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Monetary Policy Works Best When Financial Markets Understand the Fed's Objectives: St. Louis Fed President Poole


NEW YORK Consumers and businesses must understand not only the Federal Reserve's monetary policy objectives, but also the decision-making process through which the Fed achieves those objectivesa process made easier when policymakers refer to rules focused on price stability.

That was one of the key messages delivered by William Poole, president of the Federal Reserve Bank of St. Louis, speaking to members of the New York chapter of the National Association of Business Economics. In his speech, titled "Understanding Inflation," Poole outlined how monetary policymakers' improved understanding of price stability contributes to overall economic stability.

Under the Federal Reserve Act, the Fed has a dual mandate to foster both maximum employment and price stability.

"It used to be thought that the dual mandate required the Fed to temper pursuit of its inflation goal from time to time in the interest of minimizing disturbances to employment," said Poole. "Over time, the mainstream view in the economics profession has increasingly emphasized the importance of price stability for achieving maximum employment and maximum sustainable economic growth. I myself have become passionate about price stability."

Poole noted that the central bank can refine its pursuit of prices stability in three ways:

  • A consensus should form around the goal of a specific low-inflation rate. "The particular chosen number is less important than commitment to a specific goal," said Poole.
  • A consistent policy model, or decision framework, must be developed, for responding to incoming data. "The framework," said Poole, "must explain how policymakers reconcile near-term movements in inflation, over which monetary policy has no influence, with the path to medium- to-long-term inflation, for which the central bank is wholly responsible."
  • Communication of the decision framework in a credible and transparent way.

Poole said that over the past decade or so, the Fed has gravitated toward the position of placing primary emphasis on the core rate of inflation, as measured by the PCE (personal consumption expenditures) price index, which excludes food and energy, since those two commodities are "subject to large, short-run disturbances that are beyond the ability of monetary policy to control."

He emphasized that any understanding of inflation in the U.S. economy must focus on the "Great Inflation," which ended with the Fed's policy reform of October 1979. "During the 1970s, consumer price inflation (measured by the price deflator for PCE) averaged 6-1/2 percent, approximately double the historical average since 1930 and triple the average of the prior two decades," Poole said. He added: "The 1970s illustrate the importance of a well-thought out commitment to price stability as a bulwark against large shocks to individual commoditiesthat is, large relative price changesfeeding into more general inflation."

The FOMC during that time, Poole noted, "lacked a clear, forward-looking framework for monetary policymaking containing a commitment to price stability. Without it, the Committee reacted to events as they happened; that is, its behavior consisted of a series of individual policy actions that did not add up to define a coherent policy regime."

Those experiences, Poole said, led monetary policymakers to shift their focus toward more forward-looking behavior.

"If the central bank is perceived as being prepared to acquiesce to higher inflation and unprepared to pursue policies consistent with lower inflation, then both inflation expectations and actual inflation will rise," Poole said. "And the reverse is true: If the central bank is perceived as unwilling to underwrite higher inflation and prepared to pursue policies consistent with lower inflation, then expectations and actual inflation will fall."

Poole also said that "when policy departs from usual practice, it is incumbent that policymakers communicate the changeits nature and rationalecarefully to the public."

In his concluding remarks, Poole said if the FOMC communicates its objectives and strategy effectively, then forward-looking financial markets will "amplify" the FOMC's near-term decisions and, to a great degree, "do a good deal of the Committee's work for it."

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