The Neal Resolution, now in Congress, would make price stability the dominant goal of monetary policy. The first of these two articles holds that policymakers’ discretion over the price level increases political conflict. Further, it argues that removing this discretion would restore the dollar to the role envisioned by the Framers of the Constitution. The second article proposes an instrument for measuring inflation expected by the market and argues that such a measure would encourage monetary policy-makers to maintain price stability.Inflation (Finance) ; Monetary policy ; Prices

Robert L. Hetzel

English

Research Papers in Economics

Maintaining  Price  Stability:  A  Proposal 
Robert L.  He& 
The  Neal  Resolution  would  make  price  stability 
the  dominant  goal  of  monetary  policy.  This  paper 
proposes  giving the  Fed  and  Fed-watchers  a measure 
of whether  ongoing  policy  is consistent  with  this goal. 
This  measure  would  require  the  Treasury  to  issue 
two  kinds  of  bonds  at  each  maturity: 
The  difference  in yields  on  the  two  kinds  of  bonds 
would  offer  a measure  of expected  inflation  over  the 
life  of  the  bonds.’ 
Investors  holding  fixed-income  securities  have 
an  incentive  to  forecast  inflation  accurately;  their 
A Standard  Bond:  As presently  issued,  interest 
and  principal  are paid  in current  dollars.  The  yield 
equals  a  real  (inflation-adjusted)  yield  plus  the 
inflation  expected  by  the  market. 
An  Indexed  Bond:  On  this  new  bond,  interest 
and  principal  payments  would  be  adjusted  by 
changes  in  a  price  index;  thus  payments  would 
be  of constant  purchasing  power.  Because  of this 
indexing,  the  yield  would  be  a straight  real  yield, 
incorporating  no  inflation  premium. 
r This  proposal  is similar in spirit to one  made  by Alan Greenspan 
(1981),  who  advocated  issuance  of a five-year  Treasury  note  with 
interest  and  principal  payable  in gold.  Milton  Friedman  (1974) 
has  long  advocated  indexing  of all government  bonds  on  ethical 
grounds.  He  objected  to  the  experience  of the  1960s  and  1970s 
in  which  the  government  issued  bonds  that  promised  to  pay 
dollars  in the  future  and  then  inflated  away  the  real value  of the 
promised  dollars.  Assar  Lindbeck  (1989,  p.  498,  fn.  4)  has 
proposed  the  issuance  of  indexed  bonds  in  order  to  permit 
observation  of  changes  in  money  growth  on  ex  ante,  as 
opposed  to  realized,  real  rates  of  interest.  Humphrey  (1974) 
discusses  earlier  proposals  for indexed  bonds,  for example,  pro- 
posals  made  by  Keynes  in  1924,  Bach  and Musgrave  in  1941, 
and  Friedman  in  195 1. 
FEDERAL  RESERVE  BANK  OF  RICHMOND  53 consensus  forecast,  however,  is  not  signalled 
clearly  by market  rates  because  these  rates  embody 
a changing  estimate  of the  expected  real yield.  Com- 
paring  the  yields  on  standard  and  indexed  bonds 
would  costlessly  and  continuously  indicate  the  infla- 
tion  expected  by  investors. 
The  market’s  reaction  to monetary  policy  actions 
would  be  reflected  in the  yield  spread  between  stan- 
dard  and  indexed  bonds.  The  advantage  of  such  a 
measure  can  be  seen  in the  publicity  accorded  the 
exchange  rate  in  relatively  small,  open  economy 
countries.  Headlines  in a recent  edition  of the Finan- 
cial Times  of London  (l/31/90,  p.  3) read:  “Canada 
Puts  Brakes  on  Interest  Rates  Fall:  dollar  plunge 
brings  caution  to  easing  up  on  inflation  fight.”  The 
article  states: 
An  unexpected  plunge  in the  Canadian  dollar  has  strength- 
ened  the  view  that  an  abrupt  fall in domestic  interest  rates 
earlier  this  month  will not  be  sustained.  . . . The  tumble  in 
the  Canadian  dollar  caused  by  the  relatively  small  fall in 
interest  rates  reinforces  a widely-held  view  that  the  Bank  of 
Canada’s  watchword  is  likely  to  be  caution.  The  central 
bank  responded  to  the  sudden  weakness  in  the  currency 
by  pushing  short-term  rates  up.  By  Tuesday  this  week, 
the  yield  on  three-month  Treasury  bills  had  climbed  back 
at  12.3  percent,  compared  with  11.9  percent  when  the 
bank  sent  its  initial  signal  that  it  was  ready  to  relax  its 
