Summary
Interest rate policy works to sustain price stability by stabilizing production costs against shocks to current productivity and future income prospects. The Fed should publicly target core PCE inflation in a 1 to 2 percent range to improve short-run communications and lock in credibility for low inflation. To secure credibility against deflation, the Fed should arrange more fiscal support for monetary policy at the zero bound on nominal interest rates than is ordinarily granted by Congress and the Treasury. By featuring price-cost, employment, and output gap indicators more prominently in its communications, the Fed can clarify the potential for inflation or deflation and its intentions for dealing with these threats.
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Sustaining Price Stability
The year 2003 was a watershed in Federal Reserve history. In his semi-annual testimony to Congress on monetary policy in July, Chairman Greenspan declared that measures of core consumer inflation had decelerated in the first half of the year to a range that could be considered "effective price stability."1 The Chairman paused briefly to acknowledge, with understated satisfaction, the achievement of this goal, which Congress had assigned to the Federal Reserve and the Fed had pursued for over two decades. He quickly pointed out, however, that the Fed would be confronted now with new challenges in sustaining price stability-specifically preventing deflation as well as inflation. Earlier in the year, at the conclusion of its May meeting, the Federal Open Market Committee (FOMC) had expressed concern for the first time that inflation might decline too far, saying that "the probability of an unwelcome substantial fall in inflation, though minor, exceed(ed) that of a pickup in inflation from its already low level."2
The case for maintaining price stability-in the United States and elsewhere-is rooted in experience and theory, which indicate that monetary policy best supports employment, economic growth, and financial stability by making price stability a priority. The full rationale for price stability has been elaborated elsewhere, and we will refrain from repeating it here.3 This article, instead, is about how to sustain price stability now that it has been achieved. We build our argument in several stages. First, we present a framework for understanding the inflation and deflation processes. Our framework, borrowed from the "new neoclassical synthesis" macroeconomic model, focuses on the management of the markup of price over marginal cost by monopolistically competitive firms.4 Next, we provide examples of shocks that are potentially inflationary or deflationary and explain how interest rate policy actions can counteract them effectively to maintain price stability....See the full content of this document
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