A MARKET SYSTEM WORKS most effectively when price signals are not confused by inflationary expectations. Evidence shows that no consumer behavior has seemed motivated by fear of inflation since September 11. A few lines at gas stations emerged that day, based on unfounded fears of a physical shortage and sharply higher prices. In the weeks after the attacks, energy prices fell, reflecting reduced demand in the face of a global economic slowdown.

Consumer price inflation has not accelerated. Survey measures of longer-term inflation expectations have remained unchanged. The spreads between regular Treasury bonds and the Treasury's inflation-indexed bonds--another measure of inflation expectation--receded after the terrorist attacks and have remained low.

Indeed, some commentaries in the immediate aftermath of September 11 raised concerns about deflation. Such fears arose out of short-run data that appeared immediately after the attacks and out of an inadequate understanding of deflation in Japan, where wholesale and consumer prices generally drifted downward starting in the mid-1990s and where asset prices (land and equities) collapsed. A more complete analysis indicates that the U.S. economy is in no danger of replicating Japan's experience in the 1990s.

One of the great economic accomplishments of the last 20 years is restoration of a climate of price stability in the United States. During the early 1980s, the Fed managed monetary policy to stabilize the inflation rate at a much lower rate than in the 1970s; in the 1990s, the Fed was able to put the inflation rate on a gentle downward trend. The outcome was accompanied by steadily declining unemployment, contrary to the forecasts of many.

By the middle of the 1990s, the objective of reducing inflation to a low-enough level that it was largely ignored in the day-to-day decision making of consumers and businesses was substantially achieved. That we now take price stability in this sense almost for granted is a great strength of our current condition. (See sidebar.) This environment gives the Fed flexibility in responding aggressively to situations where there is the potential for a liquidity crisis, such as on September 11 and the following days, or where there is evidence of an economic slowdown. As always, the Fed's responses must be tempered by consideration that an overreaction, or a failure to reverse short-run policy actions in a timely fashion, could result in a deterioration of expectations about future inflation.

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