Ben S Bernanke: "Constrained discretion" and monetary policy
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, before the Money Marketeers of New York University, New York, 3 February 2003.
The references for the speech can be found on the website of the Board of Governors of the US Federal Reserve
System.
* * *
What is the appropriate framework for making monetary policy? This crucial question has sparked
lively debate for decades. For much of the period since World War II, at least until recently, the debate
has been carried on mainly between those favoring the use of rules for making monetary policy and
those arguing for reliance on discretion.
Under a strict rules-based approach to monetary policy, advocated most prominently by Milton
Friedman and his followers, the policy instruments of the central bank would be set according to some
simple and publicly announced formula, with little or no scope for modification or discretionary action
on the part of policymakers. For example, under Friedman's most famous proposal, the so-called
kpercent rule (Friedman, 1960), the central bank would be charged with ensuring that some specified
measure of the national money supply increase by a fixed percentage each year, irrespective of
broader economic conditions. Friedman believed that such a rule would have the important advantage
of preventing major monetary policy errors, as when the Federal Reserve permitted the U.S. money
supply to collapse in the 1930s - a blunder that contributed substantially to the severity of the Great
Depression. In addition, Friedman argued, a rule of this type would have the advantages of simplicity,
predictability, and credibility, and it would help insulate monetary policy from outside political pressures
and what Friedman saw as an inherent tendency toward excessive policy activism.
Neither the k-percent rule nor any comparably strict policy rule has ever been implemented, but
"rulelike" monetary policy arrangements have existed in the real world. An important example is the
international gold standard, the dominant monetary system of the late nineteenth and early twentieth
centuries. Under the gold standard, at least in principle, the central bank's responsibility regarding
monetary policy extended only so far as ensuring that the value of the currency in terms of gold was
stabilized at the legally specified value. In short, under a strict gold standard the monetary policy rule
would be, "Maintain the price of gold at so many dollars per ounce." Although the gold standard
system malfunctioned and ultimately collapsed during the chaotic economic and financial conditions
that followed World War I, many economic historians have credited it with promoting price stability and
robust international trade and capital flows during 1870-1913, the so-called classical gold standard
era.1 Another example of a rule-like monetary policy institution is a currency board, such as the ones
currently employed by Hong Kong and several eastern European nations.
On the other side of the debate, advocates of discretion have firmly rejected the use of strict rules for
policy, arguing that central bankers must be left free to set monetary policy as they see fit, based on
their best judgment and the use of all relevant information. Supporters of discretion contend that policy
rules of the type advocated by Friedman are simply too mechanical and inflexible for use in real world
policymaking; in particular, simple rules cannot fully accommodate special circumstances or
unanticipated events.2 During the past few decades, for example, financial innovation and new
transactions technologies have led to large and difficult-to-predict changes in the empirical relationship
between money growth and the rates of growth of output and prices. If central banks had slavishly
followed Friedman's k-percent rule for money growth during this period, critics point out, substantial
economic instability would have been the likely result; indeed, most central banks have
deemphasized money growth as a policy target or indicator in recent years. More generally, opponents of
rules have argued that, as a practical matter, policymakers can never credibly commit to abandoning
discretion in favor of supposedly "unbreakable" rules.3 The problem, this argument runs, is that the
public will understand that the central bank always has the option of abandoning its rule, should the
rule happen to dictate a policy action perceived at the time as counterproductive. Hence, an
announcement by the central bank that it is adopting a strict policy rule would carry little credibility.
Although a strict rules-based framework for monetary policy has evident drawbacks, notably its
inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out
- with considerable justification - that the record of monetary policy under unfettered discretion is
nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated
as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism
about the ability of policymakers to "fine-tune" the economy. Contrary to the expectation of that era's
economists and policymakers, however, the subsequent two decades were characterized not by an
efficiently managed, smoothly running economic machine but by high and variable inflation and an
unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors
contributed to the poor economic performance of this period, I think most economists would agree that
the deficiencies of a purely discretionary approach to monetary policy - including over-optimism about
the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short
policy horizons, and insufficient appreciation of the costs of high inflation - played a central role.
Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the
instability of unfettered discretion? My thesis today is that there is such a middle ground - an approach
that I will refer to as constrained discretion - and that it is fast becoming the standard approach to
monetary policy around the world, including in the United States.4 As I will explain, constrained
discretion is an approach that allows monetary policymakers considerable leeway in responding to
economic shocks, financial disturbances, and other unforeseen developments. Importantly, however,
this discretion of policymakers is constrained by a strong commitment to keeping inflation low and
stable. In practice, I will argue, this approach has allowed central banks to achieve better outcomes in
terms of both inflation and unemployment, confounding the traditional view that policymakers must
necessarily trade off between the important social goals of price stability and high employment.
In the rest of my talk, I will first define constrained discretion more precisely and argue that, to an
increasing extent, this approach characterizes contemporary Federal Reserve policymaking. I will then
explain why I think constrained discretion is the best operating framework for monetary policy, and in
particular why it constitutes the best approach for achieving the economic goals that the Congress has
set for the Fed. Finally, I will briefly discuss the close relationship between constrained discretion and
the strategy for monetary policy known as inflation targeting. Before proceeding, though, I should note
that my remarks today do not necessarily represent the views of my colleagues on the Board of
Governors of the Federal Reserve System or the Federal Open Market Committee.
What is constrained discretion?
The approach to monetary policy that I call constrained discretion can be defined by two simple and
parsimonious principles.
First, through its words and (especially) its actions, the central bank must establish a strong
commitment to keeping inflation low and stable.
Second, subject to the condition that inflation be kept low and stable, and to the extent possible given
our uncertainties about the structure of the economy and the effects of policy, monetary policy should
strive to limit cyclical swings in resource utilization.
In short, under constrained discretion, the central bank is free to do its best to stabilize output and
employment in the face of short-run disturbances, with the appropriate caution born of our imperfect
knowledge of the economy and of the effects of policy. However, a critical proviso is that, in
conducting stabilization policy, the central bank must also maintain a strong commitment to keeping
inflation - and, hence, public expectations of inflation - firmly under control. Because monetary policy
influences inflation with a lag, keeping inflation under control may sometimes require the central bank
to anticipate and move in advance of inflationary developments - that is, to engage in "preemptive
strikes" on inflation.
In my view, constrained discretion characterizes the current monetary policy framework of the United
States. And it has done so to an increasing degree over time. First, since the Fed under Chairman
Paul Volcker broke the back of inflation in the early 1980s, inflation in the United States has been both
declining and becoming more stable. From a high of nearly 10 percent in 1980, inflation (as measured
by the core PCE deflator, twelve-month rate of change) fell to 4 percent by the end of 1984 and to 3
percent by the end of 1992.5 Inflation breached the 2 percent barrier in the spring of 1996 and has
remained consistently within the narrow range of 1.5 to 2 percent for the past six and a half years - for
practical purposes, a good approximation to price stability.6 Likewise, expected inflation - as measured
by financial-market indicators as well as surveys of both professional forecasters and consumers - has
stabilized at a low level. Thus, the Fed in recent years has demonstrated a commitment to keeping
inflation low and stable - the first principle of constrained discretion.
The Fed's commitment to low inflation has not, however, prevented it from being flexible in
implementing policy in the short term; in particular, the Fed has not been precluded from responding to
adverse shocks to the economy (the second principle). Since the taming of inflation by the Volcker
Fed, the United States has faced two recessions, in 1990-91 and in 2001. In both cases, as you know,
the Fed eased policy significantly to support real activity. In particular, in 2001 the Federal Open
Market Committee lowered the federal funds rate target by 475 basis points in a period of just under a
year. Importantly, inflation and inflation expectations seem to have been virtually unaffected by this
large move - a direct benefit, I argue, of the Fed's previous investment in establishing a commitment to
price stability. Moreover, both output and employment have become considerably more stable in the
past twenty years, relative to previous decades - a result I attribute in substantial part to improvements
in monetary policy.7 The Fed has also responded aggressively and flexibly to crisis conditions in
financial markets, in episodes ranging from the 1987 stock market crash to the 1998 Russian crisis to
the aftermath of the September 11, 2001, terrorist attacks.
