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Principles of Sound Central Banking

By any measure, 2008 was an extraordinary year. The economic turmoil that began in housing two years ago swelled into a financial tsunami, which roiled the economy over the course of the year. That turmoil has not been confined to the U.S. Slowing economic growth and the deepening credit crisis have affected the global economy and prompted historic actions by policymakers in the U.S. and around the world. The crisis has led to fundamental changes in the financial landscape, prompting debates about the central bank's roles and responsibilities and the appropriate approach to conducting policy.

In this year's annual report essay, I want to focus attention on some of the principles that I believe make for sound and effective central banking. Relying on sound principles to guide policymaking is always useful. But it is particularly important and helpful in times of crisis, when the temptation is to abandon all guiding principles and simply react to the daily challenges based on what seems expedient at the time. I believe that adhering to these principles can enhance the effectiveness of monetary policy in these challenging times and can provide insights into how the central bank can promote greater financial stability.

One of the most significant developments in economic theory during the last quarter of the 20th century was the recognition of the importance of expectations in understanding economic behavior. Expectations about the future play an important role in the economic decisions of both households and businesses. This is particularly evident in financial markets, where expectations about the future play a role not only in investment decisions but also in the valuation of securities. Of course, the public's expectations about future actions by policymakers are also important. Will Congress raise or lower taxes in the future? Will the Federal Reserve ensure that inflation remains low and stable? Expectations about these future policy actions influence the decisions by households and firms today. Moreover, actions taken by policymakers today help inform the public about the likelihood of future policy actions. Thus, policymakers must make decisions with the understanding that those decisions may affect the public's expectations about future decisions — which, in turn, will affect the choices market participants make today.

The recognition of the important role played by expectations leads me to focus on four main principles of sound central banking. These four principles are based on lessons learned from both the theory and the practice of monetary policy.1 They include:

Principles

With these guiding principles in mind, let us consider how they apply to the central bank's two main responsibilities: monetary policy and financial stability. These two pillars of central banking are related but different.2 Monetary policy is responsible for price stability and promoting sustainable economic growth. Financial stability involves promoting an effective and efficient payments system and a robust and healthy financial system that helps support economic growth.

One

Clear and Explicit Objectives

The first principle of sound central banking is to be clear about the goals and objectives of policy. It makes no sense to seek goals the central bank cannot achieve. In other words, policymakers must be clear about what policy can and cannot do. Given the importance of expectations, we must set reasonable expectations for what a central bank can achieve. We must recognize that over-promising can erode the credibility of a central bank's commitment to meet its goals, whether for monetary policy or financial stability. Saying that monetary policy will achieve an objective it is incapable of delivering is a sure way to lose credibility.

Monetary Policy — Let me expand on this principle in the context of the objectives that Congress has established for the Federal Reserve's monetary policy. The Federal Reserve is charged with conducting monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."3 These are all desirable goals, yet most economists, myself included, agree that focusing on achieving one of them — stable prices — is the most effective way monetary policy can support the other two.

Moreover, we must remember that sustained inflation or deflation is always a monetary phenomenon and that in a world of paper or fiat money, the central bank has the obligation to preserve the purchasing power of the currency so that the ravages of inflation or deflation do not distort markets.

Maintaining a stable price level allows the economy to function in a more efficient and thus more productive fashion. If people and businesses need not worry that inflation will erode the purchasing power of their money, they need not divert resources from productive activities to conserve their money holdings or to hedge the risks of inflation (or deflation). Stable prices also make it easier for households and businesses to make long-term plans and long-term commitments, since they know what the long-term value of their money will be. Indeed, former Fed Chairman Alan Greenspan suggested that an operational definition of price stability is "an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms."4

Price stability also promotes efficiency. Prices give signals about the relative supplies and demands of goods and services in a market economy. With a stable price level, changes in prices can easily be recognized as changes in relative prices. With price signals undistorted by inflation, individuals and businesses are able to make better decisions about where to allocate their resources. Thus, price stability helps a market economy allocate resources efficiently and operate at its peak level of productivity.

