The characterization here of policy in the final Greenspan years is that the FOMC pursued its basic expected inflation/growth gap procedures but raised its implicit inflation target from price stability to low inflation. If that characterization is correct, the issue arises of whether there is a conflict between the twin objectives of “price stability” and “maximum employment” legislated in the Federal Reserve Act. Does achievement of “maximum employment” require secular depreciation of the currency, albeit at a low level? Does positive inflation “buy” stability of real output?

Raising the Implicit Inflation Objective

After the Asia crisis, the FOMC replaced its implicit long-run objective for price stability with an objective of low inflation (Chapter 17). Henceforth, the FOMC demonstrated an aversion to inflation as low as 1%. Figure 20.1 shows inflation compensation inferred from the difference in nominal and TIPS yields for the five-year interval, five years in the future. It measures the market's expectation of trend CPI inflation. Markets expected near-price stability in fall 1998. Over 1999, expected trend CPI inflation rose to 2.5%. The FOMC conveyed no message that this level of expected inflation exceeded its desired level for actual inflation.

Over 2000, expected trend CPI inflation drifted down and at year end reached 1.75%. In 2001, policy followed the basic lean-against-the-wind pattern. In 2001 as the recession became evident, the FOMC lowered the funds rate in an amount commensurate with its past responses to weakness (Figure 21.5).