the seven policy began to find their way into economic governors and five of the Federal Reserve Bank research. The fiscal authority’s reign over the presidents as voting members, ensuring that subservient monetary authority was replaced by power within the Federal Reserve would be a more subtle and complicated institutional shared between political appointees and regional structure, a world in which fiscal and monetary hank presidents. Thus the fire wall that made the authorities played a game of chicken, the out- Federal Reserve, and not the executive branch, come of which left both parties less than fully responsible for monetary policy objectives was satisfied.~Although deficits may be detrimental reinforced. It was strengthened further by the to economic performance, the ability of the Treasury-Federal Reserve Accord of 1951, which Federal Reserve to resist monetizing debt has served as a clear statement that the Fed would protected the economy from even worse conse- not he coerced into solving the federal govern- quences. The Federal Reserve’s decision to resist ment’s debt-management problems. The institu- monetizing the federal debt resulted in loiver infla- tional structure was designed to ensure enough tion and contributed to fiscal reforms that started Fecletal Reserve independence within the govern- with the Gramm-Rudrnan-Hoilings legislation. ment to carry out this mandate without interference. In my view the Federal Reserve has sufficient This independence in principle has held up in independence to achieve pm-ice stability. The core- practice. ‘The dramatic increases in federal deficits problerri, however, is that the Federal Reserve is in the early- and mid-1980s prompted fiscal not accountable for that objective. Without dominance believers to predict that it would be accountability, the policy process will be neither impossible to achieve and maintain inflation credible nor predictable. The more credible the rates below the disastrous levels of the decade’s commitment to the policy goal, the fewer wrong start. So far, this prediction has not come to decisions will be made by the markets. The more pass. In 1983 the federal budget deficit was 3.8 predictable the policy reaction to unforeseen percent of GNP, a level far above the post- economic events, the more limited will be the World War II aver-age and nearly equal to the market reaction to those events. Credibility and postwar peak realized in 1975. In the same ptedictahility can substantially lower the costs

‘See Sargent (1985).

MARCH/APRIL 1993 48 of achieving and maintaining a stable price level. approach would be for the Committee to specify Yet with the disintegration of the monetary achieving the ultimate policy goal as the rule, aggregates as intermediate policy guides, discre- while using discretion in choosing actions to tionary monetary policy actions may seem espe- achieve the goal. cially hard to predict because policy objectives and Of course having today’s FOMC impose account- accountability for’ them are unclear. The exist- ability on itself (by adopting an explicit rule ing policy process, with its focus on short-term tying an instrument to a goal) is not a foolproof economic or financial developments does not way to achieve an official policy goal. Credibility provide credibility. would have to be earned through predictable How can we change the process to reinforce actions consistent with the goal. To adopt an the cm-edibility of a consistent goal? I think the explicit rule, at least a majority of today’s FOMC most secure way would be to give the FOMC a members must not only agree on an overriding legislative mandate to meet a consistent, attainable macroeconomic goal, but also renounce some and unchanging economic goal. Passage of discretion to pursue other goals. Moreover, House Joint Resolution 409, introduced by Rep- tomorrow’s FOMC could decide to change the resentative Stephen Neal, would pmovide that goal and hence the rule. In the current policy crucial reinforcement. The Neal resolution simply regime, today’s policy choice can in no way directs the Federal Reserve to make price stabil- bind tomorrow’s. Unless directed by society ity the primary goal of monetary policy and to through specific mandate, tomorrow’s FOMC achieve that goal within five year-s. History gives us always has the discretion to change the goal. little basis for expecting price stability or’ even a And with shifting goals there is no accountabil- stable rate of inflation because the FOMC has ity. I believe that the lack of accountability for a had no mandate to produce that result. Giving dominant policy goal of price stability is the the FOMC that mandate and knowing that the major cause of the inflationary bias in the U.S. FOMC intended to stabilize the inflation rate at economy since World War II. zero, would provide one gigantic piece of policy Although the specifics of the Federal Reserve informatiomi to any rational decision-maker- in charter differ from those of other central banks, the any dollar-denominated market. The Federal problems of comiflicting objectives and the lack Reserve would remain independent, and it of secure independence and explicit accountabil- would retain complete discretion about how to ity are common to all central banks in varying carry out policy. The only change would be that degrees. Experience around the world and Congress would provide more direction about through time repeatedly demonstrates that cen- the basic policy objective, and the Federal tial banks require independence from day-to- Reserve would be accountable for achieving it. day political life to perform their price-stability True accountability would also require an role. If we could create legal and cultural condi- incentive or enforcement mechanism for achiev- tions that truly fix a central batik with account- ing the objective. ability for anchoring the price level, the structure The FOMC can deliver lower inflation without of the central bank itself would become less important. Those circumstances would be a joy a legislative mandate. Of that you should have to behold, but I am afraid they will be some no doubt! Inflation is a monetary phenomenon, and the FOMC is the sole custodian of the quan- time in coming. tity of money in the United States. If a zero- inflation mandate were in effect, short-term WHY A ZERO4NFLATION deviations from zero inflation might occur, but OBJECTIVE? one way or another the FOMC could provide a stable price environment. As niany scholars I stmomigly believe for three reasons that the have urged, the FOMC might impose accounta- dominant objective of monetary policymakers bility on itself by tying policy actions to some should be price stability. First, in the long run, intermediate target variable by an agreed-on a central hank can control the price level of formula that would ensure price stability. These goods and services denominated in its own cur- days, the most popular candidates for an inter- iemicy, hut it cannot control the growth of out- mediate policy target seem to he nominal GDP put (potential or actual). Second, a credible and M2, either of which is thought capable of commitment to a price-stability objective enables producing reasonable price stability. Another a central bank to piomote economic efficiency

