Credible Monetary Policy to Sustain Growth

Article excerpt

Last spring, policymakers at the Fed were criticized for moving preemptively against inflation. This criticism is somewhat surprising given the recent track record of the U.S. economy. In the past year, our economy has grown about as fast as it has grown in any four-quarter period since 1984. Jobs have been plentiful, and job growth on a nonfarm payroll basis has been well above long-run trends in labor force growth. Meanwhile, unemployment has fallen to a low level, and inflation has remained relatively low and stable.

By the standards of postwar U.S. economic history, one could hardly ask for better performance. And yet, in the middle of this success, we hear calls for a return to the failed monetary policy prescriptions of the past. Many are asking the Fed to reconsider its successful tack. They want to replace it with the stop-and-go approach of the 1960s and 1970s, policies that proved very costly for this country in terms of lost jobs and lower living standards.

In this article, I want to address some of this criticism and set the record straight regarding what we have learned about monetary policymaking in recent times. First, I want to stress that economic growth does not cause inflation. A country can grow rapidly because of real factors without any consequences for inflation. My second point, which is closely related, is that the Fed is not against jobs and growth; on the contrary, it is following policies intended to allow the maximum sustainable levels of real activity and employment. And, finally, I want to discuss ways that we can work to keep inflation low by maintaining a credible monetary policy. By a credible policy, I mean that the Fed sets and announces clearly defined goals, and it takes action, when necessary, to achieve those goals.


Let me start with a simple idea: Economic growth does not cause inflation. If all we know about a particular economy is that it is growing rapidly, we really do not know anything about its rate of inflation. The main determinants of economic growth are real factors like the growth rate of productivity or the growth rate of the labor force. In times of rapid technological change, for instance, we tend to see productivity improvements that allow greater output per worker. This can lead to rapid growth in real output in an economy regardless of the inflation rate. In the late 19th century, for example, the United States was rapidly industrializing and, indeed, was on the road to world power status. Yet the average rate of inflation during that time was negative - actually a slight deflation. If growth caused inflation, we would have observed sharply rising prices during this era. Instead, relatively rapid economic growth was associated with deflation because money growth was constrained by the gold standard.

Of course the 19th century is far in the past, but the idea that growth does not cause inflation is borne out in modern economies as well. Around the world, since World War II, high-inflation countries have grown no faster than low-inflation countries. If anything, they have grown more slowly, on average. And even a slightly slower average rate of economic growth can have a large effect on living standards. Suppose, for example, that for every 3 percentage points of additional inflation, the average growth rate of the economy declines by 0.075 percentage points, a rule of thumb consistent with recent empirical estimates. Let's imagine two economies, one with zero inflation, growing at 3 percent per year, and an identical second economy with 3 percent inflation, which, by our rule of thumb, grows at only 2.925 percent per year because of the higher inflation. It doesn't sound like these economies are very different. But if we follow them for 30 years, we find that living standards in the economy with higher inflation have been eroded by more than 2 percent. Is this a large number? I think it is. …