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Tuesday, April 26, 2005

Cleveland Fed President: The Power of Price Stability and Public Pressure

Sandra Pianalto, President and CEO, Federal Reserve Bank of Cleveland, explains the advantages of inflation targeting when there are budget and current account deficits. In addition, she discusses the appropriate monetary policy response in both soft and hard landing scenarios. She states a clear commitment to inflation targeting and to gradually allowing interest rates to rise to their equilibrium level in the near future. The exception is a hard landing where an immediate infusion of liquidity might be necessary to avoid systemic market failure.

She also notes that the public can help the Federal Reserve with its job. She says “... it goes without saying that our job is made easier if the public expects that the fiscal authorities will address budgetary imbalances in a timely and effective fashion.” Thus, by exacting a political price for high and persistent deficits the public can help to stabilize the economy.

This is an important point. If the public does not expect or demand that politicians attend to budgetary issues, then they will have no incentive to undertake the difficult task of balancing the books. Here are President Pianalto’s remarks:

The Power of Price Stability,Sandra Pianalto, President and CEO, Federal Reserve Bank of Cleveland, The Levy Economics Institute of Bard College, Annandale-on-Hudson, NY, April 21, 2005

The economy has been expanding for the past few years, but many people seem to think that … the economy could face some challenges from fiscal and trade deficits. Today, I would like to explain how I think central banks can best meet those challenges and promote economic prosperity - by maintaining price stability, or low and stable rates of inflation. …

…Let me turn now to the issue of whether large budget deficits may undermine central banks' success in maintaining low and stable inflation rates. In the United States, current budget deficits, as well as prospective deficits over the immediate horizon, seem to be well within the boundaries of historical experience. … the United States … face[s] demographic changes where we see entitlement liabilities growing faster than the tax base available to support them…

… resolving fiscal imbalances is not the job of monetary policymakers, but that does not mean that we can ignore their consequences. The stance of monetary policy - that is, whether a specific setting of the federal funds rate target is determined to be "tight," "easy," or "neutral" - depends on the level of what economists usually refer to as the "equilibrium real interest rate." …

It is not unreasonable to expect that persistent government deficits will eventually yield upward pressure on the equilibrium real interest rate. … central banks … will need to respond to this pressure with corresponding movements in their policy rates. … But… large and persistent fiscal deficits introduce another risk-namely, that they could be the source of inflationary pressures.

However, there is no need for deficits to be inflationary. The prospect of inflation arises only if the central bank ignores or, even worse, tries to resist any rise in real interest rates. By doing so, the central bank would keep its policy rates too low and inadvertently ease monetary policy. Of course, the real risk of an excessively stimulative monetary policy is that inflation expectations may eventually become unanchored. History shows that once inflation expectations become unstable, more stringent policy actions might be required.

…I believe that the FOMC is trying very hard to preserve its credibility by being clear and unwavering in its commitment to low and stable inflation. However, it goes without saying that our job is made easier if the public expects that the fiscal authorities will address budgetary imbalances in a timely and effective fashion.

Now I would like to discuss how monetary policy can best contribute to resolving the challenges brought by external account imbalances. … I think everyone agrees that these levels are unsustainable, and that a reversal is inevitable, even if the timing and pace of the adjustment are uncertain.

Some people envision a soft landing. As we all know, a return to current account balance will ultimately require that U.S. households consume less and save more of their incomes. Households could become concerned about having enough money for future consumption and step up their saving, even at today's interest rates. The more commonly expected scenario, though, is that foreign savings coming into the United States could become less plentiful over time, driving up interest rates. Then, households might be induced to save more and spend less.

If a substantial turnaround in U.S. current account deficits results in higher equilibrium real interest rates, the FOMC would most likely need to adjust its federal funds rate target accordingly to prevent a change in its policy stance. It is also possible that a decline in the exchange value of the dollar could result in temporary upward pressure on the price level, due to rising import prices and the prices of import-competing goods. The first responsibility of the central bank is to ensure that these price pressures do not feed into higher inflation expectations in the long run. …

… of course, there are those who believe that the landing might not be so soft - and that the reversal of our large current account deficits will be sudden and disruptive. … In these circumstances, it is difficult to predict what the specific course of monetary policy ought to be, but the usual answer to financial market crises is for the central bank to provide enough liquidity to short-circuit systemic market failure.

How, then, should monetary policy deal with current account imbalances today? I do not think that the FOMC should take preemptive measures to address these imbalances. However, I do think that the Committee should continue to bring the federal funds rate target to a level that is consistent with maintaining price stability in the long run. If we achieve that, then we will be in a position of strength to address whatever challenges arise.

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