Price stability also works to promote moderate long-term interest rates. First, it reduces the level of compensation built into long-term interest rates to make up for the loss of purchasing power due to inflation. Second, it reduces the need for an additional risk premium to compensate for the risk that arises from uncertainty about inflation.

In short, price stability is not only a worthwhile objective in its own right. It is also the most effective way monetary policy can contribute to economic conditions that foster the Federal Reserve's other two objectives: maximum employment and moderate long-term interest rates.

While price stability enhances the economy's ability to achieve its maximum potential growth rate, monetary policy plays no role in determining what that growth rate is. In the long run, the economy's growth rate largely reflects two factors. The first is the growth rate of the labor force, which is determined by demographic factors such as the birth rate, age distribution, and immigration. The second is the growth in the productivity of the labor force, which depends on a number of elements, including both physical and human capital. Monetary policy cannot be used to achieve a long-run growth rate that is inconsistent with these economic fundamentals.

The corollary to this emphasis on price stability is that monetary policymakers should not commit to what they cannot deliver. It is not possible for a central bank to achieve a specific rate of real economic growth or unemployment. And it is not desirable to lead the public to believe it is within the central bank's power to do so.

This does not mean monetary policy should ignore changes in broad economic conditions. The best strategy is to set policy consistent with controlling inflation over the intermediate term. By keeping inflation stable when shocks occur, monetary policy can foster the conditions that enable households and businesses to make the necessary adjustments to return the economy to its long-term growth path. Depending on the nature of the shock, though, this new growth path may be lower, higher, or the same as its previous growth path. However, monetary policy itself does not determine this sustainable path.

Consequently, monetary policy should be managed in a way that yields the best economic outcome given the environment at the time. As long as inflation and expectations about inflation are well anchored at a level consistent with price stability, the target federal funds rate should fall with market rates when the economy weakens and increase as market rates rise when the economy strengthens. Yet, this systematic approach should not be confused with a desire for active management of the real economy.

Unfortunately, what the public has come to expect of monetary policy, and central banking more generally, has risen considerably over the years. Indeed, there seems to be a view that monetary policy is the solution to most, if not all, economic ills. Not only is this not true, it is a dangerous misconception and runs the risk of setting up expectations that monetary policy can achieve objectives it cannot attain. To ensure the credibility of monetary policy, we should never ask monetary policy to do more than it can do. Monetary policy's objectives should be not only clear but also realistic and feasible.

Thus, in order to clarify the central bank's mission, many countries have passed legislation that spells out specific objectives, often clearly assigning the central bank the task of maintaining a stable price level or a low level of inflation. Some governments have defined what level of inflation the central bank should target. In other countries, the central bank itself has adopted an inflation target. In so doing, these countries have helped to recognize what a central bank can and cannot do. I am in favor of the Fed setting an inflation target for this reason, as I'll discuss in the next section.

Financial Stability — Setting clear and explicit objectives for a central bank's financial stability goals is more difficult and less well understood.

We first must be clear about what we mean by financial stability. Central banks cannot and should not prevent all types of financial instability. Indeed, the economy benefits when financial institutions and markets take on and manage risk. That means inevitably some firms will fail. As my friend the economist Allan Meltzer has said, "Capitalism without failure is like religion without sin. It doesn't work."5 The goal of government oversight should not be to try to prevent every financial failure. Instead, the objective should be to reduce the systemic risks that such a failure may create.

Systemic risk generally refers to the risk that problems at one financial institution will spill over to a broad set of otherwise healthy institutions, thereby posing a threat to the integrity of the financial system and perhaps the economy as a whole. When the financial system works well, financial intermediaries fulfill a useful role in bearing and managing the liquidity risk that arises from funding long-term assets with short-term liabilities. In most cases, this process works well. However, if depositors and other liability holders suddenly demand large withdrawals, an intermediary may be forced to sell long-term assets at prices well below their value if they were held to maturity. This can quickly transform an illiquidity problem into a solvency dilemma, eventually leading to the firm's failure. Such failures have the potential to cascade among counterparties, ultimately leading to a major breakdown of borrowing and lending. Lack of transparency about risk and the value of assets, imperfect or asymmetric information, and uncertainty about exposures can all help fuel such financial contagion.

