Sound monetary policy, credibility, and economic performance.

• Author: Levy, Mickey D.

History is a constant reminder that sustainable healthy economic development requires sound and credible monetary policy. This is true of all nations, industrial and developing. Frequently, economic policy conferences focus on issues that elicit tirades about how everything is going wrong and radical reform is required. But recent trends in the conduct of global monetary policies have been highly favorable, helping to generate dramatic improvement in international inflation and economic performance. My focus in this article is on the key foundations for sound and credible monetary policy, the plusses and minuses of when simple principles are followed or violated, and suggestions for maintaining recent favorable trends. The bottom line is that well-understood principles--such as zero inflation and the importance of maintaining inflation-fighting credibility, transparency, central bank independence, reliance on market-based mechanisms to address undesired imbalances--apply to both developing and industrialized nations, and must be pursued independently of fiscal and regulatory policies. If such independence is impossible--primarily because of the lack of independence between the monetary authorities and the treasury--other institutional arrangements are required to ensure monetary soundness and credibility.

A generation ago, around 1980, the circumstances and perceptions about central banks and monetary policy were far different than now. Inflation was very high and economic and financial market performance was poor in industrialized and developing nations alike. Central banks lacked credibility and inflationary expectations were high and volatile. Budget deficits were high and rising, and projections of soaring government debt-to-GDP ratios dominated the fiscal debate. The projected unsustainable rises in debt-to-GDP and the associated "unpleasant monetarist arithmetic" that pointed to eventual debt monetization suggested that monetary policy ultimately may be hostage to irresponsible fiscal policy. On top of the undesirable macroeconomic trends of the day, this perception undercut the implied independence and credibility of the monetary authorities. The potential for improvement seemed remote.

Other aspects of monetary policy were also distinctly different, and weighed heavily on central bank credibility. Many monetary authorities--including the U.S. Federal Reserve--either did not have sound objectives that included zero inflation, did not articulate them effectively, or were not credible. Central bank opacity of policies and actions was the rule, as it long had been, with market participants and the public purposely left in the dark. Some misunderstood the rational expectations school to imply that policy surprises, theoretically necessary in order to affect real activity, were somehow desirable. In fact, the key implication, as Milton Friedman, Robert Lucas, and others were early to recognize, is that fine-tuning in order to achieve multiple objectives is ultimately counterproductive.

It has not been a smooth ride by any means--there have been supply shocks, several "crises," including financial upheavals in Mexico and other Latin American nations, the Russian default and Asian tumult of 1997, Long-Term Capital Management in 1998, and the stock market bubble of 1999-2000--but the conduct of monetary policy globally has been significantly transformed for the better, and macroeconomic performance has improved accordingly. By and large, most leading central banks now pursue low inflation objectives and have gained significant credibility. Importantly, most know that this hard-won credibility cannot be taken for granted and must be maintained through adherence to sound principles.

Successful Disinflationary Policies

What seemed remote a generation ago has largely become a reality. Inflation has receded dramatically--far more than even the most optimistic observer had speculated was possible (Rogoff 2003). It has fallen everywhere: in large industrialized nations, in emerging nations in Latin America, Asia and Eastern Europe, and even in perennially poor African nations (see Table 1). In many industrialized nations, allowing for measurement error, price stability has been essentially achieved, and inflationary expectations play a negligible role in private economic decisions. Among emerging and transition nations, the number of outlier nations still plagued by high and disruptive inflation has diminished significantly.

The declines in inflation have been attributable largely to successful disinflationary monetary policies, as central banks have slowed nominal spending growth relative to productive capacity and thus squeezed excess demand and inflation. The most dramatic reductions in inflation have occurred in select emerging nations in which central banks have been granted independence and have refused to extend credit to their governments, severing the linkage between fiscal irresponsibility and inflation.

Other "economic" factors have played a role. Global aggregate supply is expanding, reflecting the growth of output and trade by China, India, and other low-cost producers. Increased international competition, fueled by globalization, has increased productivity and reduced costs. Technological innovation and productivity growth have facilitated the trend toward lower global inflation and faster growth. However, evidence suggests this impact on inflation has not been universal: clearly, the jump in productivity gains since the mid-1990s has contributed to lower inflation in the United States, but inflation has fallen even in nations and regions where productivity has lagged--witness core European nations.

Sharply lower budget deficits or reductions in primary deficits or increases in primary surpluses (government budget imbalance less net interest) have also contributed to lower inflation in select developing nations, but the impact of deficits on inflation is not unambiguous or universal. In some declining inflation nations, the deficit-to-GDP ratio has receded but in others, like India, deficits have actually increased, as they did in deflation-plagued Japan in the 1990s...