In the United States, the Congress has assigned to the Federal Reserve the objectives of maintaining
price stability, maximum employment, and moderate long-term nominal interest rates. Of course, the
Federal Reserve System, and in particular the Federal Open Market Committee, treats each part of
this congressional mandate with utmost seriousness. Because the Fed appears to an increasing
degree to be following a policy of what I have called constrained discretion, one must ask: Is this policy
approach consistent with the Congress's mandate for monetary policy?
My answer is absolutely yes. In my view, this policy framework achieves each of the goals set by the
Congress with greater consistency and effectiveness than any alternative of which I am aware.
Broadly, there are three reasons why successful monetary policy is built on a foundation of price
stability, as implied by the framework of constrained discretion. First, of course, price stability is one of
the objectives for monetary policy set by the Congress and, indeed, is highly desirable in its own right.
And, of course, the price level is the macroeconomic variable over which a central bank exerts the
most direct control in the long run. Second, in the long run price stability promotes high employment
and low nominal interest rates - the other objectives set by the Congress - as well as productivity and
5
Throughout this talk I follow a common Fed practice in using the core personal consumption expenditure (PCE) deflator to
measure inflation. Relative to the more familiar consumer price index (CPI), the PCE deflator (1) has broader coverage, (2)
is believed to be based on more accurate expenditure weights, (3) is constructed in a manner that reduces so-called
substitution bias, (4) is measured more consistently over time, and (5) arguably does a better job measuring medical
inflation. The core PCE deflator excludes volatile components, notably the prices of food and energy. Core inflation
measures in general are probably better indicators of the underlying rate of inflation, with which central banks are typically
most concerned.
6
Standard inflation measures probably overstate increases in true inflation by about 1.0 percentage point. For example,
Lebow and Rudd (2002) estimate that measured inflation using the consumer price index overstates the actual change in
the cost of living by about 0.9 percentage points per year, with a confidence interval ranging from 0.3 percentage point to l.4
percentage points per year. (The bias in the PCE deflator, which is chain-weighted, may be a bit less.) In addition, as I
discussed in a previous talk, aiming for an inflation rate modestly above zero provides a useful buffer against deflation risk.
7
Stock and Watson (2002) note that the standard deviation of annual growth rates in real GDP fell from 2.7 percent during
1960-83 to only 1.6 percent in 1984-2001. They attribute 20 to 30 percent of this reduction in volatility to improvements in
monetary policy. Arguably, however, stabilizing factors that Stock and Watson treat as exogenous, such as the reduced
variability of commodity prices (other than oil), are actually in part the result of more stable policies.
BIS Review 5/2003 3
economic growth. Third, and most subtly, in the short run a record of consistently low inflation
increases central bank credibility and stabilizes inflation expectations, effects that in turn actually
increase the flexibility of the central bank to respond to shocks to the economy. I will discuss each of
these points, beginning with the importance of price stability in the long run and then turning to the
short-run issues.
Price stability and economic performance in the long run
Constrained discretion, at its foundation, recognizes the critical importance of maintaining price
stability, both in the long run and in the short run. The desirability of maintaining price stability in the
long run is by now hardly a matter for dispute, with virtually all economists in agreement that, in the
long run, low inflation confers many benefits on the economy. Most fundamentally, only when inflation
is low do nominal - that is, dollar - values provide a reasonably stable measure of real economic
values. We should not underestimate the importance of this simple point. Although economists are
used to the idea of "real" or inflation-adjusted quantities, making inflation adjustments in practice
requires significant information, expertise, and effort. Thus, instability in the price level significantly
impedes the ability of the typical household to make long-term financial plans, for example, or to
compare prices of goods and services separated in space and time. (In a high-inflation economy, price
information grows "stale" more quickly than newly baked bread.) Planning, investment, and pricing
decisions by firms are likewise complicated and often distorted by inflation. Because prices constitute
the market economy's fundamental means of conveying information, the increased "noise" that
inflation adds to prices raises transactions costs and erodes the efficiency of the free market system.