FEDERAL RESERVE BANK OF ST. LOWS 49 and growth (potential and actual). Third, price. efforts to index the tax system for inflation. level stability, popularly called zero inflation, is Even the bracket indexation implemented by superior- to inflation-rate stability. recent tax reform does not fully protect tax- payers from bracket creep, or nonlegislated Among economists, support for’ the fir-st reason increases in marginal tax rates created by infla- is nearly universal. There is also widespread tion. Complete indexation of the tax code, how- agreement on the second point. A central bank ever desirable it may be, will be extremely that pur’sues price stability promotes economic difficult to achieve. Will another inflationary efficiency and growth. I would venture further experience like that of the 1 970s be required to say that experience shows that central banks to induce further progress on tax indexation? that have sought to enhance economic growth I fail to understand why some feel that these directly have failed miserably at providing sta- inflation-tax interactions are a significant drag ble price levels and ironically have undercut eco- on the economy, yet argue that only Congress nomic growth in the process. The last reason—that should be concerned with the problem. The prob- rio inflation is prefer~ihleto stable, non-zero 1cm exists because of the interactions between inflation—is most contentious, particularly when inflation amid a tax systetn based in current dol- people attempt to compare the transitional costs lars. Therefore it seems that the responsibility of achieving price stability with the costs of for minimizing these costs lies as much with stabilizing the inflation rate at the status quo. the monetary authorities as with Congress. The argument that the cost of pursuing a zero- Doesn’t it make more sense for monetary inflation target would outweigh the benefit of authorities to try to correct the inflation part of reaching that target has two dimensions. The first the problem rather than simply hoping that is that the benefit of achieving zero inflation Congress will implement changes that it may he would he small. The second deals with the costs unable or unwilling to pursue? We speak about of moving from a 4 percent trend rate of infla- the costs of achieving zero inflation, but what tion to zero inflation. This is the transition-cost about the costs of fully indexing the tax system? argument, which essentially says that even if zero Surely they would he significant. is the place to be, getting there is riot worth the Another area of concern is the role of uncertainty ride. I believe that the benefits of zero inflatiomi as a source of inflation costs. How important are great and that the transition costs can he at-c the distortions that arise from pt-ice—level reduced if the Federal Reserve commits to an uncertainty? There is a class of models—the explicit plan for achieving zero inflation. market-clearing, imperfect-information paradigm The interaction between inflation and our cur- associated with Robert Lucas and others—in which inflation uncertainty harms the economy rent tax system, especially as it applies to income generated by capital, represents one of by distorting the period-to-period relative price the mnore significant channels through which signals that facilitate the efficient allocation of non-zero inflation can exact economic costs.’ scarce resources.’ Despite the pervasive intellec- This channel of distortiomi is often not taken tual influence exerted by the I ucas framework seriously because people think that its effects to this day, the empirical evidence accumulated are minimal or that it would be easy to index since the development of the paradigm in the the tax system. Correcting the tax code is a early 1970s has not been entirely supportive. good idea of course, but until that happens, This point is not lost on critics, who think that what possible excuse is there for not letting the the lack of eyidence on short-term distortions should persuade us that inflation uncertainty is monetary authorities do what is necessary to simply not that important to social welfare. improve 5OciLil welfare? Surel the relative-price/aggregate-price confu- It is clear that the horrendous U.S. inflation- sion stressed by the Lucas-type models isa spe- an’ experiences of the 1970s and early 1980s cial type of uncertainty. ‘I’he failure to find created the impetus for the limited inflation significant effects from uncertaint that is indexation of the current tax system; however, resolved within a few quarters tells us next to the job is far from complete. Capital gains, cor- nothing about the type of long-run uncertainty porate depreciation and interest expenses, and with which the zero-inflation position has personal interest income remain untouched by always been fundamentally concerned.

‘See Altig and Carlstrom (1990). ‘See Lucas (1972).

MARCH/APRIL 1993 50

Indeed, it seems likel that the uncertainty assume some frictions. These frictions, coupled occurring over exLended time horizons is pre- with the inability of markets to clear, mnake end- cisely what is most affected by the average ing inflation appear as costly as it does. inflation rate.’’ This is one reason why I favor a price-level tam’get. An imiflation-rate tam-get ena- Isn’t it sensible to assume that the implicit sources hles the price level to drift without bound, and of frictions that make lowering the inflation rate with no enforcement mechanism to ensure that costly would also con tr’ibute to making inflation inflation mistakes will be corrected, the long- costl in and of itself? For instance, a variety of run variance of the price level is infinite. When explicit and implicit nominal contr’acts alm’eady people have reason to believe that this standard exist, and a transition to zero inflation could alter will erode over time, they invest miujmiemous the real values of payments from those that resources to protect themselves. Those who were originally intended. But surely the entire have nominal debt outstanding will drag their institutional apparatus that generates these con- feet in paying it hack, whereas cm-editors will tracts must involve resource costs that are posi- invest in ways to accelerate the collection of tively related to the average i-ate of inflation. funds. ‘The private gains to self-protection are One should not compare the costs of achieving clear, as ar-c the social costs. zero inflation in non-market-clearing models, Recent experience is the best testimony to the where such costs are high, to the benefits of real resource cost of inflation. During the being at zero inflation in frictionless, continu- I 9705, people could see that inflation acceler- ously clearing models, whet-c the bemiefits are ated each year. The~’guessed, reasonably at the low. tf we use a model with frictions to meas- time, that financial assets had limited value in ure the cost of getting to zero inflation, then protecting their wealth from inflation. Conse- we should also use such a model to examine the quently, farmland, commercial and residential benefits of being there. This is one reason I am property, and precious metals became much skeptical of so many’ cost/benefit estimates of more expensive as people sought to shelter their reducing inflation. wealth. Not only was time spent seeking these I am also skeptical about tramisition-cost estimates investmnemits, which was socially wasteful, hut that do not account for the possibility that a also the resource misallocation itself resulted in price-stability objective will be r’egarded as a great waste of land, labor and capital that credible by the public. Ecomiomic theory and society is still paving for’ today. reasonable model simulations persuade me to It is difficult to comprehend how elficiemit believe that with credible precommitnient, a p1ann~m~gwithin the public and private sector-s central hank cami greatly minimize private-sector could not be inhibited liv this type of long-run planning errors during the transition pem’iod. uncertainty. Furthermore, the intuition that long- I think that much of the disagreement among run inflation uncertainty is costl\’ has empirical economists on the size of transition costs cen- suppor’t. In cross-country compar-isons, economic ters on the ability of a central bank to commit growth is negatively retated to the variability of itself credibly to achieving its objective. Until inflation. One finds that the case for reducing I see some hard evidence to dissuade mile, I plan price level uncertainty is far more compelling to continue my advocacy of price stability as the than a cursory analysis might indicate. overriding objective of eemitr’al banks. In evaluating the costs of attaining zero infla- It still puzzles mne that volumes of research have tion, economists almost always use morlels in been publisbed on central bank operating pr’oce- which markets do riot clear’ or do not clear dures arid management of monetary aggregates, without cost. Cone is the market-clearing, yet relatively little m’esear’ch has been published flexible-price, r’ationat-expectations model. In its on the value of a credible precor~imnitmnentto a place is a model with pm’ice conti-acts that make price-stability objective. Mv intuition tells me the tm’ansition to zero inflation extremely costly. that the latter is far more important than the ‘I’he source of the friction is usually riot entirely former in terms of economic welfare. Of course, explicit, hut the implication is I hat we must credihility depends on policy information avail-

