Roger W Ferguson, Jr: Panel discussion - safeguarding good policy practice
through maintaining flexibility
Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979,
Federal Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004.
* * *
I am pleased to address this conference commemorating the twenty-fifth anniversary of the historic
monetary policy changes implemented in October 1979. In my prepared remarks, I would like to focus
on two issues with respect to safeguarding good monetary policy practice. First, I will discuss what
constitutes good monetary policy practice and review the Federal Reserve's record in satisfying its
mandates in recent decades. Then, I will speculate on how good policy outcomes come about. In
particular, I will discuss the role of policy transparency, central bank leadership, and alternative
monetary policy regimes in preserving effective monetary policy. Of course, the usual caveat to my
remarks applies: I will express my own views, and you should not interpret them as the position of the
Federal Open Market Committee or of the Board of Governors.
Assessing the Federal Reserve's performance after 1979
When assessing what constitutes good monetary policy practice, I prefer to focus not on theory but on
the reality of the Federal Reserve's objectives. In contrast to many other central banks, the Federal
Reserve has been assigned a "dual mandate" - to pursue policies that both maintain price stability and
achieve maximum sustainable economic growth and employment. Good policy practice can be judged
by the outcomes achieved. Therefore, I would like to briefly outline the Federal Reserve's performance
with respect to the level and the variability of inflation and growth. To be sure, the strong economic
performance over the past two decades has several possible explanations, but the practice of
monetary policy has likely contributed by helping to preserve macroeconomic stability.
With respect to price stability, inflation in the United States over the past decade or so has clearly
been lower and more stable than it was earlier in our history. In fact, annual inflation in the price index
of personal consumption expenditures excluding food and energy - core PCE - averaged just over
2 percent from 1990 through the end of last year and consistently remained within a range - roughly 1
to 4 percent - that is relatively narrow compared with historical experience. This period contrasts
sharply to the fourteen-year period from 1965 through the end of 1979, when annual core-PCE
inflation averaged just over 5 percent and fluctuated between 3 and 10 percent. The recent experience
of the United States with inflation has been similar in some respects and dissimilar in others to that of
other countries. For example, based on the Organisation for Economic Co-operation and
Development's measures of overall consumer price inflation, prices rose at an annual average rate of
about 3 percent in the United States from 1990 through 2003, compared with about 3 percent in the
euro area and in the United Kingdom and roughly 1 percent in Japan.1 But, more important, the
volatility of inflation was lower in the United States than in these other economies.
An equally important indicator of the success of the Federal Reserve's monetary policy is private
expectations for future inflation. Measures of inflation expectations obtained from financial asset prices
clearly indicate that market participants expect that the Federal Reserve will maintain low and stable
inflation. For example, although the difference between the yields on nominal inflation-indexed and
Treasury securities is an imperfect measure that includes complicating factors such as inflation risk
and liquidity premiums, the five-year break-even inflation rate five years ahead has averaged about
2-1/2 percent over the past five years and has fluctuated in a narrow range of about 1-1/2 to
3-1/2 percent. Survey measures confirm that inflation expectations over this period have been
subdued and well anchored. The University of Michigan's survey of ten-year inflation expectations has
averaged less than 3 percent and has stayed within a very narrow range over the past five years.
Assessing the outcomes with respect to the Federal Reserve's goal of maximum sustainable output
growth is inherently more difficult. Estimates of the relevant measures, such as the
nonacceleratinginflation rate of unemployment (NAIRU), which in recent years has been decreasing according to
some estimates, have very wide confidence intervals. But we can point to some evidence suggesting
that the United States has enjoyed, besides subdued and stable inflation, some favorable
developments with respect to output and employment. Certainly, we can document substantial gains in
productivity in recent decades in the United States. According to the OECD, business sector labor
productivity growth in the United States averaged about 2 percent from 1990 through the end of 2003,
compared with about 1-1/2 percent in the euro area and in Japan over the same period. And since the
mid-1990s, this gap has widened, with annual productivity growth averaging about 2-1/2 percent since
1995 in the United States, compared with about 1-1/2 percent in Japan and just less than 1 percent in
the euro area over the same period.2
Another important measure of the success of monetary policy is how well the FOMC has responded to
threats to our nation's financial stability. This claim is surely hard to quantify. But everyone would
agree that, compared especially with the deleterious effects of the Federal Reserve's policy response
during the Great Depression, the Fed has responded effectively to more-recent crises so as to help
minimize the impact of such shocks on the greater economy. These episodes include the stock market
crash of October 1987, the Asian financial crisis, and the collapse of Long-Term Capital Management
in the late 1990s. Thanks in no small part to the flexibility of our policy framework, which I will discuss
in greater detail in a few moments, the Federal Reserve appropriately discharged its responsibility as
lender of last resort by providing ample liquidity and ensuring confidence during these and other
troubling episodes, including the aftermath of the terrorist attacks of September 11, 2001.
