The Fed Versus Price Stability

Its prime objective remains price stability, with real economy factors relegated to the second order of importance. By contrast, the US Federal Reserve has a dual mandate price stability and full employment.

What central banks need now is a revised mandate that upholds price stability as the primary, long term objective, while allowing policymakers to pursue other objectives when appropriate. Specifically, the central bank should be able to move slowly on price stability if it regards the real economy as unacceptably weak, or if an asset price misalignment threatens financial stability and cannot be defused quickly by the new macro prudential instruments.

In October 1998, just before the start of the European Monetary Union, the Governing Council of the European Central Bank (ECB) adopted a stability oriented monetary policy strategy. This strategy comprises three elements First and foremost it contains a clear commitment to the primary goal of the ECB, which is to safeguard price stability. Price stability was defined as an annual increase in the price level of below two percent over the medium term.

It is time for central banks to accept this fact and adopt a comprehensive, long term monetary policy approach even if it means that, in the short term, consumer price inflation deviates from what is currently understood as price stability. Temporary fluctuations in a narrow and imprecisely measured CPI are a small price to pay to secure the long term stability of money.

How can measures to increase commodity price stability and returns from commodity exports contribute to achieving the Millennium Development Goals?

Just because European governments have failed to put bread on their constituents tables doesn t mean that the European Central Bank should likewise fail in its job of promoting price stability in the euro zone. That may sound obvious, but abandoning price stability is exactly what some European politicians are advocating.

In the past 30 years, a remarkable degree of consensus had been established that the primary, if not sole, responsibility of central banks was to ensure price stability. Increasingly, since the early 1990 s, it had become fashionable to define price stability more precisely through the use of inflation targets.

The Fed decided to define price stability as a two percent annual inflation over the medium term of the price index of consumer expenditures. For the past 12 months, that rate of increase has been about 1.5 .

We continued to guide monetary policy by our assessment of the risks to price stability over the medium term. This medium term orientation paid off.

But the ECB s primary responsibility is to achieve and maintain price stability. When conventional interest rate policy becomes impotent, its duty is to rely on other instruments.

Notably, price growth turned positive last month, suggesting that the threat of deflation has been eliminated. This has prompted a modest uptick in expected inflation the ECB s favorite measure of price stability not for the immediate future, but in five years, and then for five years.

Of course, a central bank s mandate is price stability in the national economy that it serves, and price stability is influenced by exchange rates. So a case can be made that central banks should have the power to intervene in foreign exchange markets, and that this power should at least in times of crisis include commitments to foreign central banks to provide unlimited liquidity in the domestic currency.

At the same time, regulatory regimes have been toughened everywhere to prevent banks from jeopardizing the financial system again. For example, in addition to its price stability mandate, the Bank of England has been given the new task of maintaining the stability of the financial system.

But this will require a shift in the ECB s attitude. Europe needs a monetary policy that views aiding employment growth in northern Europe as more important than continental price stability.

The price stability mandate has been trumped by concerns about growth. The fear is that tightening monetary policy to bear down on inflation could snuff out the faltering economic recovery.

The discussion quickly turned to the difficulty of measuring inflation accurately and the need to build in a safety cushion to avoid deflation. According to Greenspan, Price stability is that state in which expected changes in the general price level do not effectively alter business and household decisions.

Day to day politics cannot dominate the regulation that markets need. The single most important institutional reform underlying price stability throughout the world has been the stronger independence of central banks.

In addition, to ensure price stability, it will be necessary to further reduce the need for domestic financing of Government deficits through reduced recurrent spending and sound fiscal and monetary policies.

But if that were true, central banks around the world would have set it as a target long ago. Instead, all of them define price stability as low, stable, but positive inflation.

Inflation targeting means that a central bank puts the pursuit of price stability above all other objectives. This is what the ECB does and what the Fed s Alan Greenspan does not do.

The introduction of the Real plan, launched in 1994, managed to suppress annual price growth to an acceptable 22 by the following year. Riding on the plan s success, its architect, Fernando Henrique Cardoso, a former economy minister, was twice elected President (in 1994 and 1998), underscoring voter concern about price stability.