“See Ball and Cecchetti (1990). “See Grier and Tutlock (1989) and Lebow, Roberts and Stockton (1990)

FEDERAL RESERVE BANK OF ST. LOUIS 51

able to market participants so that they can by central banks are not aimed at price stability, monitor pm-ogress toward the objective. hut rather are attempts to establish monetary protectionism. B monetary pm’otectionism, I m’efer One major benefit of imposing an explicit inten- to attempts to alter real exchange rates thm-ough tion on monetan’ policy is that policy actiomis in the manipulation of monetary policies and with the money market would become far less momentous than they are now. Currently, detecting a change hope of ultimately promoting a balance-of- paymemits objective. In the case of a deficit in the federal funds rate target from the pat- country, monetary protectionists call for an tern of open market opem’ations is crucial because expansion of money growth (om’ lower miominal it provides markets with one of the few clues as to what monetary policy the Federal Reserve is inter~estrates). A monetary expansion, other tlnngs being equal, will produce a nominal ~nwsuing. Canvassing the positions of individual depreciation. If iridiyiduals are unable to adjust FOMC members is a way of predicting futum’e prices immediately, or if they are slow in per- polic. If policy intent were explicit and credi- ceiving the inflationary aspects of this policy, a ble, however, finding the clues in open market real depreciation will accompany the nominal opem-ations would have less significance. depreciation. As most economists realize, how- 1 see the greatest payoff in more inforniation ever’, the inflation rate will eventually respond about policy intentions. An explicit FOMC com- to the monetary expamision, offsetting the nominal mitrmment to pr-ice stability would allow markets depreciation and ret um-ning the real exchange to shift resources fromn watching the Federal rate to its initial position. Nevem’theless, the tenuous, Reserve to watching the economy for produc- short-lived relationship between money and the

tive investment opportunities - Focusing on the real exchange rate is seductive enough to con- intent of policy contrasts markedly with conven- vince politicians amid other fine-tuners that tional concerns for more certainty about the monetary policy can serve mnercantilist designs. current degree of reserve restraint. There are many ways to reduce uncertainty about the My focus on this issue stems from a firm belief iriimediate funds-rate implications of policy, just that central banks can do no better than guar- as there are many time schedules by which the antee long-run price stability and that any efforts FOI’vIC directive might he released. More certainty to limnit this guarantee ar’e not likely to raise about the immediate policy implications of the world welfare. Central banks can juggle a real federal funds rate i-night make Fed-watching a exchange rate and inflation target no better bit easier, but it would riot dlo much to help than they can slide back and forth along a stable identify policy intentions hevond short horizons. Phillips cut-ye. A central bank that attempts to Releasing Fed directives eam’l~’might provide a maintain price~~stability and a nominal exchange slightly hr-ighter glimmer of policy intentions, rate tam-get has more policy targets than policy but only for a slightly longer policy horizon. instruments. At times, these two objectives might We do not need better’ information about the he compatible. For example, in the late t970s, latest directive; we need better- information limiting rapid dollar depr’eciation through inter- about the process through which all future vention could have been conipatible with a con- directives will be crafted—that is, policy imiten- ractionary monetary policy to eliminate inflation. tions. Nothing would prot’ide more insight than As often as riot, howeyer, these two policy a clearly stated goal objectives will be incompatible, amid the central bank must trade one objective for the other.

tinder such conditions, markets will view nei- MONETARY POLICY AND ther’ price stability nor exchange-rate stability as MONETARY PROTECTIONISM a credible policy. The knowledge that central banks will deviate fr’omn a policy of pm-ice stahil- Let me turn now to the effects of interria- itt’ to pursue an exchange r’ate objective will tional policy coordination on the pmmrsuit of zero raise uncertainty about real returns and will inflation.12 Exchange-r’ate regimnes and attempts distort the allocation of resources across sectors at nionetam’y union are currently undermining and through time. The resources dlevoted to the price-stability objective. Many actions taken protecting wealth fr-or-n possihle inflation could

l2This section summarizes ideas presented in Hoskings and Humpage (1990).

