frederic s mishkin : central bank commitment and communication speech by mr frederic s mishkin, member of the board of governors of the us federal reserve system, at the princeton university center for economic policy studies dinner, new york, 3 april 2008. the original speech, which contains various links to the documents mentioned, can be found on the us federal reserve system ’ s website. * * * one of the things i often tell my 25 - year - old son is, " keep your options open. " in effect, this means that today he should make the best decision possible using the information he has at hand, and when tomorrow comes he should reconsider all of his options, and again the next day, and so on. in the terminology of economists, this strategy is usually referred to as " dynamic optimal policy under discretion. " and the idea of complete discretion may sound like a great idea – after all, why should you restrict your choices? nevertheless, in the context of central banking, the modern science of monetary policy indicates that a discretionary approach can lead to poor economic outcomes. 1 therefore, in my remarks today, i would like to explain how a commitment to keeping inflation low and stable can help foster the stability of economic activity as well as the stability of prices. after analyzing the pitfalls of discretion and the benefits of a firm commitment to a nominal anchor, i will discuss the role of central bank communication in promoting this commitment. i will then illustrate these conceptual principles by considering the experiences of other central banks that have adopted explicit numerical inflation objectives. as usual, these remarks reflect only my own views and are not intended to reflect those of the federal open market committee or of anyone else associated with the federal reserve system. 2 pitfalls of discretionary monetary policy starting in the 1970s, the economics profession began to recognize that the evolution of economic activity and inflation – and hence the design of optimal monetary policy – depends crucially on how households, firms, and financial market investors form their expectations regarding the future course of policy. 3 this recognition of the central role of expectations in macroeconomic outcomes led to the discovery of the time - inconsistency problem, a concept that sounds highfalutin but is actually quite intuitive. 4 this problem arises whenever the possibility of short - run gains creates a temptation to renege on an existing plan, even though following that plan would produce a better outcome over the longer run. in essence, if a good long - run plan will not

, in other words – is very low, a view shared by the vast majority of the governing council members. there are, at least, no visible signs of especially low wage settlements, either in germany or the other large euro - area countries. negotiated wages are likely to rise by around 3 % in germany this year ; the increase just agreed for germany ’ s metal - working industry is around that size. and even in spain, where inflation rates are negative, the commission is expecting wages to rise by 0. 7 % in 2015. as for the spectre of debt deflation, there are currently no signs in any of the crisis countries other than greece that low inflation is hampering deleveraging in the non - financial sector. the primary reason why debt ratios in these countries are rising is that increased public borrowing is overshadowing the partial deleveraging that has occurred in the non - financial private sector. when assessing the monetary policy situation, of course, it is also important to look at the cause of the low inflation rates. plummeting energy prices are one of the main factors. but bis central bankers ’ speeches this slump is likely to be fairly short - lived. and although falling energy prices are slowing down inflation, they are also boosting consumers ’ purchasing power and cutting enterprises ’ costs. falling oil prices are therefore having the effect of a small stimulus package. this assessment is also reflected in the ecb staff macroeconomic projections published last thursday. while the ecb staff lowered the projection for this year ’ s inflation rate, they made perceptible upward revisions to the growth outlook for this year and next. inflation is now expected to return to the desired range of “ below, but close to, 2 % ” in 2017. another point to consider is that purchases of euro - area government bonds are not “ just another ” instrument. as the founding fathers of our monetary union were well aware, in a monetary union with a single monetary policy but continuing national sovereignty over fiscal policy, the easier it is to pass on the fallout of unsound budgetary policy to other member states or to the eurosystem, the stronger the inherent incentive for countries to run up debt. that is why the eu treaties forbid the eurosystem from purchasing bonds directly from member states or giving them loans. now the eurosystem is buying government bonds not on the primary market but on the secondary market. that is not prohibited. still, these purchases will make the eurosystem the