Because of the complexity and interconnectivity of financial markets, we have found that the failure of a major counterparty, whether a bank or a nonbank, has the potential to severely disrupt many other financial institutions, their customers, and other markets.

To address the systemic risk that has arisen since mid-2007, the Fed has taken historic actions to promote financial stability by expanding its role as lender of last resort. Starting in late 2007, the Fed expanded its existing discount window operations and created an alphabet soup of new facilities (see The Expanding Fed Toolbox) to help the credit markets function more effectively. Some of these actions required the Fed to invoke a special provision of the Federal Reserve Act — referred to as Section 13(3) — that gives the Fed the authority to lend to any individual, partnership, or corporation in "unusual and exigent circumstances."6

Consider how much has changed: Prior to this crisis, the Fed lent only to depository financial institutions — that is, banks, savings and loans, savings banks, and credit unions — and such lending was typically overnight. During this financial crisis, we have made loans to primary securities dealers, investment banks, a global insurance company, and to industrial and financial companies that issue commercial paper. These lending arrangements have been for terms of as long as 90 days or even as long as 10 years in the case of the financing provided in the Bear Stearns acquisition.

Prior to this crisis, Fed lending typically amounted to less than 1 percent of total Fed assets. By the end of 2008, lending had grown to nearly 50 percent of total Fed assets.

However, the Fed has not been as clear or explicit about the goals and objectives of its financial stability policy as it has been with its monetary policy goals. In today's financial system, we must devise new and clearer objectives for central bank lending. If the goal is to protect the financial system against systemic risk, we must clearly define such risk and articulate in advance the circumstances and terms under which we will lend and to whom.

In general, we should avoid giving the Fed overly broad mandates, missions, or goals with respect to financial stability that conflict with the one goal that is uniquely the responsibility of a central bank: price stability. In times such as these, we must remember that instability in the general level of prices — whether inflation or deflation — is itself a significant source of financial instability. Consequently, we must make sure that in trying to cure one source of financial instability, we do not sow the seeds of another.

Two

Commitment to a Systematic Approach

The second principle for sound central banking is that policymakers must go beyond just stating their objectives — words are not enough. Policymakers must also make credible those commitments to achieve their policy goals and take actions that are consistent with them.7

Figure 1

As mentioned above, expectations about the future play a crucial role in all sorts of decisions that people and businesses make today. If the central bank does not deliver on its stated objectives or takes actions inconsistent with those objectives, businesses and households will need to adjust their decisions in light of this unexpected policy outcome. The central bank's failure to deliver thus leads to unnecessary economic volatility.

If a central bank is to avoid contributing to economic instability, it must not only articulate its goals, it must also make a credible commitment to take actions that will deliver on the stated objectives. Gaining the public's confidence that central banks are committed to their policy objectives and to their plans for achieving them is not an easy task. In democratic societies, it is not possible to obtain complete commitment. But there are a variety of ways that governments and central banks have used to make their commitments more credible to the public.

Policymakers, for example, can earn a reputation for delivering on their objectives by acting in a consistent way that convinces the public their stated commitment is credible. To maintain that credibility or reputation, policymakers must continue to act in a way that is consistent with their goals. If they deviate from those goals or act in a way that is inconsistent with them, policymakers run the risk of losing credibility.

Monetary Policy — In the U.S., the Federal Reserve has built a reputation during the past 25 years for having a commitment to keeping inflation low and stable, a commitment that has contributed to economic stability. But that reputation can be lost if we do not continue to act in a way that is consistent with it. From my perspective, reputational capital is always tenuous — it is hard to acquire but easy to lose and so it must be protected.

