A Stable Price Level Standard for Federal Reserve Monetary Policy

This article appeared on Cato.org on September 25, 2008

In a recent article in the Cato Journal dealing with the transparency ofFederal Reserve monetary policy, Federal Open Market Committee (FOMC)Chairman Ben Bernanke provided an authoritative account of current FederalReserve strategy (Cato Journal, vol. 28, No. 2, Spring/Summer, 2008, "TheFed's Road Toward Greater Transparency," pp. 175-186). Bernanke notes that"inflation-targeting" does not imply a single-minded focus on inflation, but includes a "dual mandate" that also takes "account of other economic goals besides price stability--notably economic growth, employment, and financial stability--when making policy decisions" (183). Central banks, Bernanke states, agree that "maintaining low and stable inflation" is the best means to maximize economic welfare.

Bernanke observes, however, that Congress has given the Fed "two objectives, maximum employment and price stability, [and the two are] on an equal footing." He and the rest of the FOMC "strongly support the dual mandate." He recognizes that the Fed's "monetary policy determines the long-run inflation rate, whereas the factors that influence the sustainable rates of growth and employment are in the long run largely outside the central bank's control" (184). The "diversity" of views on the FOMC "drives the Committee to adopt an eclectic approach and thus serves to limit the risk that a single viewpoint or analytical framework might become unduly dominant" (185).

Bernanke's apologia for Fed policy is standard Fed boilerplate. It includesvariables of both time--short-run and long-run--and goals--maximumemployment and price level stability. Whether to concentrate on short-runreal variables, of which there are multitudes in addition to "maximum"employment, or to promote the long-run stability of the price level, whichis unequivocally a broad-based price index with zero change, requires their"eclectic" discretion. Bernanke acknowledges that price level stability, orany fixed rate of inflation or deflation, is the one goal that the Fed, andonly the Fed, can achieve. But how can it or should it reconcile these short-run and long-run goals?

Long ago, in 1950, Senator Paul Douglas (D-Ill.)--on leave from theUniversity of Chicago where he was a professor of economics--properly putthe "short run" and the "long run" into proper perspective. In this instance, a Senate Committee Report had stated that "monetary policywas unimportant in the short run." Douglas’s response pointed out whatshould be obvious: "[T]he long run . . . is made up of short runs. If it beassumed that monetary policy has no effect in each of a series ofshort-runs, then it can have no effect in the long run" (Patman Subcommittee Report. U.S. Congress, 1950). The same criterion applies to current Fed policy: If the Fed is to stabilize the dollar in the "long run," it must do the same in a succession of short runs in order to achieve its long-run objective.

Since at least 1980, "price level stability," as a major objective of Fedpolicy, has been prominent in the FOMC's Policy Directive to the Fed Bank of New York. Indeed, in 1988 with Chairman Greenspan's arrival on the scene, what had been phrased "reasonable price level stability" became justplain "price level stability," with no "reasonable" qualification.

Figure One
U.S. Price Level in a Pure Fiat Money Regime

Click Image to Zoom

The government’s Consumer Price Index (CPI) shows price level increases over this period. For 1980, the CPI was 86 (1982-84=100). By 2007, it was 211, which means that prices were almost 2 1/2 times in 2007 what they were in 1980. Therefore, the value of the dollar, being the reciprocal of "all prices," declined from 100 to 41. Is this result--a 59 percent reduction in the value of the money unit--"long-run price stability"? Is the value of the dollar "stabilized" when it loses three-fifths of its value every 20 to 25 years? Clearly not.

And what has been the payoff-the offsetting gain-for such mismanagementof the dollar’s value? Were business fluctuations any less severe? Or were the departures from zero inflation simply results of political pressure "to do something" for special interest groups, such as, financial mega firms, or the Freddies and Fannies?

Bernanke's explanation of Fed policy reminds one of the epigram of theancient Greek philosopher Archilochus, authoritatively translated by GuyDavenport as, "The fox knows many tricks, and still gets caught. Thehedgehog knows one big trick [namely, how to survive enemy attacks bycurling into a spiky ball] but it always works." The crafty Federal Reservefox knows a lot of tricks -- how to bail out banks, how to lower interestrates, how to arrange swaps of securities, and all the legerdemain offinance, plus explanations of how to alleviate short-run cyclical slumps that seem to make its operations acceptable. In attempting to practice these tricks, however, the Fed fox often finds itself generating 2-to5 percent inflation, while achieving nothing of any permanent value for the private sector.

