DR. EDWARD GRAMLICH: Thank you very much, Joe. It's a pleasure to be in Alaska. This is my second trip here and I've enjoyed both of them. I'm going to talk this morning about monetary policy. A typical monetary policy talk involves the next meeting, whether the funds rate will go up or down. That's a very interesting question, but that's actually not what I'm going to talk about this morning. I know it's what you hear about, but it's not what I'm going to talk about.
I want to stand back a little bit and talk about monetary policy in a broader, maybe a longer run sense. Talk about the strategy of monetary policy. What after all is the Fed trying to do, what after all are other central banks trying to do. This all starts with a fundamental proposition in economics which is that inflation or now you could also insert deflation are fundamentally monetary phenomenon. That is if the growth of credit is too rapid you can get rising prices. If the growth of credit is too slow you can get falling prices. And even though in the short run things like exchange rates, oil prices and things of that nature can move around the inflation rate and give little wiggles. In the long run it's really the growth of credit that is the fundamental factor. And that pretty much sets the agenda for the central bank ought to regulate the growth of credit so that we move towards stable prices. That in their own ways both inflation and deflation have significant costs. They can be by and large avoided through proper central bank policy.
Now this thinking has been formalized around the world. There's something like 20 countries now that have formal regimes called inflation targeting. And in an inflation targeting country the central bank will give a forecast of -- it'll first set an inflation target. It's usually two percent or so for the inflation target. I'll come back to that in a second because the obvious question is maybe why not zero. And there's a good reason for not zero. And the standard throughout the world is usually two percent or so.
It has the goal. There's usually a system where they issue inflation reports that would say what would happen if policy weren't changed and how we are going to change policy to climb back toward two percent. And I just got a document in the mail that was analyzing the inflation targeting regimes of all these countries, how readable their reports were, how well argued they were, and that kind of thing. So there's a huge amount of attention to this around the world.
Now, the Fed has never done this. The Fed has never adopted a formal inflation targeting regime. There is a huge debate among academic economists about whether it should. And the current chair of the Council of Economic Advisors, for example, is on record for saying we should. Glen Hubbard, the recent chair of the Council, head of a piece in the Wall Street Journal just yesterday saying we should. So there are a number of people that are urging the Fed to go over to a more formal regime. But there are also some kickback. There is an argument that we have more -- what you get with inflation targeting regime is enhanced credibility. There's an argument that the Fed contrasted to some of these other central banks already has that and we have the advantage of flexibility.
Now that is a huge debate that is going on. You'll read about it. I'm not going to take a position on it this morning. I can see value in arguments on both sides. But one point I would like to make is that economists often say you ought to look at what people, in fact, do, not what they say. And if we adopted that standard for looking at monetary policy we -- the Fed has said that its preferred measure of price inflation or deflation is something called the poor PCE. That is the price deflator for consumption expenditures in the national income accounts where you -- core means you take out food and energy prices because they have pretty much their own life and they don't fluctuate in line with basic economic fundamentals.
For various technical reasons this we think is the best price index. And over the past eight years it's risen by 1.7 percent a year with a very small variance. That is, you know, some years it'll be 1.6. Some years it'll be 1.8, but it's never oscillated much. It's been pretty stable. And if you compare that with the inflation experience of all the countries that do inflation target we are one of the lowest in the world and we are the most stable. We have the most stable rate of inflation of all inflation targeting countries in the world. So our performance would stack up very well compared with all of these countries that have a more formal mechanism. I just throw that out so we are at least doing it if we don't have all the formal apparatus.
Now one aspect of this that I think deserves some comment is that when somebody says they're inflation targeting either in fact or in formality, what does that mean exactly? What is the strategy for -- on the bottom side. And the present thinking is that inflation targeting regimes ought to be two sided. That is it's obvious that if inflation starts rising on the top side you'd want to have the central bank do something about that. But what about if inflation starts getting too low? That's the hot new item on the agenda.
The European Central Bank, for example, that is kind of developing inflation targeting regime, they just had a new report, they've done a self-examination. And they have changed their formal statement from it used to be they want to keep inflation safely under 2 percent. They use the word safely under. Now they have changed and they say they want to keep inflation around about 2 percent. In other words, they put a bottom limit. Before there was nothing that bounding (ph) inflation on the bottom, but now they are doing that.
The other countries that inflation target now have gone over to a range. It's two-sided. So in other words, you want to collapse it on the bottom. You don't want inflation to get too low, in other words, because that can also generate problems. And that is the mechanism by which countries fight either deflation or recession whichever of those -- or both whichever of those worry you most. So it is important to note that inflation targeting regimes whether the U.S. eventually adopts one or not should be two-sided. It's not enough to say you just want to get it now. It's possible to get it down too far and you don't want to do that either.
One other point on this and I'm going to move over and talk a little bit about fiscal policy here. The idea for monetary policy is, if you will, that you anchor policy on the rock of stable prices. That is the goal. And if you do that you have flexibility to deal with recession because whenever, for example, the Central Bank conducts expansionary policy when demand seems to be weakening to try to boost output. If markets felt that this would lead to explosive rise in credit and then in prices then it wouldn't be very effective. But if markets feel that the policy is anchored on this goal of price stability then it turns out you can be more effective fighting recession as well. So the idea here is to have a firmly grounded policy but flexible to deal with recession.
And I would argue that we ought to have the same rough point of view for fiscal policy. You'd certainly want budget deficits to go up and down and you'd certainly want to run deficit when demand is weak and conditions are soft. That would tend to stabilize the economy. So you'd certainly want that. If, on the other hand, we have deficits every year then basically what's happening is that private saving is being used to run the government and not -- the private savings money is not going into private investment which leads to productivity change in growth in the long run.
So my goal for -- I don't do fiscal policy, but the goal would be to, sure, to have the budget flex in times of when demand movements are strong or weak, sure, but to anchor it on a balanced budget in the long run just to prevent the government from using up the saving that would otherwise go into capital formation. So I think there is a parallel between monetary policy and fiscal policy. That both you need an anchor and you need flexibility.
At that point I will stop. These are a few overall remarks. It's not -- it doesn't get into the current day of what I'll call upsies and downsies, but I think often we get too wrapped up in that and we forget to ask the question well, what is the goal of policy at the outset and that's what I tried to address this morning. Thank you very much. (Applause)
The Edward Gramlich Commonwealth North Forum may be reproduced but credit must be given to Commonwealth North.
Introduction Questions and Answers