In the spring and summer of 2008, there was great concern that rising headline inflation rates, due to rapid and dramatic increases in the prices of oil and other commodities, would lead to rising inflation expectations, which in turn would contribute to a more persistent rise in inflation rates. The public began to question the Fed's resolve to maintain price stability. In response to this concern, I and other members of the Federal Open Market Committee (FOMC) continued to remind the public that the FOMC was committed to maintaining price stability and would resist any unanchoring of inflation expectations. None of us wanted to repeat the period of the late 1970s and early 1980s, when we saw that an unanchoring of inflation expectations made it more difficult and more costly to reduce inflation once it became too high.

Figure 2

It is just as important that expectations remain well anchored in the face of falling energy prices. Significant declines in gasoline and fuel oil prices in the last few months of 2008, for instance, led to declines in the consumer price index (CPI). This prompted some commentators to suggest that the U.S. is facing a threat of persistent deflation, as it did in the Great Depression or as Japan faced during the 1990s. I am not particularly concerned about the possibility of persistent deflation. When oil and commodity prices stabilize, the negative rates of inflation we have seen in the CPI are likely to disappear. Moreover, I am confident that the FOMC is committed to maintaining price stability.

Nonetheless, we must act to ensure that expectations of deflation do not take root, just as we must act to ensure that expectations of higher inflation do not emerge. The failure to maintain well-anchored inflation expectations can wreak havoc with the real economy, foster unnecessary volatility, and make it more difficult for the Fed to deliver on its mandate to keep the economy growing with maximum employment and price stability.

As indicated earlier, some governments and central banks have adopted institutional mechanisms to make their stated commitments more credible to the public, including specific objectives in terms of a stable price level or a low level of inflation. Such clearly articulated objectives become a form of institutional commitment, not just the choice of a specific individual or a committee whose membership may change over time. As such, they strengthen the institution's credibility regarding its commitment.

Other economists and I have long proposed establishing an explicit inflation target as one way to signal the FOMC's commitment to price stability and to help anchor expectations.8 A public commitment to a numerical inflation target over an intermediate horizon is a clear and feasible goal for monetary policy and is consistent with the Federal Reserve's mandates. Such an inflation target would not only help prevent inflation expectations from rising to undesirable levels, but it would also help prevent expectations from falling to undesirable levels. It would offer greater clarity and transparency in communicating our monetary objectives for price stability and would give us a target that we could credibly commit to meet over time.

Of course, adopting an inflation target is not enough. A central bank must also act in a way that is consistent with that target. Words alone are not enough to make commitments credible. The central bank must articulate systematic or mostly predictable policies that help communicate and provide information as to how the objectives will be achieved if policymakers hope to reduce policy-induced uncertainty.

Some central banks have experimented with adopting rules — or at least they have engaged in rule-like behavior. Some rules involve having the central bank's policy interest rate respond to changes in either money growth or certain financial or exchange rate conditions. Other rules involve adjusting the policy interest rate in response to deviations of inflation from some target as well as to deviations of output (or economic growth) from its long-term trend or some measure of potential. In a March 2008 speech, I argued that research has suggested that simple rules such as variations on the Taylor rule appear to perform quite well in a wide range of economic models.9 This implies that using simple rules as a guide to setting policy is a useful way to make monetary policy more systematic and predictable.

One important characteristic of simple rules is that they can be more easily explained to the public. That makes it easier for the public and for financial market participants to form expectations about policy. Simple rules could enhance the credibility of monetary policy, help anchor expectations, and better align the public's expectations with the central bank's intentions. Adopting simple rules would make policy more systematic and predictable, which would minimize policy surprises and the detrimental effects often caused by such surprises.

Figure 3

Financial Stability — During the past year, the Fed has taken steps to limit the systemic risks caused by the potential failure of several large financial institutions. The decisions were always made based on the risks to the financial markets, not the desire to preserve individual institutions. Yet, the old "rules of the game" were out of date. We had to improvise. Consequently, we had no choice but to generate some uncertainty.

