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Wall Street History
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03/03/2006
Fed Chairman Bernanke
Federal Reserve Chairman Ben S. Bernanke gave his first major
policy speech outside Washington on Feb. 24 at Princeton
University where he once taught. Focusing on the importance of
price stability, unlike his predecessor you can actually
understand him.
Following are some key excerpts that may provide a clue as to
future moves by the Bernanke Fed.
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The mandate of the Federal Reserve System has changed since
the institution opened its doors in 1914. When the System was
founded, its principal legal purpose was to provide “an elastic
currency,” by which was meant a supply of credit that could
fluctuate as needed to meet seasonal and other changes in credit
demand. In this regard, the Federal Reserve was an immediate
success. The seasonal fluctuations that had characterized short-
term interest rates before the founding of the Fed were almost
immediately eliminated, removing a source of stress from the
banking system and the economy. The Federal Reserve today
retains important responsibilities for banking and financial
stability, but its formal policy objectives have become much
broader. Its current mandate, set formally in law in 1977 and
reaffirmed in 2000, requires the Federal Reserve to pursue three
objectives through its conduct of monetary policy: maximum
employment, stable prices, and moderate long-term interest rates.
One of my goals today is to consider the relationships among the
three apparently disparate objectives of monetary policy. In
particular, I will argue for what I believe has become the
consensus view, that the mandated goals of price stability and
maximum employment are almost entirely complementary.
Central bankers, economists, and other knowledgeable observers
around the world agree that price stability both contributes
importantly to the economy’s growth and employment prospects
in the longer term and moderates the variability of output and
employment in the short to medium term .
Price stability plays a dual role in modern central banking: It is
both an ‘end’ and a ‘means’ of monetary policy.
As one of the Fed’s mandate objectives, price stability itself is an
end, or goal, of policy. Fundamentally, price stability preserves
the integrity and purchasing power of the nation’s money. When
prices are stable, people can hold money for transactions and
other purposes without having to worry that inflation will eat
away at the real value of their money balances. Equally
important, stable prices allow people to rely on the dollar as a
measure of value when making long-term contracts, engaging in
long-term planning, or borrowing or lending for long periods.
As economist Martin Feldstein has frequently pointed out, price
stability also permits tax laws, accounting rules, and the like to
be expressed in dollar terms without being subject to distortions
arising from fluctuations in the value of money. Economists like
to argue that money belongs in the same class as the wheel and
the inclined plane among ancient inventions of great social
utility. Price stability allows that invention to work with minimal
friction .
Although price stability is an end of monetary policy, it is also a
means by which policy can achieve its other objectives. In the
jargon, price stability is both a goal and an intermediate target of
policy. As I will discuss, when prices are stable, both economic
growth and stability are likely to be enhanced, and long-term
interest rates are likely to be moderate. Thus, even a
policymaker who places relatively less weight on price stability
as a goal in its own right should be careful to maintain price
stability as a means of advancing other critical objectives.
Let me elaborate briefly on the relationship between price
stability and the other two goals of monetary policy. First, price
stability promotes efficiency and long-term growth by providing
a monetary and financial environment in which economic
decisions can be made and markets can operate without concern
about unpredictable fluctuations in the purchasing power of
money .High and variable inflation degrades the quality of the
signals coming from the price system, as producers and
consumers find it difficult to distinguish price changes arising
from changes in product supplies and demands from changes
arising from general inflation. Because prices constitute a
market economy’s fundamental means of conveying information,
the increased noise associated with high inflation erodes the
effectiveness of the market system. High inflation also
complicates long-term economic planning, creating incentives
for households and firms to shorten their horizons and to spend
resources in managing inflation risk rather than focusing on the
most productive activities.
Research is not definitive about the extent to which price
stability enhances economic growth Nevertheless, I am
confident that the effect is positive and see the international
experience as at least consistent with the view that, in
combination with other sound policies, the maintenance of price
stability has quite significant benefits for efficiency and growth.
That view appears to be widely shared among policymakers, as
governments around the world have made extensive efforts to
bring inflation down over the past two decades or so, with
substantial success .
[In looking at today’s oil price increases vs. those of the 1970s]
Thirty years ago, the public’s expectations of inflation were not
well anchored. With little confidence that the Fed would keep
inflation low and stable, the public at that time reacted to the oil
price increases by anticipating that inflation would rise still
further. A destabilizing wage-price spiral ensued as firms and
workers competed to “keep up” with inflation. The Fed,
attempting to gain control of the deteriorating inflation situation,
raised interest rates sharply; however, initially at least, these
increases proved insufficient to control inflation or inflation
expectations, and they added substantially to the volatility of
output and employment. The episode highlights the crucial
importance of keeping inflation expectations low and stable,
which can be done only if inflation itself is low and stable.
By contrast, the oil price increases of recent years appear to have
had only a limited effect on core inflation (that is, inflation in the
prices of goods other than energy and food), nor do they appear
to have generated significant macroeconomic volatility. Several
factors account for the better performance of the economy in the
recent episode, including improvements in energy efficiency and
in the overall flexibility and resiliency of the economy. But, the
crucial difference from the 1970s, in my view, is that today
inflation expectations are low and stable (as shown, for example,
by many surveys and a variety of financial indicators). Oil price
increases in the past few years, unlike in the 1970s, have not fed
through to any great extent into longer-term inflation
expectations and core inflation, as the public has shown
confidence that any increases in inflation will be temporary and
that, in the long run, inflation will remain low. As a result, the
Fed has not had to raise interest rates sharply as it did in the
1970s but instead has been able to pursue a policy that is more
gradual and predictable. Of course, the relatively benign state of
inflation expectations in a narrow range has been the product of
Fed policies that have kept actual inflation low in recent years,
clear communications of those policies, and an institutional
commitment to price stability.
Price stability also contributes to the third component of the
Fed’s mandate, the objective of moderate long-term interest
rates. As first pointed out by the economist Irving Fisher,
interest rates will tend to move in tandem with changes in
expected inflation, as lenders require compensation for the loss
in purchasing power of their principal over the period of the loan.
When inflation is expected to be low, lenders will require less
compensation, and thus interest rates will tend to be low as well.
In addition, because price stability and the associated
macroeconomic stability reduce the risks of holding long-term
bonds and other securities, price stability may also reduce the
premiums that lenders charge for bearing risk, lowering the
overall level of rates.
Source: federalreserve.gov
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Wall Street History returns next week.
Brian Trumbore
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