Mises Daily Articles
Does Fed Transparency Fuel Growth?
In their various speeches Fed policy makers have been emphasizing the importance of price stability for economic growth. For instance, in his speech on April 2 2007 to the National Association for Business Economics (NABE) the President of the Federal Reserve Bank of St. Louis William Poole said,
Over time, the mainstream view in the economics profession has increasingly emphasized the importance of price stability for achieving maximum employment and maximum sustainable economic growth.1
According to Poole the central bank can achieve price stability in three ways,
First, the leadership of a central bank should form a consensus around the goal of a specific low inflation rate; the particular chosen number is less important than commitment to a specific goal. Second, the central bank must develop a consistent policy model, or decision framework, for responding to incoming data. The framework must explain how policymakers reconcile near-term movements in inflation, over which monetary policy has almost no influence, with the path of medium-to long-term inflation, for which the central bank is almost wholly responsible. Constructing the policy model is far from a trivial task. And, third, the central bank must communicate this framework to the public in a credible and transparent way.2
In this view, transparency is the key for achieving price stability. It is held that transparent policy enables individuals to adjust their inflation expectations in line with the stated policy goal of the central bank. Furthermore, it is held stable inflationary expectations prevent various shocks from spilling over into a general rise in prices of goods and services. All this in turn leads to a better performance of the economy. On this a governor of the Fed Frederic Mishkin said,
My view — that recent changes in inflation dynamics result primarily from better-anchored inflation expectations…. Potentially inflationary shocks, like a sharp rise in energy prices, are less likely to spill over into expected and actual core inflation.3
The whole idea of price stability originates from the view that volatile changes in the price level prevent individuals from clearly seeing market signals as conveyed by changes in the relative prices of goods and services. For instance, as a result of an increase in the demand for tomatoes relative to potatoes the prices of tomatoes increase relatively to the prices of potatoes. This relative price increase gives an impetus to businesses to lift the production of tomatoes versus potatoes. By being able to observe and respond to market signals as conveyed by changes in relative prices, businesses are said to be in tune with market wishes and therefore promote an efficient allocation of resources.
As long as the rate of inflation as measured by the rate of increase in general price level is stable and predictable individuals can identify changes in relative prices and thus maintain the efficient allocation of resources, so it is held. However, when inflation is unexpected i.e. the rate of increase in the price level is of a sudden nature, it tends to obscure the relative price changes of goods and services. This in turn makes it much harder for people to clearly observe market signals. Consequently, this leads to the misallocation of resources and to a loss of real wealth.
Note that in this view, changes in the price level are not related to changes in relative prices. In short, unstable changes in the price level only obscure but do not affect the relative changes in the prices of goods and services. So if somehow one could prevent the price level from obscuring market signals obviously this will set the foundation for economic prosperity.
It is not surprising that Fed officials and mainstream economists strongly recommend that central bank policies must be "transparent." If policies are made known in advance surprises will be avoided and price level volatility will be reduced, so it is held. The so-called policy of achieving price stability is presented as some kind of panacea that can do a lot of good for people's well being. But is it true?
The answer to this presupposes that there is such thing as the price level. Elsewhere we have shown that the price level as such cannot be conceptually defined on the grounds that the total purchasing power of money cannot be established.4 This means that individuals in the market place do not observe such a thing as the price level. All that they see are prices of various goods and services.
According to Rothbard,
Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.5
The policy of price stability is therefore a policy of stabilizing an arbitrary price index, which supposedly represents the price level. (The construction of price indices is an attempt at the impossible task of establishing a non-existent price level).
The main tool that the Fed employs to influence the general price level is the manipulation of the federal funds interest rate — and hence the interest rate structure — which falsifies the key signal as far as allocation of capital is concerned. This causes businesses to overinvest in tools and machinery and underinvest in the production of non-capital goods.
By implication, any attempt to stabilize the price level must involve both direct and indirect influences on various individual prices. Changes in the individual prices will not be uniform and will therefore distort relative prices in relation to the state of non-interference. In brief, it is not possible to "stabilize" the price level without affecting the relative prices. It follows then that the transparent policy of stabilizing the so-called price level actually causes the businesses to be in total darkness and to embark on wrong activities.
Expectations in a free market versus expectations in a hampered market
In a free market economy, whenever individuals act on expectations that run contrary to the facts of reality this sets in place incentives for a renewed assessment and different actions.
Let us assume that as a result of incorrect expectations too much capital was invested in the production of cars, and too little invested in the production of houses. The effect of the over-investment in the production of cars is to depress profits, because the excessive quantity of cars can only be sold at prices that are low in relationship to the costs that went into making them. The effect of under-investment in the production of houses on the other hand, will lift their prices in relation to costs, and thus will raise its profit.
This process will lead to a withdrawal of capital from cars and a channelling of it toward houses, implying that if investment goes too far in one direction, and not far enough in another, counteracting forces of correction will be set in motion. In other words, in a free market the facts of reality cause individuals to fairly quickly move away from activities that are out of sync with the market.6
This is, however, not so in a hampered market economy. By enforcing their policies, central banks can set a platform for a prolonged deviation of expectations from the facts of reality, which in turn give rise to activities that weaken the process of real wealth formation. The central bank however, cannot indefinitely defy these facts. A classical case of this is the artificial lowering of interest rates by the central bank that results in boom-bust cycles.
Contrary to the accepted way of thinking, the Fed's tampering with markets by means of transparent policy (transparent tampering) actually stifles individual's ability to form valid expectations. As a result of this individuals lose their touch with reality. Therefore economic busts always occur as a surprise to individuals (economic busts arrive when least expected).
We can conclude that in a free market economy individual's expectations have a tendency to change in tandem with true market conditions and therefore guide individual actions in accordance with the facts of reality. Consequently, this generates fewer surprises and fewer shocks. This is in contrast to a hampered economy where central bank policies give rise to expectations that are out of sync with reality.
It seems that the policy of transparency (transparent tampering) that Fed policy makers are striving to implement under the banner of achieving price stability might not be that good for the health of the economy. Also, it is a contradiction in terms to suggest that by means of manipulation of the price indexes and interest rates the Fed could somehow set the basis for the efficient allocation of resources and fulfill the role of an agent for economic growth.
 William Poole, Understanding Inflation (National Association for Business Economics, April 2, 2007.
 "Inflation Dynamics - Remarks by Governor Frederic S. Mishkin," annual conference, Federal Reserve Bank of San Francisco, March 23, 2007.
 George Reisman, The Government Against the Economy (Ottawa: Janeson Books, 1985 p. 5).
- 1. William Poole, Understanding Inflation (National Association for Business Economics, April 2, 2007.
- 2. Ibid.
- 3. "Inflation Dynamics - Remarks by Governor Frederic S. Mishkin," annual conference, Federal Reserve Bank of San Francisco, March 23, 2007.
- 4. Frank Shostak, "Labor Productivity Myth"
- 5. Murray N. Rothbard, in America's Great Depression, p. 153.
- 6. George Reisman, The Government Against the Economy (Ottawa: Janeson Books, 1985 p. 5).