Indeed, the financial problems at Bear Stearns, AIG, and Lehman Brothers elicited different responses. When serious funding problems led to the prospect that Bear Stearns might go bankrupt and potentially bring down many other financial firms and disrupt important pieces of the payment system, the Federal Reserve, in consultation with the Treasury, invoked its emergency powers as lender of last resort to allow for a more orderly resolution of the firm's problems. A private-sector buyer (JPMorganChase), with Fed assistance, then purchased Bear Stearns. When AIG and Lehman faced severe funding problems, the Fed and the Treasury again attempted to find private-sector solutions to avoid the imminent failure of these firms. None was forthcoming. The judgment was made that given the nature of AIG's financial obligations, its disorderly collapse would severely threaten financial stability. Therefore, the Federal Reserve provided an emergency credit line to facilitate an orderly resolution. In the case of Lehman, the Fed and Treasury declined to commit public funds, since Lehman's problems had been known to the market for some time.

In hindsight, some have criticized these decisions. However, at the time, each decision was a reasonable judgment based on systemic risk. Yet, these actions did lead to uncertainty about how nonbank financial failures would be handled, and arguably, this uncertainty contributed to the stress in the markets.

One way to alleviate uncertainty is to arrive at more predictable guidelines for our lending and intervention policies. Achieving greater clarity about the criteria by which the Fed will lend to banks or nonbanks in order to prevent systemic risk concerns will improve the Fed's decision-making and the understanding in the marketplace, thus reducing instability and uncertainty.

We should also establish alternative resolution mechanisms that are more predictable and systematic in their approach. One of the lessons from the current financial crisis is that, for policymakers, bankruptcy is not an attractive option for a failing institution that poses systemic risk. In fact, the underlying rationale of bankruptcy law is maximizing the payoffs to the firm's creditors, which in some cases could exacerbate systemic risk. Although state insurance regulators do have special procedures for the orderly liquidation of regulated insurance companies that fail, their focus is on paying off policyholders and claimants. Their procedures are not intended to address systemic risk.

Since bankruptcy proceedings do not normally make provisions for systemic risk, we have long had a specialized regimen for dealing with bank failures. The Federal Deposit Insurance Corporation (FDIC) may consider systemic concerns in a failing bank's resolution and has the authority to act as a receiver for a failed commercial bank and run a bridge bank for up to five years. However, there is no similar mechanism for the orderly liquidation of most nonbank financial firms that pose systemic risk. Policymakers are thus left with one of two outcomes: (1) very costly failures; or (2) very costly interventions to avoid the failure.

One alternative resolution mechanism might follow the one used by the FDIC. That is, extend some type of "bridge-bank" authority to regulators of nonbank financial firms that pose systemic risk. It is not clear to me whether centralizing that type of bridge authority in one regulatory body — whether it is the FDIC, the Office of the Comptroller of the Currency, the Fed, or the Securities and Exchange Commission — would be optimal. Certainly, that is an issue for further study. However, I do not believe that the Fed is the appropriate institution for such a role because of the potential conflicts of interest between monetary policy and the resolution of a single institution. Thus, I think this bridge-bank authority should not be the responsibility of the Federal Reserve.

We can look to banking for other examples of systematic policy approaches. For instance, the prompt corrective action provisions of the 1991 FDIC Improvement Act (FDICIA ) provide an example of a systematic approach that is required when a bank gets into trouble and is at risk of failing. Trigger points are specified for when bank regulators must take action to deal with the bank's problems. Because Congress embodied these provisions in legislation, regulators are more insulated from near-term political pressures and constrained to behave more systematically. This gives the regulators a degree of political independence and the markets more clarity.

Three

Transparency

The third principle simply stresses that policymakers should be clear and transparent in communicating their policy and actions to the public. At one level, transparency is simply a part of making credible commitments. Central bankers must clearly articulate to the public their objectives and their plans to achieve those objectives, as well as explaining those occasions when they have reason to deviate from their plans.