MARCH/APRIL 1993 52 he applied to more productive uses under a pol- Administration and Congress. The opportunity icy of price stability. Moreover, attempts to cost of government inaction, measured in terms maintain nominal exchange rates will not eliminate of votes lost, seemed to m’ise sharply in the exchange rate uncertainty because countries early i980s. will inevitably resort to periodic exchange-rate The U.S. current account deficit reflected realignments. Hedging exchange risk will remain imbalances between savings and investment in an important aspect of international commerce. the United States, West Germany and Japan. Politicians, however, cannot easily redress such Although monetary protectionism seems most structum-al relationships through fiscal policies prevalent under the present system of floating because of strong vested interests in maimitairnng exchange rates, it does not follow that floating various tax and expemiditum-e patterns. Umiable to exchange rates promote its use. Monetary pro- address these structural problems directly and tectiotnsm can result any time a govem’nnient quickly, policymakers might resort to exchange- accepts nonmarket criteria for exchange rates. market imitervention. When coordinated through Imi principle, a gold standard or a fixed exchange the Group of Seven, such intervention offers a rate regime can limit the scope of monetary highly visible signal that governments are respond- protectionism because, if all countries play by ing to the desires of theim constituemicies.’~ the rules of the game, they link money supplies closely to the flow of international reserves. Exchange rate policies can also offer temporary In pr-actice, however, such regimes do not benefits to specific constituencies. When goods destroy the political motives for monetary pro- prices are slow to adjust, a nonunal currency tectionism, and examnphes of monetary protec- depreciation is equivalent to a temporary, tionism under fixed exchange rates abound. across-the-board tax on imports and a subsidy By allowing some discretion in the choice of to expor-ts. With the terms of trade temporarily exchange m~ateadjustments, fixed exchange m’ate altered, certain gm-oups mi the traded-goods sectors m’eginies often produce a mechanism that weakens can realize benefits fmomn monetary protectionism the allocative efficiency of exchange markets similar to those afforded by more traditional and promotes rnercantilist objectives. forms of protectionism. Ultimnately, any benefits from monetary protectionism dissipate with a In contrast to the inten’entionist literature, high inflation rate and with reduced credibility tyhich presupposes an all-wise govem’nment act- of monetary policy. The inflation costs of mone- ing in the public’s best interest, a rich, growing tary protectionism, hotvet’em’, are dispersed across literature on political economy cham-acterizes a wider spectrum of individuals and over a elected officials as seeking to enhance their own longer time horizon than the benefits. A constit- power, prestige and wealth by maximizing their uency that m’eceives net benefits from monetary ability to gain votes. Politicians amid bureaucrats protectionism (export- and import-competing attempt to extend the scope of their influence firms) can exist. Such a constituency is likely to by responding to the demands of the most polit- he niore politicably cohesive than any coristit- uency for price stability. Consequently, a policy ically active constituencies, ‘~ A lioliticil justifica- tiomi for exchange rate manipulation is that it defers that seemns myopic fromn an econonnc perspec- criticism and postpones niore fundamental actions. tive can be politically attractive. For instance, in 1985 dollar exchange rates Another seemimigly attractive aspect of mone- were at their zenith, the U.S. current account tars’ protectionnsni is that Congress and the was detem-iorating rapidly and evidence sug- admninistration can justify it in terms of broader gested that the t/nited States was becoming a macroeconomnic considerations, such as exchange debtor country for the first time since %‘Vomld rate misalignment or cut-remit account innhalamice, War I. U.S. manufacturers, facing increasingly instead of industry—specific considerations, stiff competition worldwide, besieged Comigress such as automobile mmd steel employment. for trade legislation. Most impot-tant, analysts Consequently, the rent-seeking aspects of mone- increasingly linked the deterioration in the exter- tars’ protectionism am-c less obvious than those nal accounts with the fiscal policies of the Reagami of standard protectionist policies.

“See Quibria (1989) “The Group of Seven countries are Canada, France, Italy, Japan, the United Kingdom, the United States, and West Germany

FEDERAL RESERVE BANK OF ST. LOUIS 53

Countries interested in establishing exchange tent with a goal of price stability. When these rate targets have a strong incentiye to collude objectives conflict, the Federal Reserve System is in their efforts with foreign governments.” In torn between its independence amid its accounta- the case where countries attempt to alter nomi- bility to the broad national policy goals set by nal exchange rates, such collusion provides tacit Comigress and the Admniniistratiomi. The Federal for’eign approval of these policies arid linnts the Reserve does not wish to appear to the public chances that a foreign goyernment will take as unresponsive to the objectives of Congress steps to neutralize the exchange policies of and the administration. Participation also enables another government. Sometimes such collusion a central bank to imifluence policy formulations involves having cartel mnemhem~sdelay policy that it is powerless to prevent. Such reasoning negotiations, or exchange rate adjustments, is a certain sign of a central bank unsure of its when indiyidual cartel members face critical objective and insecure about its independence. electiomis. Bnetton Woods and the Eumopean In countries with independent central banks, Monetary System (EMS) are examples of collu- intervention policies might enable fiscal agents sion that were fairly successful for a period. to extend their influence beyond the foreign ‘rhe competitive currency devaluations of the exchange niarket to domestic monetary policy. 1930s show what can happen when govern- Elected officials often seek more stimulative ments attempt to fix a price but thieir cartel monetary policies than do cemitral banks, hoping breaks down. Coordinated efforts to fix exchange to lower nominal interest rates and to stimulate rates can allow individual countries to influence real gi-owth and employment. In choosing a the policies of others and to defer some of the nominal exchange-rate target, intervening and adjustment burdens of maintairnng the peg. encouraging the central batik not to sterilize the Such mechanisms are found in the EMS and intervention, fiscal agents have a mechanism for figure in some proposals for tam’get zones and for fixed exchange rates. Many support the pro- such influence that would usually riot he open. At timnes, however, such as when the centmal posal for a European Central Bank for just this bank policy conimittee is not in unanimous reason. The alternative is to sacrifice monetary agreement, such an influence, marginal though sovereignty to maintain a flxed exchange rate it may be, could pmove decisive in charting and to follow the monetary policy of a major future monetary policy actions. trading partner.

