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Federal Reserve's Role in Keeping Inflation Low Aids U.S. Financial Stability: St. Louis Fed's Poole

CONWAY, Ark. — Despite several shocks to the U.S. financial system in recent years, the Federal Reserve has been successful in helping to keep inflation low and stable, according to William Poole, Federal Reserve Bank of St. Louis president. And that, along with the Fed's providing timely financial services to banks and regulating and supervising banks and bank holding companies, has greatly improved the country's financial stability, he said.
Poole's comments were part of a speech to University of Central Arkansas faculty and students, and Conway business leaders.

Poole mentioned several nationwide financial shocks, starting with the 1907 banking panic that led to the Federal Reserve's creation by law in 1914. He also covered the Great Depression, the Great Inflation of the 1970s, the Savings and Loan crisis in the '70s and '80s, the 1998 Russian default on its bond obligations, the near-collapse of Long Term Capital Management and the aftermath of the Sept. 11, 2001 attacks.

Concerning the Great Inflation, Poole noted that after inflation had remained high for several years, businesses and consumers began to borrow on the expectation that high inflation would continue indefinitely. "Interest rates that borrowers would have considered extremely high a few years earlier appeared more acceptable in light of their expectation of continued high inflation," he said.

After an aggressive Fed tightening of monetary policy in late 1979, inflation began declining sharply. The Consumer Price Index (CPI) stood at 13.5 percent in 1980, but only 3.2 percent in 1982. Long-term interest rates, however, took a much longer time to decline. "A long period of relatively low inflation was necessary to convince investors that the economy would not repeat the inflationary experience of the 1970s," Poole said, noting that inflation has remained low and stable for a number of years now. Since 1992, he said, year-over-year percentage change in the CPI has ranged between 1.5 and 3.5 percent.

Poole noted that the banking industry is also in relatively strong financial condition. He said the ratio of equity to total assets for all banks has increased from 6.4 percent in 1990 to 8.5 percent in 1998 and to 9.2 percent in 2002. "The strength of the banking system was an important source of stability in the fall of 1998, after Russia defaulted on its bonds," Poole said. "That strength has also been important in limiting the extent of the recession of 2001 and helping to sustain the economy in the face of the large decline in equity markets," he said.

The Federal Reserve in recent years has implemented a policy of insuring that default by one or more banks that are involved in operating systems to settle financial transactions would not disrupt the settlement of transactions by these systems. "The Fed acted vigorously to maintain operation of the payments system following the terrorist attacks of 9/11, and has since strengthened its processes further," he said.

Poole said that in an entrepreneurial market economy, businesses and households are guided by price signals and expectations of profits from new markets and technologies. The Fed's responsibility, he said, is to maintain a steady general price level and not take a position on the appropriateness of individual prices. "We have ample evidence that stock prices can fluctuate substantially even while the general level of goods price is stable," Poole said. "Avoiding inflationary disturbances to economic activity and financial markets is a major achievement of the last 20 years or so."

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