There is greater disagreement about how well the Federal Reserve responded to the bursting in recent
years of the so-called bubble in technology stocks. This topic is broad, but I would like to note that, as
many of my colleagues and I have previously argued, prospectively addressing perceived asset-price
bubbles is a matter of such great uncertainty that, even with the benefit of hindsight, it is not clear that
policy decisions in the late 1990s, for example, should have been any different. In any case, the
recession that followed the sharp decline in stock prices was shallow by historical standards.
How can we safeguard good policy outcomes?
I would now like to turn to issues related to preserving, as best we can, a continuation of good policy
practice in the future.
Central bank transparency
Consider first the important role of central bank transparency. Transparency of central bank
decisionmaking is desirable, not only for economic reasons, but also because it is supportive of central
bank independence within a democratic society. Because of the lagged effects of monetary policy on
output and prices, the time horizon of central bankers is necessarily more distant than that of other
policymakers. Thus, the central bank needs substantial insulation from political pressures to execute
policy: An independent monetary authority is less tempted to make policy for the short term, such as
boosting output or refinancing national budgets, at the expense of long-run objectives. Of course, the
goals of monetary policy should be determined within the democratic process, but the central bank
should have discretion to achieve those ends. In short, an appropriate arrangement within democratic
societies is for central banks to have independence with respect to the instruments, but not the goals
of monetary policy, and transparency is an appropriate condition for that independence.
Besides its inherent virtues in a democratic society, transparency can enhance monetary policy's
economic effectiveness by more closely aligning financial market forces with central bankers'
intentions. Like other central banks, the Federal Reserve controls only a very short-term interest rate,
the overnight federal funds rate. However, theory and empirical evidence suggest that longer-term
interest rates and conditions in other financial markets, which reflect expectations for short-term rates,
matter most for monetary policy transmission to the economy. If the monetary authority is transparent
about the rationale and the stance of policy as well as its perception of the economic outlook, then
investors can improve their expectations of future short rates.3
The path that monetary policy will follow in the future is uncertain even to policymakers because that
trajectory will depend on incoming news about the economy and the implications of that news for the
economic outlook. But announcing policy decisions in a timely manner and explaining those decisions
fully allows market participants to better anticipate the response of policy to unexpected developments
and to speed needed financial adjustments.
Central bank leadership
Next, I consider the role of the individuals entrusted with the responsibility for making policy decisions.
Although monetary policy frameworks have a potentially great influence on macroeconomic outcomes,
we should not forget that the individuals who serve in central banks themselves have a crucial role in
preserving policy outcomes. Even with a monetary policy regime that follows best practices and
shapes the decisionmaking process, ultimately individuals' beliefs and perceptions still matter for the
actual policy taken.
An interesting recent study of the history of the Federal Reserve by Christina Romer and David Romer
finds a very strong link between the skill and knowledge of the FOMC, particularly the Chairman, and
macroeconomic outcomes.4 For example, with little reference to transformations in the disclosure
policy and the independence of the Federal Reserve over the years, they ascribe the policy successes
of two periods - the 1950s and the 1980s and 1990s - to a conviction of Federal Reserve Chairmen
regarding the high costs of inflation and their tempered views about the sustainable levels of output
and employment. In contrast, they attribute the deflationary and counterproductive policies of the
1930s to the erroneous belief that monetary policy can do little to stimulate output and that the
economy can actually overheat at low levels of capacity utilization.
But there is one aspect of the process that Romer and Romer do not emphasize enough - the ability of
central bankers in general, and indeed members of the FOMC in particular, to withstand political
pressures. In addition, central bankers should have a thorough and practical, rather than a purely
academic, understanding of the economy and, given the Federal Reserve's objective to preserve
financial stability, of financial markets and institutions.
The committee's institutional memory may also matter in this context. Today, the FOMC is well versed
in the monetary history of the 1970s and 1980s, for example, and recognizes the great efforts that
previous members of the FOMC undertook to achieve price stability. I trust that future generations of
policymakers will continue to share that understanding and thus help to preserve good policy
outcomes.
Will inflation targets preserve good policy practice?
Finally, I would like to touch on a topic that is perhaps more controversial in the context of
safeguarding good policy practice. Several academic and professional economists, including
distinguished colleagues of mine at this conference, have eloquently advocated the adoption of explicit
numerical goals for central bank objectives, most notably inflation targets. The adoption of numerical
targets, it is argued, facilitates central bank accountability and better anchors private expectations
about inflation and monetary policy and thereby yields better macroeconomic outcomes.
Quantifying central bank objectives has some positive aspects and, certainly, vigorous advocates.
Nonetheless, I harbor significant reservations about this approach regarding both its practical
implementation, in the specific context of the Federal Reserve System, and its demonstrated
effectiveness based on inferences from the recent experience of regimes that have specific numerical
targets, particularly with respect to inflation, around the world.
A basic, yet difficult, issue is the selection of a particular price index to guide policy, even in the case
of a single goal such as inflation. Experience tells us that economies and the composition of
productive enterprises change over time, and therefore the appropriate index and inflation value for
the monetary authority would also need to change to reflect technological and other advances. In light
of this inherent uncertainty associated with the construction of a price index, one might be concerned
that choosing and rigidly adhering to an inappropriate index could have negative economic
consequences that might outweigh prospective benefits.