Under floating exchange rates, a rapid depreciation in the nominal exchange rate imi INTEGRATED MARKETS AND response to such inflationary policies signals the POLICY CONSTRAINTS market’s displeasure and constrains governments. Through collusion to fix the exchange rate, I have attempted to instill a healthy skepticism however, governments can ternpomarily blunt for exchange market manipulation, arguing that the exchange rate reaction to their policies and it is a form of monetary protectionism that harms reduce the political costs of pursuing inflation- economic welfare. Monetary protectionism stems ary policies. Coordimiation to limit exchange mate as a near-term palliative from the political inter- fluctuations is politically attractive because it actions between policymakers and constituen- eliminates an important, immediate barometer cies with vested interests in particular market of the market’s opinion of government policies. outcomes. Any international monetary order willing to accept nonmarket criteria for exchange For their part, centnal banks often are willing rates and failing to bind governments with a participants, viewing exchange rate management price-stability objective is ripe for monetary pro- as a legitimate aitn of monetary policy. Exchange tectionism. To counter the political incentives rate mnovememits can impart useful information for toward monetary protectionism, nations should policymaking, and as already noted, exchange rate adopt monetary mandates, such as the Neal targets can sonnetimes he consistent with a Resolution in the United States, that focus monetary policy of price stability. As often as monetary policy on achieving and maintaining not, however, exchange rate policies conflict long-tenm price stability.” ‘rhis would do more with price stability. For example, U.S. put-chases to eliminate exchange market uncertainty and of foreign curremicies in 1990 seemed inconsis- foster the efficient worldwide use of real

“See Vaubel (1986) “See Hoskins (1990).

MARCH/APRIL 1993 54 resources than mimi~’ pmogrann to manipulate as the goal, and piice stability is a more impor- miommunal exchange rates. tant goal than either. Scones of new natiomis are busy constructing My comments are riot meant as a blanket con- central banks to implement mnonetam-y policy. demnnation of imiternational policy cooperation. Using history as a guide, these miew cenitnai I strongly support cooperation that mnakes price bamiks will try to pursue objectives other than stability the dominant objective amid mecogmnzes piice stability, especially since thes’ are being coumi- market-determnined exchange rates. Only cooper- seled by cemitral hankers with weak records on ation based on these comiditions seems both price stability. Short-term political agendas will feasible amid credible because it recognizes that likely dominate their policy actions and push nations want monetary sover~eigntyand will them away fromn the pursuit of price stability. pursue diflerent economic policy objectives. Yet it seems that there are powerful market forces that will crimp the effom’ts of central Comitr-ar to what some mnight infer, tlns approach banks to misnnanage their currencies. does not preclude European monetar unnfication in the future, hut it suggests a different appn~oach ‘I’he integration of world mnarkets, particularly than curn-entlv seems to he favored. European financial markets, is limiting the degree to which govermimiients are not likely to relinquish national pohcymnakers are willing to drift away froni monetary sovereignty on adoption of a single price stability, at least for the major economies. market - Consequently, greater exchange rate Twenty years ago the Fedem-al Reserve paid flexibility than the EMS currently pmovides scant attention to the effect of foreign rnai-kets seems necessary to ensure that exchange mates on the price of U.S. govem’nnient securities amid do miot interfere with the efficient flow of iritemest mates in the United States. Yet when goods, lahom’ and capital following the removal I participated in FOMC deliberations, we almost of restrictions. The free flow of resources, if it always discussed the effect of a policy’ action on occurs, will foster a convergemice of policy long-term Treasun-y n~ates,cul-m-ency values or pm-efem-enices within Europe as goverrunemits com- the shape of the yield curve. The FOMC now pete for these resources by providing stable looks at how tt’om-ld financial nnarkets assess the economic and political environments. Govern- credibility of its policy actions with respect to mnents that fail to provide such an environment inflation expectations. This process, in effect, will lose resources as markets vote omi policies. limits the degmee to which the FOMC is willing The resulting convergence of nmiomietary and fis- to risk inflationary policy actions. cal policies will lead to greater exchange i-ate In Ermrope, smaller countries often peg their stability. If in time, governmemital competition curi-encies to the Gem’man mnark, allowing the for resources attaimis a convergence of macm-o- Bumideshank to determine their monetary Pol- econonnc policy, issues of national policy sover- icies. The Germami central hank is also limited eigmity will he muted. Only then will nnonetarv by world markets in ternis of the inflation path umiiomi augmenl the efficiency gains of a single it chooses to pursue. I am not so hold as to niam-ket. As seems obvious from r-ecent develop- aigue that miiarkets will cause central banks to ments in Europe, efforts to rush monetary wither away to agemicies that siniph’ 1)rniip out union mu-c effom-ts that put the cart before the monetary growth rates that provide price stability. horse amid may well interfere with the progress It does seem to me, however, that market forces toward a single market. are stn’engthening the hand of central banks in fighting political pressures for short-term “quick ‘to fix exchange rates before a convergence of fixes” to economic problems. Perhaps even poli- policy preferences within the European Economic ticians will learn the limits of goven-nments in Cornmnurnty seenis to ensnmre that interest rates solving economic problems. and pr-ices will hear more of the adjustment burden. Mom-coven-, judging from the experiemice If this view proves incorrect, central banks of Bretton Woods, fixed exchange rates would seemn will face the prospect of mmu~ketparticipants to guarantee speculators periodic exchange i-ate developing private money to a much greater adjustments and to encourage govermiments to degree than exists today. When government impede the flow of goods amid capital through management of paiticulam institutions results in the m-eintroduction of restraints. The dynannics failume, private-sector- alternatives appear— of achieving monetar-y union are as important witness the privatization trend imi U.S. schools

