What monetary policy can and cannot do: it can do a lot, but it is important to know its limits

Business Economics, Jan, 2002 by Anthony M. Santomero

There is general agreement that price stability is necessary for macroeconomic success and that only monetary policy can achieve price stability. The Fed has been successful in this respect over the past twenty-two years. However, there is disagreement on whether monetary policy can do more. Future potential is limited by both the quality of data and the state of economic science. However, past success has created the irony that--while there is recognition that monetary policy is a blunt instrument--there are calls for the Fed to use it with surgical precision. A realistic appraisal of the potential for monetary policy suggests that persistent, incremental action--rather than aggressive attempts at fine-tuning--is the right direction for achieving an environment for maximum sustainable economic growth.

In this paper, I will present my thoughts on what monetary policy can and cannot do. I will first try to stake out the common ground--the ideas on which we can readily agree. Then, I'll talk about the more contentious issues-the areas in which there is legitimate room for disagreement--and offer some of my own perspective on these issues as well. I'll conclude with some thoughts about the implications of all this for the conduct of monetary policy.

I think most Fed policymakers--indeed, most professional economists today--would agree that: (1) the goal of monetary policy is to help create an economic environment that fosters maximum sustainable growth, and (2) the most important contribution the Fed can make to that environment is to provide price stability.

Behind this philosophy of appropriate monetary policy goals lie some important economic principles on which, again, I think there is broad agreement. The first economic principle is that price stability is crucial to a well-functioning market economy. Prices are signals to market participants. A stable overall price level allows people to clearly recognize shifts in relative prices and adjust their decisions about spending, saving, working, and investing in welfare-enhancing ways. Inflation, by contrast, jumbles and distorts price signals and generates bad economic decisions.

The second economic principle is that price stability is a contribution to financial stability and attendant economic growth that only monetary policy can make. We know that relative prices will fluctuate in response to shifts in the supply or demand for particular products, but it takes a persistent influx of excess money and credit to sustain a general inflation. At the same time, money is neutral in the long run. That is to say, changing the supply of money does not affect the pool of real resources available to economy and so ultimately affects only the price level.

To these two principles I will add two empirical observations about which I hope we can also agree. The first is this: for the past twenty-two years, the Fed has focused on the goal of price stability and has been relatively successful in achieving it. We took the economy from the double-digit inflation of the late 1970s to a core inflation rate in the two-to-three percent range. This is a range approaching essential price stability, that is, inflation low enough to no longer significantly influence economic decisions.

Equally important, as the downward trend in market interest rates attests, we have succeeded in reducing inflation expectations. Market participants not only see stable prices today, they also expect stable prices to persist for the foreseeable future. This is evident from a number of sources. Not surprisingly, our own bank's Survey of Professional Forecasters is my personal favorite. Long-term inflation expectations, measured in our survey as the average rate of change in the Consumer Price Index over the next ten years, have held steady at 2.5 percent since early 1999. Establishing and maintaining confidence in the Fed's goal of reaching for price stability is crucial to fostering productive saving and investment decisions.

The second empirical observation on which I think monetary economists will agree concerns the Fed's policy strategy. We talk about monetary policy, recognize that inflation is a monetary phenomenon, and express belief in the neutrality of money. But the mechanism used to achieve our goal of price stability no longer involves setting targets for monetary aggregates. Indeed, the entire disinflation period coincides with the abandonment of one monetary aggregate after another, as none exhibited a predictable velocity.

Rather, the Fed's policy strategy has been to move the fed funds rate in the direction we think necessary to achieve our inflation target and bring aggregate demand into balance with the economy's long-run potential supply. This is the essence of the so-called Taylor Rule.

The principles and observations I've just enumerated deliver a straightforward answer to the question of what monetary policy can do. Monetary policy can and should strive to establish a stable price environment; and the Fed has made considerable progress toward that goal by pursuing a persistent, if not particularly precise, strategy over the past twenty years.