Academic journal article Economic Commentary (Cleveland)

Is Noninflationary Growth an Oxymoron?

Academic journal article Economic Commentary (Cleveland)

Is Noninflationary Growth an Oxymoron?

Article excerpt

One question on the minds of policymakers and economic analysts alike is, "When will the bill come due for the robust economic growth the United States has been enjoying?" That is, when will inflation begin to pick up? But a better question might be, "Just because inflation and above-trend growth have coincided in the past, does that mean that they must do so in the future?" Contrary to popular wisdom, it is quite possible to have a booming economy without an acceleration in the price level.

Just before the Federal Open Market Committee's (FOMC) May 20 meeting, popular opinion about the near-term future of U.S. monetary policy was summarized by John O. Wilson, chief economist at BankAmerica Corp.:

Mr. Wilson views the economy as continuing to expand too fast for the Fed's comfort and anticipates that a series of central bank moves will be needed to bring the economy back onto what economists call the sustainable non-inflationary growth path. 1

The FOMC did not choose to alter the average level of the federal funds rate at its May meeting. A typical interpretation of this decision appeared in the May 21 Los Angeles Times:

The decision by the ... Federal Open Market Committee was designed to provide time for analysts to determine whether the economy is slowing down on its own ... or will require additional reining in.2

These observations underlie one of the most widely held and persistent beliefs about the "theory" of inflation; that is, inflationary pressures will inevitably result from high levels of economic activity, defined as real GDP growth that exceeds some "natural," or normal, rate. The obvious consequence of such a belief-duly expressed in the quotations above-is that if the Fed desires to contain inflation, it must also contain economic growth.

This is indeed a predicament for a central bank that by its own pronouncements desires to conduct monetary policy to maximize the well-being of the average citizen. There is, of course, a distinction between a policy aimed at stabilizing output growth near its longterm trend and one designed to "fight growth" more generally. But the distinction is a subtle one, and the casual observer might be forgiven for not understanding why the goal of long-term economic growth appears to require periodic policy actions that seem aimed at slowing growth.

This confusion is unnecessary and unproductive, because much of the popular commentary about monetary policy, inflation, and the pace of real economic activity is based on a none-too-accurate portrayal of economic theory and evidence. Economic growth is not the enemy of low inflation, and expanding employment and income do not, in and of themselves, threaten the Federal Reserve's legitimate role in protecting the purchasing power of money.

The contrary perception is, at least in part, due to a failure to communicate (for which those of us in the business of central banking are not blameless). In particular, the long-established and widely held theory of money, prices, and income does not suggest an obvious linkage between high levels of economic activity and high rates of inflation (or, more specifically, between accelerating inflation and growth in excess of "potential").3 Just the opposite, in fact: Higher GDP growth should put downward, not upward, pressure on prices.

This Economic Commentary reviews the theoretical and empirical case for disinflationary economic growth. The basic story line is as follows: Rising prices follow from nominal money supply growth in "excess" of its demand.4 More rapid GDP growth, however, implies an increase in the growth of money demand. Thus, everything else being equal, an uptick in GDP growth should lead to disinflation, not rising inflation.

The tricky step between theory and reality, of course, is that all else is rarely equal. Inflation and above-trend growth have tended to coincide in the past. But it is important to recognize that this can arise because growth is sometimes associated with other changes that exert upward pressure on prices, not because growth per se is inflationary. …

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