These costs emanate from a variety of sources, including: increased uncertainty about the outcome of business decisions and profitability; adverse effects on the cost of capital resulting from the interaction of inflation with the tax system; reduced effectiveness of the price and market systems; and distortions that create perverse incentives to engage in nonproductive activities. BIS Review 17/1997  -2-  As a former commercial banker, I am especially aware of the negative effects of one particular type of nonproductive activity induced by inflation’s distortion of incentives -- the overinvestment of resources in the financial sector. It is well known that, in high-inflation economies, the resources diverted from productive activities to nonproductive financial transactions are enormous. But even moderate inflation rates can cause substantial diversion to nonproductive financial activities, and this diversion deserves greater attention than it often receives in economists’ list of the costs of inflation. As I look back over the last ten years or so, I am pleased that the Federal Reserve and many other central banks have been successful in controlling price pressures and putting inflation on a long-run downward track. Success in dealing with inflation clearly enhances the credibility of monetary policy and policy makers. From my perspective, the continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining low inflation environments. Central banks are generally better able to meet this challenge if they are substantially immunized from short-term political pressures, and are firmly committed to price stability as the overriding goal of monetary policy.

The important role played by the central bank in helping to build and maintain confidence in the underlying stability of the financial system in turn implies that there must be a high degree of public confidence in the central bank itself. This brings me back full circle: achieving and maintaining that public confidence depends first and foremost on the success of the central bank in discharging its monetary policy responsibilities. A sound economy and sound money are virtually synonymous, which is why monetary policy stands at the center of central bank functions. The importance of monetary policy is also the reason why central banks need special independent status within the governments they serve. In my view, it is particularly critical that the central bank not be directly responsible for financing government budget deficits; such a responsibility can, over time, compromise the financial integrity of the central bank, and thereby, public confidence in it. Note, however, that even without any involvement in direct financing of government budget deficits, central banks have a major stake in the development and maintenance of a smoothly-functioning government securities market, which can provide substantial benefits to the economy beyond those emanating from private sector financing of government budget deficits. In closing, I want to stress that the commitment to price stability as the primary goal of monetary policy in no way implies that the health of the economy or of the financial system should be sacrificed.