A few minutes ago I made the point that monetary policy cannot influence the economy’s growth or employment potential over the long run. The fact is that economists have had a very difficult time identifying any reliable and exploitable link between monetary policy actions and real output or employment in the short run either. Policymakers have neither the knowledge nor the tools to manage aggregate demand with the timing and precision necessary to neutralize the impact of unexpected shocks on output or employment.
Nonetheless, it is the economy’s best interest for policy to respond to conditions in a manner that is consistent with the goal of price stability. So, for example, if stronger productivity growth enables the economy to sustain higher output growth, then the market will demand a higher level of interest rates…
…Now, I recognize that the policy approach I am advocating here is difficult to implement. We often don’t observe economic shocks in a timely way, nor are we able to precisely measure the level of interest rates the economy is seeking in response to such shocks. Consequently, monetary policy should not be overly sensitive to short-run fluctuations. Thus, keen judgment is called for, and a little luck doesn’t hurt either.
But I believe the principle behind the approach is sound. Indeed, it is simply an elaboration of my first principle: the central bank should always set interest rates consistent with the goal of maintaining long-run price stability so as to foster maximum economic growth and employment. Moreover, trying to use monetary policy to stabilize output and employment in the short run — can actually do more harm than good. A look back at the 1970s underscores the point quite dramatically. When the economy was hit with a series of oil price shocks, the Fed responded with stimulative policies intended to maintain output and employment growth. These policies largely failed, generating excessive inflation even as the unemployment rate rose and the economy weakened. The Fed was relying on a short-run relationship between economic activity and inflation that is simply not reliable.