Also, we must consider the ramifications of quantified goals in the context of our democracy. That is,
the quantification of objectives becomes even more problematic for central banks such as the Federal
Reserve with multiple democratically based mandates, some of which are notably less disposed to
quantification than others. For example, considering our dual mandate from the Congress, how do we
measure maximum sustainable employment? Indeed, as I mentioned previously, estimates of the
NAIRU and other possible related measures that address the full-employment objective such as the
output gap have uncomfortably wide confidence intervals and are far more controversial than selecting
a target for a specific price index.
Of course, the central bank could in principle quantify only the inflation objective. However, I fear that
quantifying one goal and not the other would present problems because the monetary authority might
inadvertently place more emphasis on the quantified goal at the expense of the nonquantified
objective. Doing so would seem inappropriate. The ease of quantification should not influence how the
Federal Reserve pursues its dual mandate.
In addition, I worry about the potential loss of flexibility from the implementation of an inflation target,
as explicit numerical goals might inhibit the central bank's focus on output variation or financial
stability. I would argue that, besides the episodes of financial turmoil in the late 1990s mentioned
earlier, supply shocks, such as large increases in oil prices that simultaneously increase the price level
and decrease aggregate output, can be problematic for inflation-targeting regimes.
Of course, some variants of the approach - so-called flexible inflation targeting for instance - can
address the issues I just raised by stipulating wide target ranges, by maintaining escape clauses that
allow inflation to diverge from the target, or by aiming at average inflation over the business cycle. But
the credibility gains from inflation targeting seem to me to be inversely related to its flexibility. Simply,
credibility is less likely to be gained and expectations are less likely to be anchored if the central bank
frequently uses escape clauses, widens the target bands, or pushes out its time horizon.
Ultimately, real credibility for achieving goals must come from performance, and predetermined
frameworks do not seem to be a necessary or a sufficient condition to safeguard desirable policy
outcomes. Observation of more-recent Federal Reserve actions reveals the apparent preferences of
policymakers. In recent years, the Federal Reserve has apparently leaned against disinflation when
core inflation threatens to fall much below 1 percent, and, similarly, against inflation when the core rate
threatens to rise above 2 to 2-1/2 percent. The Federal Reserve has demonstrated this strategy
without the formal adoption of a specific inflation target or range for the FOMC.
Given the subdued and stable inflation witnessed over the past fourteen years, I have to ask: What
would be gained from a formal goal for inflation? Can we draw compelling general inferences from the
recent experience of inflation-targeting central banks? As a caveat regarding this evidence,
economists have very limited data to work with, as the first recognizable inflation targeting regime
appeared in New Zealand in 1990. But to date, I would argue that the case for inflation targeting has
yet to be proved.
Certainly, I would not deny that numerical inflation targets have proven useful for several countries in
particular circumstances. One example is the United Kingdom, where, in the aftermath of
"Black Wednesday" in October 1992, an inflation target helped provide a nominal anchor after sterling
was removed from the European exchange rate mechanism. I should also add that the Bank of
England has quite successfully helped to achieve low and stable inflation ever since. In addition,
inflation targeting can have demonstrable benefits in lower-income countries that have experienced
high and variable inflation rates in the recent past.
In several cases, quantified inflation targeting has served as a means of achieving the central bank
independence necessary to focus more effectively on controlling inflation. That is, the adoption of an
inflation target is frequently part of a broader program to increase the autonomy and transparency of
central bank practice. But inflation targeting is not the only means by which to achieve these ends.
Again, the recent experience in the United States that I have noted is an object lesson in this regard.
Unfortunately, the empirical evidence for industrial countries available to date generally appears
insufficient to assess the success of the inflation-targeting approach with confidence. For example, it is
unclear whether the announcement of quantitative inflation targets lessens the short-run tradeoff
between employment and inflation, and whether it helps anchor inflation expectations. In addition,
some research, controlling for other factors, fails to isolate the benefits of an inflation target with
respect to the level of inflation or its volatility over time, and output does not seem to fluctuate more
stably around its potential for countries that have adopted numerical targets.5 Future data may or may
not produce compelling evidence, but I maintain that the case today for inflation targets in countries
that already enjoy low and stable inflation rates has certainly not been proved.
With respect to both its practical implementation, particularly in the United States, and the empirical
evidence to date, I submit that the adoption of a numerical inflation target does not promise any
obvious incremental benefits, at least in countries that have already achieved reasonable price
stability. That said, a continuing commitment to price stability is certainly important, and the Federal
Reserve has established a solid record of such commitment.
Conclusion
Based on this brief review, I conclude that, at least since the policy reform of October 1979, most
observers would agree that the Federal Reserve has achieved generally good policy practice and
outcomes. In my assessment, good policy practice cannot be safeguarded with certainty using a single
rule or framework, such as inflation targeting. Good outcomes ultimately depend on flexible execution
of an evolving strategy and policymakers with an unwavering commitment to low and stable inflation
as the foundation for maximum sustainable growth.