interest-rate  policy. 
As  this  article  shows,  the  Canadian  central  bank 
is constrained  by the  behavior  of the  exchange  rate. 
Investors  holding  fixed-income  assets  denominated 
both  in  U.  S.  dollars  and  in Canadian  dollars  make 
portfolio  decisions  based  in  part  on  the  expected 
difference  in inflation between  the  U.  S. and Canada. 
If these  investors  believe  that  a reduction  in the  Bank 
of Canada’s  discount  rate  will raise  Canadian  infla- 
tion  (relative  to U.  S. inflation),  given  the  prevailing 
interest  rate  differential,  they  will attempt  to  move 
out  of  Canadian  assets  and  into  U.  S.  assets-the 
Canadian  dollar  will  fall  immediately  against  the 
dollar.  Moreover,,  because  imports  comprise  about 
a  third  of  the  basket  of  commodities  in  the  Cana- 
dian  consumer  price  index,  the  fall in the  exchange 
rate will appear  quickly  in inflation  figures.  This  swift 
association  between  the  actions  of  the  Bank  of 
Canada  and  price  indices  thus  acts  as  a  check  on 
inflationary  policy  actions. 
Because  imports  are  still  only  a  relatively  small 
fraction  of U.  S.  consumption,  the  U.  S.  public  is 
not  sensitive  to  the  foreign  exchange  value  of  the 
dollar.  Also,  changes  in the  foreign  exchange  value 
of the  dollar  do  not  solely  measure  changes  in  ex- 
pected  domestic  inflation.  Particularly  over  the 
198Os, the  preponderance  of changes  in the  foreign 
exchange  value  of the  dollar  have  reflected  changes 
in the  real terms  of trade  caused  by capital  flows.  For 
these  reasons,  the  exchange  rate  does  not  exercise 
the  kind  of constraint  in the  U.  S.  that  it exercises 
in  smaller,  more  open  economies.  The  role  the 
exchange  rate plays in these  countries,  however,  does 
indicate  the  advantages  of  creating  a  measure  of 
expected  inflation. 
First  of all, a ready  measure  of the  real  (inflation- 
adjusted)  rate  offered  by  the  indexed  bond  would 
lessen  pressure  for  inflationary  monetary  policy  by 
eliminating  public  confusion  over  market  rates  and 
real rates.  Public  perception  that  increases  in market 
rates  necessarily  indicate  increases  in real rates  creates 
pressures  for  stimulative  monetary  policy.  If,  for 
example,  new  statistics  indicated  higher  expected 
inflation  than  previously  forecast,  a higher  funds  rate 
would  be  necessary  to  keep  real  interest  rates  un- 
changed.  Such  an increase  in the funds  rate,  however, 
has  often  been  seen  by  the  public  as causing  an  in- 
crease  in  real  rates  and,  thus,  as  a “tightening”  of 
policy.  With  the  yield  on  indexed  bonds  measuring 
the  real  rate,  the  Fed  can  easily  dispel  the  percep- 
tion  that  all increases  in the  funds  rate  are  increases 
in real  rates.  Furthermore,  the  public  will easily  be 
able to see  how  little leverage  the  Fed  can exert  over 
real  rates  through  allowing  monetary  acceleration.z 
A  measure  of expected  inflation  would  also  pro- 
vide  a  direct  check  to  monetary  policy  actions  (or 
inactions)  judged  inflationary  by  the  market-such 
actions  would  produce  an immediate  rise  in the  yield 
on  standard  bonds  and  in  the  differential  yield  be- 
tween  standard  and  indexed  bonds.  The  rise  in the 
yield  on standard  bonds  would  impose  a capital  loss 
on  the  holders  of these  bonds.  Holders  of variable- 
rate  mortgages  with  yields  tied  to the  yield  on  stan- 
dard  bonds  would  incur  higher  interest  payments. 
Indeed,  all creditors  receiving  payment  in dollars  in 
the  future  would  feel  their  financial  interests  threat- 
ened.  A readily  available  measure  of expected  infla- 
tion  that  rose  in response  to monetary  policy  actions 
judged  inflationary  by  the  market  would  make  it 
easier  for creditors  to counteract  pressure  on the  Fed 
to trade  off price  stability  for short-term  output  gains. 
In the  U.  S.,  the  long lag between  monetary  policy 
actions  and changes  in prices  means  that  it is difficult 
to  associate  particular  policy  actions  with  inflation. 
2 Numerous  economists  have  documented  the  virtual  end  of the 