FEDERAL RESERVE BANK OF ST. LOUIS 55 and coum’ts. Pemliaps those who eam’n to revisit Hoskins, W. Lee. “The Case for Price Stability,” Econom/c Commentary, Federal Reserve Bank of Cleveland (March the Scottish system of free banking may live to 1990). seeaversion of it replace central banking. If so, and Owen F. Humpage. “Avoiding Monetary we are likely to pa~’a heavy price along the way. Protectionism: The Role of Policy Coordination,” Cato Journal (Fall 1990), pp. 541—55. REFERENCES Lebow, David E., John M. Roberts, and David J. Stockton. “Economic Performance under Price Stability,” unpub- Alessina, Alberto. ‘‘Macroeconomics and Politics,” Macro- lished manuscript, Board of Governors (December 1990). economics Annual (The MIT Press, 1988), pp. 38—43 and table 9. Lucas, Robert E. Jr. “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972), pp. 103—24. Altig, David, and Charles T, Carlstrom. “Inflation and the Personal Tax Code: Assessing Indexation,” Federal Reserve NABE Policy Survey. Econom/sts Expect Further Monetary Bank of Cleveland, Working Paper 9006 (July 1990), Easing; Do Not Favor FOMC Restructuring; Oppose Govern- ment Act/on to Curb Stock Market Volatility (National Ball, Laurence, and Stephen G. Cecchetti. “Inflation and Association of Business Economists, 1990). Uncertainty at Short and Long Horizons,” Brookings Papers on Economic Activity, vol. I, (1990), pp. 215—54. Quibria, M.G. “Neoclassical Political Economy: An Application Banaian, King, Leroy 0. Laney, and Thomas D. Willett. to Trade Policies,” Journal of Economic Surveys (1989), “Central Bank Independence: An International Comparison,” pp. 107—36. Federal Reserve Bank of Dallas, Economic Review (March Sargent, Thomas J. “‘Reaganomics’ and Credibility,” in Albert 1983), pp. 6—8. Ando and others, eds., Monetary Policy in Our Times: Friedman, Milton, and Anna J. Schwartz. “Has Government Proceedings of the Fir-st International Conference Held by Any Role in Money?” Journal of Monetary Economics the Institute for Monetary and Econom/c Studies of the (January 1986), pp. 37—62. Bank of Japan (MIT Press, 1985), pp. 235—52, Goodhart, Charles, The Evolution of Central Banks (MIT Press, Vaubel, Roland. “A Public Choice Approach to International 1988). Organization,” Public Choice, vol. 51(1), (1986), pp. 39—57. Grier, Kevin B., and Gordon Tullock. “An Empirical Analysis White, Lawrence H. Free Banking in Britain: Theory, Experi- of Cross-National Economic Growth, 1951—80,” Journa/ of ence, and Debate, 1800—1845 (Cambridge University Monetary Economics (September 1989), pp. 259—76, Press, 1984).

MARCH/APRIL 1993 56

Gcorg Rich

Georg Rich /8 a director and the deputy head of Department I at the Swiss National Bank.

1 Commentary

EE HOSKINS HAS WRITTEN a fine paper multiple objectives that often conflict. Phan~’ ott ruonetarv policy. I share most of his views cemitral bankers attempt to achieve at least two On the role arid duties of central banks. I loskins goals—to keep prices stable and to sniooth cycli-

discusses why the conduct of monetary policy cal fluctuations in output and emnplovmnent . ‘too has been entrusted to central banks. He also often, iloskins maintains, central bankers also examines the conditions that nimmst he satisfied for tr to manipulate the exchange rate with a view central banks to play an effective policy role. to strengthening the comnpetitive position of domnestic industry. Of course they do not pur- Hoskins’ l)Iilicipal thesis is that cemitral banks are sue rnul I iple objectives because of a character needed to manage a standard based on fiat miionev. defect. ‘l’liev mnerel i’eflect prevailing opinions But a fiat stamidard imposes few constraints on held by politicians, bankers, economnist sand central banks. If central banks ~ue pemmnil led to othem- members of the general lJLll)lic. issue fiat mnomwv, there is always the m-isk that they will abuse their powers. Consequenth’, In Iloskins’ \‘ie\\’, the performance of central under a fiat standam-d it is necessary to ensum-e banks could he much improved if they were that central banks act in the public interest. granted independence fronn govem-nmnemits and given a single objective—price stability. ‘the cell- Why rIo central banks frequemith’ harm the pub- tral banks—thonmgb independent—would not lie lic interest by debasing the currency? Hoskins allowed IC) choose policy objectives but would discusses several possible reasons. lIe dismisses he given a cIcai’ legislative mandate to achieve the answei-s offered by public-choice economists and main lain pm-ice stability. Moreover, they and also rejects the notion that unsatisfactory would he ac-countable to the public for theim performamic of centi-al b uiks is due to the pursuit of inappropriate targets om- operating proce- policy actiomi s. dures. Instead, lie main tainis that ‘‘cemitmal bank- I am largely sympathetic to Iloskins’ sugges- ers are suffem’ing fm’om a Kevmesian hangover-.’’ tions. An imidependent central bank with a clear Fm-equenth’ they do not dit-ect monetary policy mandate to pursue l)lic(~stability’ is likely’ to solely at price stability’ but attempt to prmrsue perform better than an imistitution attenipting to

