Price Stability

Face to face
Each classic case
We shadow box and double cross
Yet need the chase
--Sade

Phillips et al. (1937) present compelling evidence that the primary objective behind the Federal Reserve's fateful financial market interventions during the 1920s was to stabilize general prices at some level that the institution thought appropriate. Included are several statements from Fed officials during the period that reflect a price stability motive.

But why should these researchers expend such effort to present the obvious, I wondered? Everyone knows that one of the Fed's charters, as poorly executed as it as been, is price stability.

It turns out, however, that the central bank was assigned no such mission in the original Federal Reserve Act of 1913. Developed largely in reaction to the Panic of 1907, the original Act created the Federal Reserve primarily to govern national banking operations and to serve as the 'lender of last resort' in times of market stress.

No explicit monetary policy objectives appeared in the original Act. They were added later as an amendment in 1977. These policy objectives empower the Fed "to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates." [emphasis mine]

The price stability motive, then, has been a consequence of mission creep at the Fed.

Of course, most people have been conditioned to think that price stability is a good thing. After all, who should oppose consistent, predictable prices in the marketplace?

You and I, if we were smart.

In unhampered markets, the natural direction of prices is down. As Phillips et al. (1937) point out several times in their analysis, productivity improvements funded by investment capital create more goods over time. More goods spread over a constant amount of money means lower unit prices.

As productivity improves, prices go down and purchasing goes up.

People pounding the table for stable prices (much less the 2% price increase currently promoted by the Fed) effectively seek to rob you of purchasing power. They want to raise your cost of living.

Who would want to do this? Who would want prices to be higher than they otherwise have to be? We'll consider this question in a future post.