The single-minded Fed hedgehog, by contrast, knows the One Big Trick it always has the power to carry off: Control the nominal stock of money tomaintain a stable price level. When it does so, it thereby keeps the valueof the money-unit (the dollar) constant so that markets function withtheir maximum efficiency. For which role is the Fed better fitted?

Circumstances and political reality answer this question. The Fed cannot bea crafty fox that does a lot of desirable things. It cannot control interest rates. It has only an ephemeral effect on a few short-term interest rates as artifacts of the means by which it controls the stock of money. It cannot create anything real. But it can do One Big Thing extremely well: Maintain absolute stability in the average of money prices by its control over the nominal stock of dollars that it provides to the U.S. economy and the world. With this device, the Fed can generate any rate of price-level change that Bernanke and the FOMC chooses. If it irresponsibly ignores this talent and initiates its other temptations, it necessarily sacrifices price level stability. Not even a crafty fox can catch two rabbits at the same time.

With its power over the nominal quantity of money the Fed can maintain anyrate of price level change from less-than-zero to infinity (hyperinflation).The proper rate of change for a number of good reasons, however, is ZERO.

  1. Only zero inflation provides absolute price stability. By contrast, anynon-zero inflation rate, no matter how small, continually erodes the valueof the dollar. Even with an inflation rate of "only" two percent, the dollar loses 50 percent of its real value every 35 years, and all interest rates are constantly two percent higher than they would otherwise be.

  2. Everyone understands zero inflation, whereas even a "low," non-zeroinflation target is vague and uncertain as it can only promise "near-pricestability." An inflation rate of 10 percent per year is "nearer" pricestability than an inflation rate of 15 percent. Only zero is unequivocal.

  3. Zero inflation requires the Fed to correct occasional inflationarymistakes with equal and opposite amounts of deflation. Consequently, withthe commitment to price level stability, the FOMC would immediately correctall vagrant price level variations before they became large enough to be a problem.

  4. Zero inflation provides the standard monetary unit with the sameconstancy required of all standard weights and measures, and is implied bythe U.S. Constitution, Article 1, Section 8. Non-zero inflation rates, bycontrast, render the monetary standard elastic, similar to a stretchableyardstick, variable ton, or shrinkable mile, and not even constancy in thevariation.

  5. Zero inflation eliminates the confusion and misunderstanding betweenrelative and absolute price changes that keep markets from operating at peak efficiency. With a stable price level, all dollar price changes are alsochanges in real values.

  6. Finally, explicit FOMC adherence to a stable price level, i.e., zeroinflation, i.e., a constant-value dollar, is an effective buffer againstpolitical encroachments. If Fed spokesmen, such as Bernanke, emphasize thatzero inflation is the stratagem and that nothing any good can be achieved bybreaching it, they have an effective and valid defense against politicalpressures to "ease up," or "lower interest rates." This defense isespecially valuable now, and may become even more pertinent in a few yearswhen some future administration "asks" the Fed to buy new Treasurysecurities to fund Social Security and Medicare payments. Without someformal devise to counteract an ambitious or threatened Administration andits penchant for "lower interest rates," the Fed could easily cave in. Onecan only shudder at the potential hyperinflation waiting in the wings undersuch circumstances: Nine trillion dollars of government securities waitingto be monetized.

A monetary standard has been missing in the United States since the formal abandonmentof gold in 1971. Under the working gold standard throughout the nineteenthcentury and up to World War I, the world-gold-value of goods determined allmoney prices. World prices were astonishingly stable, even though allrelative prices could fluctuate in accordance with real demands and realsupplies. After the United States went off the gold standard, however, the FOMC, buffeted by the political forces in Washington, has determined monetary policy. The long-run result has been ninety-five years of various rates of inflation, and a dollar that has lost ninety percent of its purchasing power since the Fed came into existence in 1913.

Congress has the power and the responsibility to specify a Stable PriceLevel Standard for the U.S. monetary system. To implement this newstandard, either the FOMC would apply it operationally, or Congress would formally charge the Fed to deliver a zero rate of inflation as measured by a comprehensive price index from quarter to quarter. This move would effectively substitute a new price level standard for the old gold standard. The Fed would necessarily have the crucial role of maintaining that standard, and would have every incentive to do so. It would, of course, have to tell political pressure groups that it was a "hedgehog" and not a "fox." But at least it would be a very good hedgehog.

Richard H. Timberlake Jr. and Thomas Humphrey

Thomas Humphrey is the former vice president of the Federal Reserve Bank of Richmond and the author of Money, Banking, and Inflation. Richard Timberlake is professor emeritus of economics at the University of Georgia, an adjunct scholar of the Cato Institute, and the author of Monetary Policy in the United States.