Another important benefit to transparency is that it increases the central bank's accountability to the public. In a democratic society, it is important that institutions with the delegated authority to act in the public interest be as clear and as transparent as possible regarding their actions. Failing to do so risks the loss of confidence and credibility — two essential ingredients for sound central bank policymaking. As former Fed Vice Chairman Alan Blinder has stressed, central bankers must be as transparent as possible and clearly communicate their views on monetary policy to the public, to whom they must be accountable.10

Monetary Policy — One of the benefits of greater transparency is that it can help align the public's view of monetary policy with the central bank's objectives and therefore better align the public's expectations about the economy and inflation.

Although the Federal Reserve is now much more transparent about its monetary policymaking than it was 20 years ago, in my view, central banks in many other countries are ahead of the U.S in this area. Other central banks often provide the public with much more detail about their policy deliberations than we do.

In recent years, the FOMC has improved communications between the Fed and the public. Today, more than ever before, the Fed reports more frequently and more thoroughly on the economy, and the public is well-served by the central bank's explanation of its actions. For example, the FOMC now releases Committee participants' projections for the economy and inflation on a quarterly basis. With more information about the Federal Reserve's outlook, individuals and market participants are able to make economic decisions armed with a better understanding of what the central bank expects will happen in the economy. Transparency increases the public's understanding of monetary policy, which in turn increases the credibility and effectiveness of monetary policy.

Timeline to Transparency


Financial Stability — Transparency is also important in communicating the policy and actions that the central bank takes on financial stability. This is an important part of reducing the uncertainty and making the "rules of the game" clear as the central bank responds to a crisis.

Another reason to ensure clear and transparent communications when policymakers take extraordinary actions to ensure financial stability is that such actions can create moral hazard. Indeed, the mere act of creating the Fed's special lending programs over the course of the past year has created moral hazard. To the extent that market participants now feel more comfortable asking for the central bank's support when they get into trouble, they may be inclined to take on more risk than would otherwise be prudent — thus sowing the seeds for the next crisis.

Intervening too often or expanding too broadly the set of institutions that have access to the central bank's credit facilities not only creates moral hazard but also distorts the market mechanism for allocating credit, thus increasing the probability and severity of a future financial crisis.

Clarifying the criteria under which we will intervene in markets or extend credit, including defining what constitutes the "unusual and exigent" circumstances that form the legal basis for the Fed's nontraditional lending, will be essential if we are to mitigate the moral hazard we have created and reduce uncertainty about future actions.

Of course, announcing the central bank's criteria in advance does not commit it to act as stated in every case, but it does raise the costs of deviating from the criteria. We should be prepared to stay the course once our policy is set and clearly communicate the lending policy and the actions we take in our capacity as lender of last resort.

FourEnsuring the Independence of the Central Bank

The fourth principle of sound central banking is independence. A central bank's independence has many dimensions; however, it does not mean that central bankers or other policymakers should not be accountable to the public. The importance of transparency and the communication of clearly articulated goals as guiding principles are keys to ensuring the legitimacy of our public institutions.

Monetary Policy — Research has suggested that countries with more independent central banks have benefited from lower rates of inflation, on average, without sacrificing real economic growth.11

One of the primary reasons independence is so essential is that monetary policy works with long lags. So, central bankers must take a longer-term view of their policies. This need to take a long-run view is undoubtedly one of the reasons that more central banks around the world have been given greater independence from their nations' treasury departments or finance ministries and the political process. History is replete with examples of the dangers of central banks being used as an arm of a country's fiscal authority. The result is often high levels of inflation.

Freeing central bankers from the short-term pressures that inevitably manifest themselves in the political arena helps monetary policymakers better balance the short- and long-term factors inherent in their decisions. This independence, though, underscores the need for accountability and, therefore, transparency, which further illustrates that these four principles are mutually reinforcing.

Financial Stability — Just as we know that independence leads to more effective monetary policy, free from fiscal and political influence, I believe independence is also vital to a more effective lending or financial stability policy.

To protect this independence, the central bank's lending policies should avoid straying into the realm of allocating credit across firms or sectors of the economy, which I believe is appropriately the purview of the market. The perception that the Federal Reserve is in the business of allocating credit is sure to generate pressure on the Fed from all sorts of interest groups. In my view, if government must intervene in allocating credit, doing so should be the responsibility of the fiscal authority rather than the central bank.

