donald l kohn : modelling inflation - a policymaker ’ s perspective remarks by mr donald l kohn, member of the board of governors of the us federal reserve system, to the international research forum on monetary policy conference, frankfurt am main, 20 may 2005. * * * nothing is more important to the conduct of monetary policy than understanding and predicting inflation. price stability is our responsibility as central banks - it is how, in the long run, we contribute to society's welfare. achieving and maintaining price stability will be more efficient and effective the better we understand the causes of inflation and the dynamics of how it evolves. 1 i think central bankers are asking more of inflation analysis these days. in the united states, our attention was focused for many years on containing and then reducing inflation. the risks and rewards were one - sided, and policymakers were mostly interested in whether inflation would rise. now that we are in the neighborhood of price stability, we can be faced with looking at the possibility that inflation will fall too low as well as rise too high. moreover, so long as inflation expectations are well anchored, we can tolerate limited changes in inflation, but we need to know that a rise or fall is not the beginning of a more extended trend. consequently, we focus closely on the reasons for any changes in inflation and their implications for the outlook. of course, i have always known how important the analysis and forecasting of inflation was for monetary policy, but i must admit that as someone who now has to go on record with a vote on the basis of some notion of the future course of inflation, the exercise has taken on added meaning. i thought i might take advantage of this captive audience of researchers on central bank policies to ruminate a bit on the evolution of inflation modeling and suggest areas for further research. i know that european central banks have been in the forefront of recent efforts to improve our understanding of some key issues in this area, but i will focus on our practices in the united states. the stability of the basic framework i find it remarkable how fundamentally stable our basic framework for analyzing inflation has remained over the past thirty - five years or so : that basic framework is essentially the expectations - augmented phillips curve introduced by milton friedman and edmund phelps in the late 1960s. 2 one of the key assumptions underlying this basic framework is the temporary rigidity of wages and prices. it is because of these nominal rigidities that monetary shocks have real effects : in the well - known litany,

a very significant structural change, which has improved the conditions for investment and trade in the euro area. all things being equal, this much more stable environment facilitates decisions by producers, investors and consumers. it increases the confidence of economic agents and is therefore favourable to growth and job creation. had the single currency not existed, the various crises that have occurred at the global level over recent years would have translated into major turbulence for our economies. my third comment relates to the very powerful impact the euro has had on the creation of the single market. the euro has led companies to see the euro area as a whole as the relevant domestic market for their business, rather than their own national markets as in the past. in this respect, the single currency has undoubtedly been a catalyst for the progressive reshaping of the european productive sector, which are in turn creating a more efficient and vibrant economy. low medium and long - term market interest rates, better protection against external risks and shocks, and the strengthening of the european productive sector are all important benefits for the citizens of the euro area. it is always difficult to compare what you have with what you would have, had the euro had not been established five years ago. the present benefits are extremely substantial, a fact which is unfortunately not very often stressed. let me summarise the advantages for the citizens of the euro area, which would not exist without the euro : • the credible medium and long - term protection of their purchasing power throughout the euro area ; • the credible medium and long - term preservation of their savings throughout the euro area ; • favourable financing of their medium and long - term investment, in particular in housing, throughout the euro area ; • a total elimination of adverse effects on households from intra - european crises such as those observed in 1992 and 1993 ; and finally • a more efficient and resilient productive sector, which is particularly important in a global environment of renewed healthy competition, both within the industrialised world and between industrialised countries and emerging economies and economies in transition. let me add one final remark. i know that some of our fellow citizens have the feeling that euro area inflation has been, and perhaps continues to be, above the levels of cpi inflation computed by national institutions and by eurostat. i want to tell them that the figures published are not underestimating inflation. but i also want to tell them that the governing council of the ecb is fully aware of their fears. i want to assure them of our determination to preserve price