In a similar vein, as economist Martin Feldstein has frequently pointed out, price stability permits
contracts, tax laws, accounting rules, and the like to be expressed in nominal (dollar) terms without
concern about fluctuations in the value of money.8 If prices are instead variable and unpredictable,
then contracts or laws written in dollar terms will produce unintended and probably undesired
economic outcomes.9 Feldstein, for example, has emphasized how the interaction of inflation with the
tax code leads to unintended increases in the real cost of capital, which inhibit investment and reduce
economic growth. Likewise, because debt contracts are written in nominal terms, unanticipated
inflation transfers wealth from creditors to debtors, adding to the risk of financial contracting and at
times posing a significant threat to the financial system itself. For example, the savings and loan crisis
of the 1980s, which cost U.S. taxpayers hundreds of billions of dollars, was to a substantial extent the
result of the unexpected inflation of the 1970s, which greatly reduced the real value of mortgage loans
made by the S&Ls in an earlier, low-inflation era. These losses effectively de-capitalized the savings
and loans, setting the stage for the problems that followed.
Given the Congress's mandate to the Federal Reserve, the long-run relationship between price
stability and employment is an issue of particular importance. Our understanding of this relationship
has evolved considerably over the past forty years. During the 1960s, U.S. policymakers appeared to
believe that a long-run tradeoff between these two objectives existed and that that tradeoff could be
exploited for policy purposes (Samuelson and Solow, 1960). That is, it was thought that by accepting a
modest increase in the inflation rate, policy could achieve a permanently lower rate of unemployment.
Both economic theory and U.S. economic experience have shown this view to have been in error, and
that no long-run tradeoff between inflation and unemployment exists is now widely accepted. Indeed,
because price stability promotes efficiency, productivity, and capital investment, one can reasonably
presume that low inflation actually increases employment and real wages in the long run. Because
price stability also promotes moderate long-term nominal interest rates, a commitment to price stability
clearly is fully consistent in the long run with the objectives set by the Congress.
Price stability and economic performance in the short run
That price stability is beneficial to the economy in the long run is well established. As economists and
policymakers have increasingly come to recognize, however, the benefits of a commitment to price
stability in the short run are probably at least as significant.
I think it worthwhile, before discussing the short-run benefits of price stability for the economy, to note
the simple fact that, historically, periods of unstable prices have also tended to be periods of marked
instability in output and employment. In the nine decades since the founding of the Federal Reserve
System, the United States has experienced two large, sustained departures from price stability. The
first was the precipitous deflation of 1929-33, during which prices fell at a rate of about 10 percent per
year; the second was the prolonged inflationary period that began in the latter part of the 1960s and
did not end until the early 1980s. Of course, each of these episodes was associated not only with
instability of prices but also with exceptionally poor economic performance more generally. The
192933 deflation ushered in, and to a significant extent was the cause of, the broad economic collapse we
now know as the Great Depression. The inflation that began in the United States in the second half of
the 1960s was associated with slow growth, bouts of high unemployment, and instability in economic
activity, including the two worst recessions of the postwar period in 1973-75 and 1981-82.
What is the link between price instability and instability in output and employment in the short run? In a
previous talk I focused on the risks, so evident in the 1930s, that uncontrolled deflation poses for the
economy, and I doubt that many of my listeners today will require much convincing on that point.10 So
that no misunderstanding occurs, however, let me state clearly that the commitment to price stability
under constrained discretion entails strict avoidance of deflation as well as of inflation. That said, I will
concentrate for the remainder of the talk on the risks that inflation creates for economic stability in the
short run. For illustration, I will emphasize the U.S. "Great Inflation," the experience of the late 1960s
through the early 1980s.
The primary cause of the Great Inflation, most economists would agree, was over-expansionary
monetary and fiscal policies, beginning in the mid-1960s and continuing, in fits and starts, well into the
1970s. The fiscal expansion of this period had a variety of elements, including heavy expenditures for
the Vietnam War and President Johnson's Great Society initiatives. Monetary policy first
accommodated the fiscal expansion, and then - for reasons I will note - began to power the inflationary
surge on its own. The breakdown of the price stability that had characterized the 1950s and early
1960s was remarkably quick; inflation was perceived as a problem by the late sixties. Though
temporarily restrained by the Nixon price controls, inflation (again as measured by the core PCE
deflator) rose from 2.6 percent in February 1973 to 9.8 percent in February 1975. After the deep
197375 recession, inflation fell back to the range of 6 to 7 percent for several years before rising again to
9.8 percent in September 1980.