The Fed's extraordinary lending facilities already pose a number of problems that the Fed must confront. As mentioned above, the lending programs have dramatically altered the types of assets on the Fed's balance sheet as well as its size. When financial markets begin to operate normally and the outlook for the economy improves, our balance sheet must contract if we are to maintain price stability.

Some of the new facilities will naturally unwind gradually once they are terminated. For example, the commercial paper lending facility only purchases commercial paper of 90 days or less. Once the Fed stops new purchases, those assets will mature and begin to shrink the Fed's balance sheet.

Yet, some of the assets will not go away so quickly. For example, as 2008 ended, the Fed had begun the process of purchasing $500 billion of mortgage-backed securities, many of which will not roll off its balance sheet for years unless the Fed sells them in the marketplace. In 2009, the Fed also plans to purchase a substantial amount of asset-backed securities whose maturity will be about three years or even longer.

While the Treasury Supplementary Financing Program, which was used in 2008 and will be available in the future, gives the Fed a tool for managing its balance sheet and sterilizing the effects of its lending and securities purchases on bank reserves, the Fed is likely to still face challenges as it attempts to liquidate these longer-term assets from its portfolio.12 Will there be pressure from various interest groups to retain certain assets? Will there be pressure to extend some of these programs by observers who feel terminating the programs might disrupt "fragile" markets or that the economy's "headwinds" are too strong? Such pressures could threaten the Fed's independence to control its balance sheet and monetary policy. We will need to have the fortitude to make some difficult decisions about when our policies must be reversed or unwound.

By setting realistic and feasible objectives, pursuing a systematic approach to its lending policies that avoids credit allocation, and communicating its objectives and actions in a clear and transparent manner, the Fed can operate independently of these types of pressures and resist them when they arise. This will help the Fed better ensure both its ability and its credibility to maintain financial stability as well as its monetary policy objectives of price stability and maximum sustainable long-term growth.

Summary

To sum up, the past year has been a challenging time for the U.S. economy and for policymakers. The Fed responded to the deteriorating economic outlook and ongoing stresses in financial markets with monetary policy and extraordinary actions to ensure financial stability.

Extraordinary times are precisely when sound principles are most necessary for sound policymaking. A set of guiding principles, like a compass, can be useful to direct the course of action even in normal times. But, in the midst of a storm, a compass becomes an essential tool to ensure that we do not stray from the path consistent with our long-term objectives.

It is always tempting to take action based on short-term concerns and argue that we will worry about consequences later. Yet, as I noted in the beginning of this essay, the policy decisions we make today help shape expectations, which influence the economic decisions of households and businesses. By following a set of sound principles, we can anchor expectations and thereby reduce the inefficiencies and distortions that arise from expectations going unfulfilled.

I believe we must strive to develop sound policies that follow the four principles outlined above: clear and feasible objectives; a commitment to systematic policies; transparency; and a healthy respect for the independence of the central bank. Adherence to these principles will allow the Fed to focus its efforts on achieving its objectives in a more effective manner.

Finally, policy rules may evolve as our understanding of the economy evolves. Some future crisis may bring uncertainties and unknowns that require changes that policymakers cannot foresee. Yet, the need for such evolution or change does not negate or diminish the importance of these guiding principles. Instead, these forces of change should heighten our resolve to develop a principled, systematic approach and to clearly communicate any necessary changes, so we can continue to anchor expectations for a sound future.

