A Framework for the Pursuit of Price Stability

It is often said that there is a worldwide community of central bankers. I certainly feel that way. Central bankers in all countries share a number of concerns. Perhaps the most important of these is the desire for price stability. While central bankers may differ in the ways they seek to achieve price stability— differences grounded in our respective histories, customs, and institutions—the goal we all strive for is no less important. Recognizing that no one country's central bank has a monopoly on the right answers, I would like to share with you my views on why I believe price stability is so important and what approaches can be taken to achieve this goal. Before turning to these issues, we must first be clear about what we mean by price stability and how to recognize it when we see it. In my view, a goal of price stability requires that monetary policy be oriented beyond the horizon of its immediate impact on inflation and the economy. This immediate horizon is on the order of two to three years. This orientation properly puts the focus of a forward-looking policy on the time horizon over which monetary policy moves today will have their effect and households and businesses will do most of their planning. This is the horizon that is relevant for the definition of price stability articulated by Chairman Greenspan: that price stability exists when inflation is not a consideration in household and business decisions. A central bank's commitment to price stability over the longer term, however, does not mean that the monetary authorities can ignore the short-term impact of economic events. It is important to recognize that, even if we set ourselves successfully on the path to price stability and even if, as a result, price expectations are contained, we still will not have eliminated all sources of potential inflationary shocks. The reality is that monetary policy can never put the economy exactly where we want it to be. For example, supply shocks that drive prices up sharply and suddenly—such as the two oil shocks of the 1970s—are always possible. In such an eventuality, the appropriate monetary policy consistent with a goal of price stability would not be to tighten precipitously, but rather to bring inflation down gradually over time, as the economy adjusts to the shift in relative prices. In the event of a shock to the financial system, …