FEDERAL RESERVE BANK OF ST. LOUIS 57 respond to diverse and conflicting political pres- frequently variable lag. In Switzerland the time sures. I also agree with Hoskins that the social lag may be as much asthreeyears. Therefore mone- value of a credible price-stability objective is tary policy decisions do not affect the inflation rate often underestimated, whereas the costs of until long after they are implemented. Because eradicating inflation are overstated. of the lag, such decisions invariably entail a great deal of uncertainty. Central banks may Thus I support Hoskins’ call for committing err even if they try to adhere closely to their central banks to a price-stability objective. In mandate. Once they recognize their mistakes, it my view, however, the story does not end here. is usually too late to take corrective action. A clear price-stability mandate by itself is not enough to improve the performance of central To lower the danger of policy blunders, cen- banks. Even if we agree that the objective of tral banks require reliable early warning signals monetary policy should be price stability, we still or leading indicators of inflation. Operational have to address a second question: How should rules centered on these leading indicators give central banks achieve and maintain a stable central banks a good chance of accomplishing a price level? goal of achieving and maintaining price stability. Hoskins plays down the problems of designing operational policy rules consistent with the Do central banks possess reliable leading indica- price-stability mandate. Yet as practitioners of tors of inflation? Thisquestion cannot be answered monetary policy know, the translation of such a straightforwardly. Monetarists tend to empha- mandate into specific policy rules is far from size the close relationship between money trivial. Switzerland offers a good case in point. growth and the inflation rate. They maintain I argue that the Swiss National Bank (SNB) pos- that the money stock serves as a good leading sesses a clear mandate to achieve and maintain indicator of price movements. Therefore central banks are likely to meet the price-stability objec- price stability even though Swiss law does not precisely define the objectives of monetary pol- the if they adopt an operational rule providing icy. This mandate, albeit informal, rests on a for steady growth in the money supply. remarkable consensus among the Swiss public Most central banks today share the monetarist about the objectives of monetary policy. view that inflation is due largely to excessive The SNB’s informal mandate explains why the money growth. Nonetheless, they hesitate to opt inflation rate in Switzerland has tended to be for strategies of steady money growth. The SNB low by international standards. Since the begin- is no exception. En Switzerland the growth in ning of 1975—when Switzerland shifted to both the monetary base and the money stock money stock targeting—inflation in Switzerland Ml tend to lead inflation. Therefore the SNB has averaged 3.5%. This average, however, still focuses attention on these two aggregates and far exceeds the SNB’s stated inflation target of 0 sets an intermediate target for the Swiss mone- percent to 1 percent. Consequently, the SNB has tary base. It strives to increase the monetary failed to achieve pricestabilitydespite the informal base at a rate of 1 percent per year. The SNB mandate. The SNB’s failure to meet its stated views this target as consistent with price stabil- target results largely from two short episodes of ity in the medium and long runs. accelerating inflation. From 1979 to 1981 and from 1989 to 1991, Swiss inflation temporarily Although the SNB follows a money-growth rule, rose to more than 7 percent and 6 percent, it need not augment the monetary base by 1 respectively. percent year after year. Depending on the circumstances, it may temporarily undershoot or overshoot the 1 percent target. For this reason, NEED FOR OPERATIONAL RULES the SNB frames its money-growth rule in terms of a medium-range target, to be met on the average The SNWs failure to achieve price stability did of a five-year period. Temporary deviations not reflect a Keynesian hangover. Rather, the from the 1 percent growth path may be SNB encountered various problems when it required ifserious unexpected shocks hit the Swiss attempted to translate its price-stability mandate economy. Two kinds of shocks may prompt the SNB into suitable operational policy rules. The need to deviate: unexpected shifts in money demand for operational rules arises because monetary and other unexpected shocks such as excessive policy affects the inflation rate with a long and movements in the exchange rate.

MARcWAPRIL 1993 58

SHIFTS IN MONEY DEMAND With hindsight, various students of Swiss monetary policy attribute the most recent surge ,\ strategy of steady money growth is effective in the Swiss inflation rate to the SNB’s cautious only if money demand is stable. In contrast to reaction to the demand shift. The SNtI, they many other countries, Switzerland has been assert, should have acted more aggressively. blessed with reasonably stable money-demand pat- The SNB’s cautious response no doubt was terns. But this does not imply that instabihties equivalent to a temporary easing of monetary have not occurred. Serious instabilities arose in policy. Nonetheless, it cannot be regarded as the the late 1 980s as a result of two Financial inno- main cause of the rise in inflation. Iamnot vations A new electronic interbank payments sys- aware of any economic theory able to explain tem and a major overhaul of liquidity requirements, how six months of easy money, which the mar- or minimum reserve requirements, imposed on ket correctly regarded as transitory, could have banks caused a huge liernianent drop in the generated three ~‘ears of high inflation. For this demand for base money. Much of that decline reason, I still maintain that central banks should occurred in the first half of 1988, but stability react cautiously to shifts in money demand. was riot restored until about 1990 or 1991.