Endnotes

  • 1 These four principles were outlined in a series of speeches, including Plosser (2008a), Plosser (2008b), Plosser (2008c), and Plosser (2008d).
  • 2 See Plosser (2007).
  • 3 See the Federal Reserve Reform Act of 1977 and the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act).
  • 4 See Greenspan (2002).
  • 5 See Meltzer (1998).
  • 6 For more information on the Federal Reserve Act's Section 13(3), see Fettig (2008). This article, which is available on the Federal Reserve Bank of Minneapolis's website External Link Icon, also references a more complete history in the December 2002 issue of The Region.
  • 7 See Dotsey (2008) and Plosser (2008e).
  • 8 For instance, see Mishkin (2008) or Bernanke (2003).
  • 9 See Plosser (2008e).
  • 10 See Blinder (1998).
  • 11 Forder (2000) and Cukierman (2006) survey the more recent literature on central bank independence. Earlier analysis can be found in Alesina and Summers (1993), Cukierman (1993), and Debelle and Fischer (1994).
  • 12 See the joint statement issued by the Treasury and the Fed, March 23, 2009.

References

  • Alesina, Alberto, and Lawrence H. Summers. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, 25 (May 1993), pp. 151-62.
  • Bernanke, Ben S. "A Perspective on Inflation Targeting," speech at the Annual Washington Policy Conference of the National Association of Business Economists. Washington, D.C., March 25, 2003.
  • Blinder, Alan. Central Banking in Theory and Practice. Cambridge, MA: The MIT Press, 1998.
  • Cukierman, Alex. "Central Bank Independence, Political Influence and Macroeconomic Performance: A Survey of Recent Developments," Latin American Journal of Economics (Cuadernos de Economía), 30:91 (1993), pp. 271-92.
  • Cukierman, Alex. "Central Bank Independence and Monetary Policy Making Institutions: Past, Present, and Future," Chilean Economy (Economía Chilena), 9 (April 2006), pp. 5-23.
  • Debelle, Guy, and Stanley Fischer. "How Independent Should a Central Bank Be?" in Jeffrey C. Fuhrer, ed., Goals, Guidelines, and Constraints Facing Monetary Policymakers. Federal Reserve Bank of Boston Conference Series No. 38 (1994), pp. 195-221.
  • Dotsey, Michael. "Commitment Versus Discretion in Monetary Policy," Federal Reserve Bank of Philadelphia Business Review (Fourth Quarter 2008), pp. 1-8.
  • Fettig, Dave. "The History of a Powerful Paragraph," Federal Reserve Bank of Minneapolis The Region (June 2008).
  • Forder, James. "Central Bank Independence and Credibility: Is There a Shred of Evidence?," International Finance, 3 (April 2000), pp. 167-85.
  • Greenspan, Alan. "Transparency in Monetary Policy," Federal Reserve Bank of St. Louis Review (July/August 2002)
  • Meltzer, Allan. "Asian Problems and the IMF," Cato Journal, 17:3 (Winter 1998), pp. 267-74.
  • Mishkin, Frederic S. "Whither Federal Reserve Communications," speech at the Peterson Institute for International Economics, Washington, D.C., July 28, 2008.
  • Plosser, Charles. "The Financial Tsunami and the Federal Reserve," speech given at William E. Simon Graduate School of Business, University of Rochester 30th Annual Economic Outlook Seminar, Rochester, NY, December 2, 2008a.
  • Plosser, Charles. "Some Thoughts on the Economy and Financial Regulatory Reform," speech given to the Economics Club of Pittsburgh, Pittsburgh, November 13, 2008b.
  • Plosser, Charles. "The Limits of Central Banking," speech given to the New York Office of the Council on Foreign Relations, New York, October 8, 2008c.
  • Plosser, Charles. "Foundations for Sound Central Banking," speech given for Global Challenges in Monetary Policy session of the Global Interdependence Center Abroad Conference, Cape Town, South Africa, March 28, 2008d.
  • Plosser, Charles. "The Benefits of Systematic Monetary Policy," speech given at the National Association for Business Economics, Washington Economic Policy Conference, Washington, D.C., March 3, 2008e.
  • Plosser, Charles. "Two Pillars of Central Banking: Monetary Policy and Financial Stability," opening remarks to the Pennsylvania Association of Community Bankers 130th Annual Convention," Waikoloa, HI, September 8, 2007.
  • U.S. Department of the Treasury and the Federal Reserve, Joint Statement. "The Role of the Federal Reserve in Preserving Financial and Monetary Stability," March 23, 2009.