A normal monetary union, which is what the eurozone aspires to be, requires a normal central bank to carry out the entire range of central banking functions. This starts with ensuring price stability.

The second reason might be that even with anchored inflation expectations (and thus price stability), policymakers do not know how to keep them anchored while boosting the flow of spending in the economy.

They just care about three things and three things only price, price and price.

When forced to choose between full employment and price stability, the international finance economists say that the Fed will choose price stability, because its institutional memory of the 1970 s, when inflation ran rampant, remains very strong. Therefore, since a fall in the value of the dollar raises import prices, and thus functions as a negative shock to the supply side of the economy, the Fed will have to raise, not lower, interest rates, and sell, not buy, bonds.

Their mandate is to maintain price and financial stability, as well as maximum employment. The more intently Fed governors focus on their core responsibilities, the more inclined politicians will be to respect their independence.

In 2010, when it began raising its policy rate to contain financial excesses, it put price stability at risk. Before long, Sweden had succumbed to deflation, from which it is still struggling to recover.

But the ECB, whose only mandate is to maintain price stability, cannot pursue this policy without fundamental changes in legislation. Moreover, this scenario cannot take place before the slump has turned into a boom.

(2) The transaction price or the price range

A sustained price recovery requires a healthier global economy that combines faster inclusive growth and greater financial stability. And this will not occur quickly, especially given the policy shortcomings in both advanced and emerging countries.

The notion of integrating asset price concerns into inflation targeting remains a source of significant controversy, with opponents citing the Tinbergen Principle if policymakers have one instrument, the interest rate, they can pursue only one objective, price stability. Attempts to pursue multiple objectives, the logic goes, would confuse financial markets and private sector agents.

Moreover, the highest priority for central banks can no longer be to maintain their credibility as guardians of price stability, but rather their credibility as guardians of the financial system s stability and soundness. Once that highest goal has been achieved, central banks can turn their attention to trying to keep the economy near full employment.

Modern central banking has worked wonders to bring down inflation. Ultimately, however, a central bank s anti inflation policies can work only within the context of a macroeconomic and political framework that is consistent with price stability.

A 40 fall in the value of the dollar of which half passes through to increased dollar prices of imports thus implies a 3.2 rise in the overall price level. A Federal Reserve committed to effective price stability will likely raise interest rates rather than allow any year s inflation rate to jump from 3 to 6 .

Sometimes its critics will say often the advice provided by the IMF and World Bank is misguided. This was certainly true in the 1980 s and early 1990 s, when right wing ideology dominated, producing a one size fits all prescription entailing privatization, liberalization, and macroeconomic stability (meaning price stability), with little attention to employment, equity, or the environment.

The demand that the ECB should be the central supervisory authority in an integrated capital market met strong resistance, above all from Germany s Bundesbank, which worried that a role in maintaining financial stability might undermine the Bank s ability to focus on price stability as the primary goal of monetary policy. There was also bureaucratic resistance from existing regulators.

This does not mean imposing rigid inflation targets. But a predictable monetary policy aimed at delivering medium term price stability with a flexible exchange rate where appropriate  benefits both the private sector and, most importantly, the poor.

Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

This does not mean imposing rigid inflation targets. But a predictable monetary policy aimed at delivering medium term price stability with a flexible exchange rate where appropriate benefits both the private sector and, most importantly, the poor.

PRICE

This two pillar approach constitutes a framework for cross checking indications from the shorter term economic analysis with those from the longer term monetary analysis in order to obtain a robust view about the risks to price stability.

(3) The price setting method and the basis for the price setting

Price comparison measures can provide direct measures of price impacts of NTBs.

As holders of euro denominated assets recognized this situation, they turned to the ECB for insurance (which the ECB could not deliver under its previous president, Jean Claude Trichet, whose leadership was defined by his commitment to maintaining price stability). Investors subsequent efforts to price in the risk of a eurozone breakup not the volume of sovereign debt caused bond yields to spike.