Like inflation, the real economy was also highly volatile during this whole period. The civilian
unemployment rate, below 4 percent throughout the second half of the 1960s, rose above 6 percent
during the 1969-70 recession, declined briefly, then rose again to 9 percent in May 1975.
Unemployment declined slowly from there, falling below 6 percent only in late 1978 and early 1979.
But during the 1981-82 recession, unemployment peaked at 10.8 percent - a rate not seen since the
1930s - and remained above 10 percent as late as June 1983. Taking the inflation and unemployment
performance together, one should not be surprised that a recent chronicler of the period called the
Great Inflation the 1970s "the greatest failure of American macroeconomic policy in the postwar
period" (Mayer, 1998, p. 1).
Why was this episode so dismal? Critically, although Fed officials often mentioned the importance of
keeping inflation low during the 1960s and 1970s, the record of inflation outcomes during that period
shows that their commitment to maintaining price stability was spotty. Several factors contributed to
the Federal Reserve's inflationary policies, including the political pressures exerted by the Johnson
and Nixon administrations (Mayer, 1998, chapter 5). Mistakes of analysis - among them a tendency to
blame nonpolicy factors (such as union wage pressures) for inflation, a misplaced belief in the
potential efficacy of wage-price controls, and overly optimistic assessments of the economy's growth
potential in both the 1960s (DeLong, 1997; Romer and Romer, 2002) and early 1970s (Orphanides,
2001) - also played a key role.
Yet another miscalculation, particularly important in the early stages of the Great Inflation, was the
already-mentioned idea of an exploitable long-run tradeoff, according to which policymakers
supposedly would be able to achieve permanently lower unemployment by accepting a bit more
inflation.11 Indeed, initially the tradeoff idea appeared to be valid, for unemployment fell while inflation
rose only moderately during the latter part of the 1960s. However, as we now understand, in this early
period the Fed was living off the capital of two previous decades of price stability, which had
conditioned the public to expect low inflation. Because the period began with expected inflation under
control, monetary expansion in the latter part of the 1960s stimulated real spending and production
without leading immediately to wage and price pressures. As the public woke up to the new reality of
high and rising inflation, however, inflation expectations began to rise as well. Within a few years, the
Federal Reserve found itself in a situation in which inflation and inflation expectations had risen
considerably, while the earlier gains in terms of lower unemployment and higher growth had
dissipated.
The high and erratic inflation of this period contributed to instability of output and employment in a
number of ways. I will highlight two. First was the pattern of go-stop policies followed by the Fed. The
Fed understood in principle that stabilizing inflation and inflation expectations was important, but -
knowing that a slowdown in spending and output (of a magnitude difficult to guess) would be an
unwelcome side effect - it was extremely reluctant to tighten monetary policy enough to do the job.
The resulting compromise has been appropriately described as "go-stop" policy. First, over-expansion
led to inflation, the "go" phase. Then, periodically, when inflation became bad enough, the Fed would
tighten policy (the "stop" phase), only to loosen again when the resulting slowdown in the economy
began to manifest itself. The net result of this policy pattern was to exacerbate greatly the instability of
both inflation and unemployment, while making little progress toward restoring price stability or
reanchoring inflation expectations. This cycle ended only under Chairman Volcker, who (together with
his colleagues on the FOMC) had the courage to keep policy tight until inflation and inflation
expectations finally began to stabilize in the early 1980s. Of course, the cost of this critical stabilization
was the high unemployment and lost output associated with the sharp 1981-82 recession.
The second link between the instability of inflation and that of unemployment in the Great Inflation
operated through the behavior of inflation expectations. As I have noted, when the episode began in
the 1960s, inflation expectations were well anchored, in the sense that the public was conditioned by
long experience to expect low inflation. Hence, the first expansionary policy moves of the 1960s did
succeed in raising output and employment without much initial effect on prices. As demand pressures
accumulated and inflation rose, however, the Fed's credibility as an inflation-fighter was lost and
inflation expectations began to rise. The unmooring of inflation expectations greatly complicated the
process of making monetary policy; in particular, the Fed's loss of credibility significantly increased the
cost of achieving disinflation.