OTHER UNEXPECTED SHOCKS It is clear that central banks must adjust the money supply to permanent demand shifts or Similar problems arise from other unexpected long-lasting temporary demand shifts if the\’ are shocks that may impinge on the central banks’ to keep the price level stable. It is not always anti-inflationar monetary policies. In small advisable to react quickly to demand shifts, countries like Switzerland, central banks are however. Money demand is subject to frequent frequently compelled to take the real exchange transitory movements that do not call for a rate into account when setting monetary policy. central-hank response. Moreover, demand shifts Real exchange i-ate movements often fail to are hard to detect. They often become fully reflect economic fundamentals. As 1 pointed out apparent only after considerable time has elapsed. before, Swiss inflation picked up temporarily in For these reasons, Meltzer (1987) and McCallum the early 1980s and early 1990s. Although the (1989, Ch. 16) recommend a slow reaction pattern. SNB attempted to keep the monetary base on a They propose mechanical rules that would prompt growth path consistent with medium-run price central banks to adjust the money supply gradu- stability, the Swiss franc weakened sharply in ally to demand shifts. I support Meltzer and real terms during both periods of high inflation; McCallum’s call for a gradual response, hut 1 that is, the depreciation was much larger than doubt that central banks should be committed would have been expected on the basis of infla- to a mechanical reaction pattern. The speed of tion differentials between Switzerland and other the response is likely to depend on the nature countries. Therefore the exchange-rate deprecia- of these shifts. For example, if central banks tion reinforced the inflationary pressures in know in advance that a major shift will occur, Switzerland. ‘the SNB reacted to this situation they should adjust the money supply quickly. by tightening monetary policy. As a result, the monetaiy base fell below the medium-run growth path. The tightening of the monetary Confronted with the demand shift of the late reins eventually caused the Swiss franc to 1980s, the SNB opted for caution. SNB officials appreciate again. In this way, the SNB counter- knew that a shift would occur but did not acted the inflationary pressures emanating from know how big the shift would be or how fast the exchange rate. base-money demand would fall. As a result of Lee Hoskins takes a dim view of central-bank the SNB’s cautious response, short-term domes- attempts to manipulate the exchange rate. How- tic interest rates fell sharply at the beginning of 1988 ever, he considers only central-bank efforts to but rose again as the SNB gradually lowered the stimulate domestic employment by means of an supply of base money. By summer 1988, short- exchange-rate depreciation. Such policies, I agree, term domestic interest rates returned to their may be inconsistent with the mandate to achieve pre-shift levels. Long-term rates, however, did and maintain price stability. But we should not not budge. Thus market participants correctly overlook the situations in which exchange-rate regarded the fall in short-term interest rates as movements undermine central banks’ anti- transitory. inflationary policy stances.

FEDERAL RESERVE BANK OF ST. LOtUS 59

Nevertheless, Hoskins’ objections to exchange- Faced with an excessive real depreciation, on rate policy aie often valid. Exchange-rate policy the other hand, it would push the monetary may or may not he consistent with p1-ice stability. base below that path. The resulting policy might Swiss experience offers examples of both types he closer to shock therapy than to gradualism. of exchange-rate policy. The SNB did mnore than The i-cal costs of the shock therapy would con- try to counteract excessive real depreciations of stitute the price the SNB would have to pay for the Swiss franc. In 1978 and 1987 it reacted to playing it safe. an excessive real appreciation by relaxing mone- In practice, I doubt that central banks are able tary policy. to disregard entirely the real costs of eliminating Although the real appreciation supported the inflation. The SNB has repeatedly emphasized fight against inflation, the SNR tried to halt or that it cannot stabilize the price level without even revet-se the upward movement in the accepting a temporary increase in unemployment. exchange rate. The SNB thought that its efforts But the Swiss pubhc also expects the SNB to to curb the appreciation of the Swiss franc keep the real costs of its anti-inflationary mone- ~yei~econsistent with its mandate to stabilize the tars’ policy as low as possible. Therefore the price level. In 1978 and 1987 inflation was low SNB, in pi-inciple, must follow a gradualist and declining. In principle it followed an opera- approach. We cou]d probably improve our per- tional sti-ategy of gradually lowering the infla- formance if in the future we display greater tion rate. In its view a gradual approach would r-eluctance to react to excessive real apprecia- minimize the real costs of achieving and main- tions of the Swiss franc than we have in the past. taining price stability. Considering its preference for gradualism, the SNB did not welcome the real appreciation of the Swiss franc because it affected the domestic economy in the same way CONCLUSIONS an unnecessary tightening of monetaj-y policy Let me conclude by emphasizing again that would. Therefore the SNB allowed money I agree with the thrust of Floskins’ reasoning. growth to rise temporarily above the level con- Monetary policy should be entrusted to indepen- with medium-run price stability. sistent dent central banks with a clear legislative man- Unfortunately, the SNB’s strategy of adjusting date to achieve and maintain price stability. But money growth to the real appreciation of the in my view, independence and a clear mandate Swiss franc turned out to conflict with the are not sufficient to guarantee a good monetary price-stability objective. In both periods inflation policy performance. It is also important that rose again in due course. The two short episodes central banks adopt opem-ational policy rules of rising inflation are largely explained by the consistent with their mandate. Although central SNB’s efforts to counteract an excessive real banks should be free to choose appmopmiate appreciation of the Swiss franc. operational rules, they should be commnitted to spell out explicitly how they intend to fulfill Thus Swiss experience lends at least partial their mandates. In particular, they should state support to Fioskins’ objections to excliai~ge~,-rate how they intend to respond to shifts in money policy. However, strict compliance with a price- demand and other unexpected disturbances. stability mandate need not imply that central banks should abstain totally from manipulating the exchange rate. Even if the SNB tried to rule out any risks of erring on the side of inflation, REFERENCES it could not afford to ignore real exchange rate McCattum, Bennett T. Monetary Economics (Macmillan, movements entirely. Instead it had to react 1999). asymmetrically. With an excessive i-cal apprecia- Mettzer, Allan H. ‘Limits ot Short-Run Stabilization Policy: tion of the Swiss franc, the, SNB would keep the Presidential Address to the Western Economic Association, monetai-t’ base on the medium-run growth path. July 3, 1986,” Economic Inquiry (January 1987), pp. 1—14,

MARCH/APRIL 1993