ne important step the Fed could take in promoting greater synchronicity between itself and the markets is to clarify its long-term policy objective. Although there has been a growing consensus that price stability--a low and steady inflation rate--is the primary goal of monetary policy, the objective remains rather vaguely defined. The Fed also--as much as possible given the price stability goal--acts to stabilize the employment and output levels. While these goals may appear to be conflicting at a particular moment in time, experience and developments in macroeconomic theory have taught us that the trade-off between employment and inflation is temporary at best. Indeed, attempts to lower unemployment by allowing inflation to rise have backfired.

Recent research at the Federal Reserve Bank of St. Louis shows that, even if there were a short-run trade-off between inflation and output, the adoption of an operational goal for long-term price stability would enhance the FOMC's ability to stabilize these measures.

What do we mean by an operational goal for long-term price stability? We mean choosing a specific number or a narrow range for a particular price index. An explicit multi-year objective would provide a benchmark that would help put the current policy situation in a longer-term perspective. This is quite unlike the current situation in which each FOMC member has an individual view about the operational definition of price stability. There is no overall objective that has been adopted to represent the consensus view. For example, some members may define price stability as 0 percent inflation, based on the GDP chain price index, some may define it is as 2 percent inflation in the Consumer Price Index (CPI), and still others may not have a precisely defined view. Also, members are likely to differ in their assessments about the probability of rising inflation or a recession. Individual members form their own views of the objectives and the current state of the economy when deciding how to vote at FOMC meetings. The nature of the committee process means that the FOMC's objectives--as a body--are not clearly defined. Furthermore, changes in the makeup of the committee can lead to subtle changes in the actual monetary policy objectives.

To see why clarification of the long-term objective is important for bringing about improved synchronicity, consider the information problem that the market would have to solve when the policy objective is explicit and policy is "perfect." Policy would be perfect if the markets and the Fed had a common understanding of three things: the monetary policy objectives, the interpretation of new information and the policy actions required to achieve the objectives in light of the new information. In these circumstances, securities prices, for example, would respond to the new information itself and not to the Fed's policy decisions. Each policy decision would be an implication of the new information. New information on the state of the economy is inherently unpredictable and, therefore, naturally takes the markets by surprise. Some surprises would be larger; most would be small. But, ideally, Fed policy actions would not be surprises at all; given the new information, the market would know what policy action to expect.

Even if perfect policy existed, we would still have much disagreement about how the world works. Markets would not know for sure how a given piece of news would affect the short-run path of inflation, or whether it would trigger a change in the Fed's policy stance. Opinions about these short-run matters would differ, but markets would know the long-term price objective, and the objective would not change because of that news, or the Fed's short-term reaction to it.

Now suppose that the price stability objective is vaguely stated, as it is now. Market participants do not know whether price stability means 3 percent inflation in the CPI, as we experienced from 1991 to 1996, 2 percent inflation as we have seen over the last three years, or 0 percent inflation--after allowing for measurement errors in price indexes--as representatives of this bank have recommended. Without a precise long-term objective, markets not only have to figure out how incoming information affects the short-run inflation path and the probability of future FOMC policy actions, they also must decide how all of this will affect the long-term objective.

If people believe the Fed is committed to price stability, market interest rates would do much of the stabilization work. If the public truly believes that the Fed would do whatever is necessary to achieve its long-run objective in response to a potentially inflationary shock, the Fed may not have to do anything or, at least, not anything quickly. During 1996, for example, news about economic performance and inflation exceeded market participants' expectations. Such a change in economic conditions would normally require an increase in the fed funds rate target. But even though the FOMC did not raise the fed funds rate target in 1996, the interest rate on one-year Treasury bills rose a full percentage point in the first half of the year. Although the strong economic growth has continued into 2000, the 1996 increase in inflation proved to be only temporary.

If the price stability objective were more specific and credible, the Fed would also not have to raise the fed funds rate target as much to lower inflation expectations. What the Fed would have to do with the target to achieve its inflation objective depends both on how strongly people believe the Fed is committed to price stability and on what sort of economic disturbances occur. Economic disturbances, such as droughts and oil price shocks, will cause temporary fluctuations in price indexes. Policy-makers cannot prevent such fluctuations, nor should they want to. What they should do is prevent these temporary events from changing people's longer-term inflation expectations. Like the physician whose first responsibility is to do no harm, the FOMC should avoid destabilizing the economy by allowing erratic changes in expected inflation. Although the Fed does not have direct control over month-to-month changes in the inflation rate, it could help stabilize and synchronize the process by choosing a long-run inflation target.

A central bank that has credibility in maintaining long-term price stability also has more flexibility in dealing with short-term problems, such as financial crises and recessions. Credibility is an asset that pays high dividends. When the Fed--responding to financial disruptions following the crisis in the Russian bond market--lowered the fed funds target in the fall of 1998, the markets' expectations of continued low inflation remained rock solid. In another era, the Fed might not have lowered the fed funds target in such a situation for fear that many might have interpreted the action as an indication that the Fed was softening its resolve to control inflation. Low inflation and high credibility enhance the Fed's range of options in taking policy actions in the face of unusual circumstances.

The gains to the economy of a sustained Fed policy to foster low inflation are manifest. The task remaining is for the Fed to make its inflation objective more precise.