The severity of the 1981-82 recession, the worst of the postwar period, clearly illustrates the danger of
letting inflation get out of control. This recession was so exceptionally deep precisely because of the
monetary policies of the preceding fifteen years, which had unanchored inflation expectations and
squandered the Fed's credibility. Because inflation and inflation expectations remained stubbornly
high when the Fed tightened, the impact of rising interest rates was felt primarily on output and
employment rather than on prices, which continued to rise.12
One indication of the loss of credibility suffered by the Fed by the time of the 1981-82 episode, and the
difficulty of getting it back once lost, was the behavior of long-term nominal interest rates. For
example, the yield on 10-year Treasuries peaked at 15.3 percent in September 1981 - almost two
years after Volcker's Fed announced its disinflationary program in October 1979 - suggesting that
long-term inflation expectations were at that point still in the double digits. The 10-year Treasury yield
did not fall below 10 percent until November 1985. Remarkably, 30-year Treasury yields were only
slightly lower than 10-year yields throughout the episode, implying that the markets had no confidence
that inflation would ever return to 1950s or 1960s levels.
The behavior of long-term nominal interest rates in the early 1980s can be contrasted with that of more
recent years. Today the 10-year Treasury yield is approximately 4 percent, suggesting substantial
confidence on the part of financial market practitioners that inflation will remain low for the next
decade. Indeed, we have the benefit of a developed market for indexed debt to make that inference
more precise: The expected inflation rate inferred from the yield on 10-year inflation-protected
Treasury bonds is now about 2.0 percent for CPI inflation. Also notable is the fact that the substantial
easing of monetary policy during 2001 appeared to generate no concerns about future inflation, as
evidenced by the record low long-term interest rates and stable survey-based inflation expectations
that we are still seeing.
You may have noticed that I have discussed the Great Inflation of the 1970s with an emphasis on
Federal Reserve behavior but without mentioning oil prices. My reading of the evidence suggests that
the role the conventional wisdom has attributed to oil price increases in the stagflation of the 1970s
has been overstated, for two reasons. First, the large increases in oil prices that occurred in this period
would not have been possible in an environment that was not already highly inflationary because of
previous monetary expansion. In an important paper, Barsky and Kilian (2001) make this case in some
detail. They note, for example, that prices of other industrial commodities and raw materials rose
substantially at the same time as oil prices, suggesting that broader monetary forces - and not factors
specific to the oil market - account for much of the rise in the oil price in 1973.13
Second, without Fed accommodation, higher oil prices abroad would not have translated into domestic
inflation to any significant degree. To see this point, note that oil prices do not directly affect the
measure of inflation that I have been using here - the change in the core PCE deflator, which excludes
energy prices. Thus, any link of oil prices to inflation must be through so-called second-round effects,
in which increased fuel prices push up wages and other costs. Comparison of the 1970s and the
1990s confirms the common finding in the literature that the degree of "pass-through" to core inflation
from supply shocks, such as a rise in oil prices or a depreciation of the exchange rate, depends
strongly on how well domestic expectations of inflation are anchored.14 Because inflation expectations
were not well anchored in the 1970s, the oil price shocks were in fact associated with substantial
passthrough, that is, increases in core inflation. As already noted, core PCE inflation rose by a whopping 7
percentage points in the years 1973-74, the period of the sharpest increase in oil prices. In the 1990s,
by contrast, oil price changes seemed to have no noticeable effect on core inflation. For example, the
price of oil at the end of 1998 was a little more than $11 per barrel; over the next two years the price of
oil tripled, exceeding $34 per barrel late in 2000. Then, over the subsequent year, the price of oil
suddenly reversed itself, dropping 40 percent. Despite these gyrations, core inflation remained firmly
anchored throughout the period, registering between 1.5 percent and 2.0 percent on a twelve-month
basis in every month. Although structural changes have occurred in the economy since the 1970s,
including increased energy efficiency, this difference in the degree of pass-through from oil prices to
general inflation can be explained, in my view, only by differences in the stability of inflation and
inflation expectations. Overall, it is reasonable to conclude that macro policy, particularly monetary
policy, was the most important single reason for the poor economic performance experienced during
the U.S. Great Inflation.
Constrained discretion and inflation targeting
I mentioned at the beginning