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Since 1980, the story of monetary policy
is essentially the tale of a dramatic drop in inflation. From double-digit
heights in the late 1970s and early 1980s, and an average of more than 3.5
percent during the early 1990s, inflation checked in at just 1.7 percent over
the 12 months ending December 1997. While conventional wisdom has held that
lower inflation can be achieved only at the expense of lower employment and
economic growth, the transition to low inflation in the 1990s has been
accompanied by substantial real growth, declining interest rates and an
unemployment rate at a quarter-century low. How was this success achieved?
An Increased Emphasis on Price StabilitySuccess in monetary policy came about because of an increased focus on price stability, sustained over the entire period after 1980. Given their experience with high inflation, many central banks around the world have come to realize that low inflation promotes sustainable economic growth. High and variable inflation, on the other hand, distorts the economy's signals about price movements and puts upward pressure on nominal interest rates, as lenders demand compensation for expected inflation and the risk associated with inflation uncertainty. How the Federal Reserve implements its low-inflation strategy has changed in response to dramatic changes in financial innovation and deregulation over the past two decades. The Fed's chief policymaking body, the Federal Open Market Committee (FOMC), employs a variety of indicators, including monetary aggregates, reserve aggregates and interest rates, to gauge the impact of its policies on the nation's economy. Given the lag between Fed actions and their effect on inflation, monetary policy must be forward-looking and, thus, is most effective when it is preemptive. To increase an understanding of the preemptive nature of its policies, the Fed has taken steps to conduct monetary policy more openly. In 1994, the FOMC began announcing its policy decisions immediately after making them; in 1995, it began to announce a target level for the federal funds rate; and in 1997, it began including this target in its policy directive. In addition, the Fed now uses the Internet to disseminate economic information, both policy-related and educational. Ultimately, efforts to broaden public understanding of the Fed's goals and objectives, along with continued innovation in the strategies that drive monetary policymaking, will play a critical part in prolonging our current monetary policy successes. Making the Fed's strategy clear and its performance measurable are key to establishing credibility for a long-term policy that seeks to foster sustained economic growth and increasing standards of living for all Americans. |
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How do we ensure that the recent success of monetary policy in reducing inflation endures? The St. Louis Fed has argued that monetary policy be "anchored" to a price level objective. For several years, we have advocated that the FOMC publicly commit to a specific inflation or price level objective, as well as a time frame for achieving it. At the same time, because an accurate measure of the growth of money is critical in assessing monetary policy's effectiveness, we revised our measures of the adjusted monetary base and adjusted reserves to reflect the increased importance of interbank settlement as a factor affecting the amount of deposits that banks hold at the Federal Reserve. |
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