liquidity  effect  whereby  an  increased  rate  of growth  of money 
is  associated  with  a  fall  in  the  real  rate  of  interest.  See.  for 
example,  Mehra  (1985). 
54  ECONOMIC  REVIEW.  MARCH/APRIL  1990 As  a result,  inflation  does  not  provide  an  adequate 
check  to  pressures  by  government  officials  to  keep 
rates  “low.”  If  an  exhortation  by  a  government 
official to lower the funds rate produced  an immediate 
rise  in  the  yield  differential  between  standard  and 
indexed  bonds,  however,  this  rise  would  embarrass 
the  official.  Officials  would  also  realize  that  such 
pressures  are counterproductive.  The  Fed,  concerned 
about  an  adverse  reaction  in the  expected  inflation 
measure,  would  be very  reluctant  to lower  the  funds 
rate  after  an  exhortation  for  easy  money. 
Finally,  the  coexistence  of standard  and  indexed 
bonds  would  encourage  the  Fed  to find ways  of com- 
mitting  itself  to  a noninflationary  policy  in order  to 
eliminate  a  yield  differential  arising  from  a  risk 
premium.  Even  with  a  return  to  price  stability,  a 
positive  yield  differential  would  appear  in  the  two 
kinds  of long-term  bonds  if the  public  feared  a future 
lapse  in the  commitment  to price  stability.  The  Fed 
would  have  an incentive  to find ways to commit  itself 
to  a monetary  policy  of price  stability. 
There  is a lack  of  agreement  over  specific  ways 
to constrain  decision-making  by the  Federal  Reserve 
in order  to achieve  price  stability.  The  proposal  made 
here  leaves  the  operational  details  of achieving  price 
stability  to the  Fed.  It provides,  however,  for a con- 
tinuously  available  assessment  of the  consequences 
for inflation  of Fed  actions.  The  assessment  would 
be  provided  by  individuals  who  have  a  financial 
interest  in monitoring  Fed  success  in achieving  price 
level  stability.  The  resulting  constraint  placed  on 
inflationary  monetary  policy  would  rest  on the  most 
effective  check  available  in  a  democracy-public 
awareness. 
REFERENCES 
Friedman,  Milton;  Charles  Walker;  Robert  J.  Gordon;  and 
William  Fellner.  “Indexing  and  Inflation.”  American  Enter- 
prise  Institute  Round  Table  held  on  July  17,  1974, 
Washington:  American  Enterprise  Institute,  1974. 
Greenspan,  Alan.  “Can  the  U.  S.  Return  to  a Gold  Standard?’ 
Th  Wall &ret  Journal,  September  1,  1981. 
Humphrey,  Thomas.  me  Concept  of Indexation  in the  History 
of  Economic  Thought.”  Federal  Reserve  Bank  of  Rich- 
mond  &mornic  R.+rur& 60  (November/December  1974), 
264-277. 
Lindbeck,  Assar.  “Remaining  Puzzles  and  Neglected  Issues  in 
Macroeconomics.”  Scandinavian  Jinma~of Eroiromic 9 l(2), 
1989,  495-516. 
Mehra,  Yash.  “Inflationary  Expectations,  Money  Growth,  and 
the  Vanishing  Liquidity  Effect  of  Money  on  Interest:  A 
Further  Investigation.”  Federal  Reserve  Bank  of Richmond 
Ecwomic  Rec.&w 71  (March/April  1985),  23-35. 
Macroeconomic  Data:  A  User’s  Guide 
Roy H.  Webb, Editor 
The  Federal  Reserve  Bank  of Richmond  is pleased  to announce  the  publication  of Mamveconomic Data: 
A User’s Guide.  This  4%page  book  will help  a user  of macroeconomic  data  to understand  the  most  important 
data  series  well  enough  to  effectively  interpret  them.  Chapters  include: 
l The  National  Income  and  Product  Accounts 
l Industrial  Production  and  Capacity  Utilization 
l Labor  Market  Data 
l Macroeconomic  Price  Indexes 
l Monetary  Aggregates 
l Seasonal  Adjustment 
Copies  may  be  obtained  free  of charge  by  writing  to: 
Public  Services  Department 
Federal  Reserve  Bank  of Richmond 
Post  Office  Box  27622 
Richmond,  VA  23261 
FEDERAL  RESERVE  BANK  OF  RICHMOND  55 

Can the U. S. Return to a

Indexing and Inflation.” American Enterprise Institute Round Table held on

Inflationary Expectations, Money Growth, and the Vanishing Liquidity Effect of Money on Interest: A Further Investigation.” Federal Reserve Bank of Richmond Ecwomic Rec.&w 71 (March/April

me Concept of Indexation in the History of Economic Thought.” Federal Reserve Bank of Richmond &mornic

Remaining Puzzles and Neglected Issues in

Maintaining price stability: a proposal

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