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Friday, November 04, 2005

Credibility, Independence, Stable Inflation, and Economic Growth

Federal Reserve Vice Chair Roger Ferguson speaks at the Cato Institute concerning the connection between central bank credibility and low inflation, and between low inflation and economic growth. He believes credibility and central bank independence are keys to low inflation and hence to robust economic growth. However, as he notes, while there is evidence that credibility and independence lower inflation rates, the empirical evidence on the connection between moderate inflation and economic growth is less clear. Still, he is confident that a relationship exists:

Monetary Credibility, Inflation, and Economic Growth, by Federal Reserve Vice Chairman Roger W. Ferguson, Jr.: By now it must be universally agreed that low and stable inflation is a primary and essential goal for monetary policy, in large part because we believe it ... fosters sustainable economic growth over the longer run.  ... To me, it is axiomatic that monetary credibility, by reducing the level and variability of inflation, lays the foundations for stronger and more-sustained economic growth. In my remarks today, I want to discuss anecdotal and academic evidence for the relationship between monetary policy credibility and economic growth and to do so in two segments: first, the link between monetary policy credibility and inflation performance and, second, the link between inflation performance and longer-run economic growth. ... [C]ommon intuition and numerous academic journal articles ... suggest that .... [w]hen the central bank is viewed to be both committed to and effective at keeping inflation contained, inflation expectations will tend to be anchored. And so long as the central bank pursues sensible policies, those expectations will tend to be self-fulfilling, as they should lead to movements in prices and wages that are consistent with inflation staying low and stable. ... One does not have to look far to see examples of the practical importance of monetary credibility. In the past two years, crude oil prices have about doubled. During the 1970s, similar run-ups set off sharp increases in global inflation. Today, by contrast, core inflation rates both in the United States and abroad, while they have moved up some, remain essentially contained. In large part, they remain so because central banks, including the Federal Reserve, have substantially bolstered their commitment to price stability since the 1970s and markets are now much more confident that monetary authorities will keep inflation from rebounding. ... Aside from such anecdotal evidence, much formal research supports the view that a strong commitment to price stability helps reduce and stabilize inflation. ... Finally, there is considerable literature on the effects of central bank independence on inflation ... [C]entral bank independence frees the monetary authority to pursue price stability more diligently, resulting in lower and less-variable inflation, is supported by many studies. ...

Assuming that monetary credibility does make it easier for central banks to pursue the objective of price stability, what can we say about how stable prices affect the bottom line--economic activity and growth? Empirical research attempting to establish solid links between low inflation and sustainable economic growth has met with mixed success... [R]esearchers seem to agree that extreme inflation rates, say above 40 percent per year, are associated with reduced economic growth. ...  But what can we say about lower inflation rates? Is the pace of economic development slower when inflation is at 15 percent than when it is at 5 percent? Research by IMF staff economists ... has turned up a negative association between inflation and growth. ... To be completely fair regarding the academic literature, however, others have not found such a clear relationship. ... Of course, as a central banker, it makes sense to me that lower and more-stable inflation, by making the returns to saving and investment more predictable and by diminishing the likelihood of shocks to the financial system, should encourage economic growth. ...  I am obviously not alone in this view, it is clear that central banks should strive to achieve low, stable inflation... In conclusion, let us not forget that the declines in inflation over the past two decades and the resulting boost to monetary credibility we currently enjoy were earned with some economic pain... If the academic evidence does not yet unequivocally support this conclusion, perhaps it is because we are only starting to see the return to sacrifices made in the past. ...

Those who would like to see the Fed pause in its campaign of raising the federal funds rate at a measured pace might wonder why the Fed is so concerned about inflation rather than a weak labor market  if there is, as governor Ferguson suggests, only mixed evidence that moderate inflation is costly to the economy.

Update: I should have distinguished between the trend growth of GDP and stabilizing GDP growth around the trend. As I read the evidence, price stability reduces variation of GDP around the trend rate of growth but does not have much, if any, affect on the trend rate of growth itself.

    Posted by on Friday, November 4, 2005 at 01:54 PM in Economics, Fed Speeches, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (10)

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