NOVEMBER/DECEMBER1998 William G. Dewald is the retiring Research Director of the Federal Reserve Bank of St. Louis. Gilberto Espinoza provided research assistance. *Earlier versions of this paper were presented at the Morgan Stanley Dean Witter Interest Rate Conference, Little Rock, Arkansas, May 6, 1998; the Conference on the Conduct of Monetary Policy, Institute of Economics, Academia Sinica, Taipei, Taiwan, June 12, 1998; and the Institute of Developing Economies, Tokyo, Japan, June 17, 1998. between such nominal variables and real Historical U.S. output. Data from the bond market show that, despite inflation being at its lowest level Money Growth, in decades, the Fed has not regained fully the inflation credibility that it lost in the Inflation, and 1960s and 1970s. Inflation NOMINAL AND REAL Credibility* GROWTH, AND INFLATION The financial press and the public often William G. Dewald seem to believe that the way to contain inflation is to pursue policies that reduce real economic growth. The view that it INTRODUCTION necessarily takes lower real growth, or even a recession, to slow inflation is an lthough many forces affect individual improper reading of historical data. It fails prices in the short run, the historical to differentiate between the short run and Arecord shows that in the long run the long run. Sustained real output growth changes in the general level of prices, i.e., depends on increases in the supply of labor inflation, have been linked systematically and capital, and increases in the productivity to changes in the quantity of money. The of such inputs. Growth in demand for output Federal Reserve uses as its principal mone- certainly influences what is produced, but tary policy target an overnight inter-bank fundamental scarcities limit the aggregate interest rate, the federal funds rate, which amount of how much can be produced on it manipulates by open market operations a sustained basis. Furthermore, as the level that change its portfolio of government and variability of inflation increase, price securities, which in turn influences mone- signals become fuzzier and decisions are tary growth. Economists both inside and distorted, which would tend to decrease real outside the Federal Reserve monitor a wide gross domestic product (GDP). Thus, one range of indicators so as to judge the should not expect an increase in demand appropriateness of a monetary policy target growth to increase real growth on a sustained relative to the goals of achieving a stable basis, but if at all, only in the short run. An price level and sustained real growth. For examination of the historical record many years presidents of the Federal Reserve supports this proposition. 1 With chain-weights, price indexes Bank of St. Louis and many of its economists Figure 1 is a plot of percentage changes and quantity indexes are calcu- have called attention to research showing over 1959-1997 in nominal GDP, real GDP, lated separately for components that long-term growth of monetary aggre- and the GDP price index. The chart includes of GDP and therefore the differ- gates is among the more important of these year-over-year and 10-year moving averages. ence between nominal GDP indicators. They also have championed the The four-quarter changes—the fine lines— and real GDP growth is only preeminence of price level stability as a remove the high frequency noise from the approximately equal to the monetary policy goal to provide the best data. The 10-year changes—the heavy change in the GDP price index. With fixed-weights, the GDP environment for sustained economic growth lines—remove the business cycle fluctua- deflator is defined as the ratio in a market economy. tions as well. The gap between nominal of nominal to real GDP and The historical data reveal a consistent and real GDP growth rates approximates hence the gap between nomi- correlation between long-term growth rates inflation, as measured by percentage changes nal and real GDP growth rates in broad monetary aggregates, spending, in the GDP price index, which are shown is precisely equal to the growth and inflation in the United States, but not in the bottom panel of Figure 1.1 rate in the GDP deflator. FEDERALRESERVEBANKOFST. LOUIS 13 NOVEMBER/DECEMBER1998 Figure 1 Inflation and Real Growth (Year/Year and 10-Year Averages) Percent 25 Nominal GDP 20 15 Real GDP 10 5 0 -5 -10 1959 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 25 20 GDP Inflation 15 10 5 0 -5 -10 1959 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 NOTE: The bold lines are centered 10 year moving averages of the respective series. Figure 1 reveals several regular patterns: the early phase of recoveries. •Inflation trended up through •In recent years inflation has been about 1980, and down its lowest and most stable since since then. the late 1950s and early 1960s, and, atypically, it has continued •Annual growth rates in nominal to decelerate in the seventh year GDP and real GDP went up and of the expansion. down together. The year-over-year movements in nominal •Annual growth rates in nominal and real GDP are matched closely in theshort and real GDP were also more run, an observation seemingly suggesting volatile than annual inflation rates. that policies to increase nominal GDP growth would increase real GDP growth,too. That •Recessions—marked by the short–run relationship, however, does not shaded bars—occurred more hold up in the long run. From the1960s frequently from the late 1960s through the early 1980s the increase in 10-year through the early 1980s when average nominal GDP growth was associated inflation was high and rising with a matching increase in 10-year average than since the early eighties inflation, but, if anything, a decrease in 10-year when it trended down. average real GDP growth.Thus, increased average nominal GDP growthin the long •Inflation typically accelerated run was not associated with increased real before cyclical peaks, but GDP growth, but only with inflation. then decelerated beginning in International evidence supports this recessions and extending into finding that inflation harms long-run growth. FEDERALRESERVEBANKOFST. LOUIS 14 NOVEMBER/DECEMBER1998 Studies of other countries have identified a MONETARY GROWTH small negative effect of even moderate inflation AND INFLATION on real growth.2Small differences amount to a lot over long periods because of com- M2 is a measure of money that Milton pounding. Thus, it may notbe an accident Friedman and Anna Schwartz trace in their of history that the most highly industrialized Monetary History of the United States.4 It is economies with the highest per capita income a broad measure made up of assets having today have had comparatively low inflation a common characteristic: Each is either over extended periods. With respect to coun- issued by the monetary authorities, for triesthat have experienced inflation of 40 example, currency and coin, or is an oblig- percent a year or more,the evidence is ation of a depository institution legally unambiguous: High inflation reduces convertible into such standard monetary real growth.3 units. M2 assets can be divided into M1 High inflation also has been linked to and non-M1 categories. M1 components cyclical instability. There was a deep reces- can be used to make payments directly sion in 1981 and 1982. This recessionwas (currency, travelers checks, and checking associated with a genuinely restrictive mone- accounts). Non-M1 components, which tarypolicy and interest rates at unprecedented can be readily turned into M1 assets, levels. The rate of unemployment built up to include savings deposits, money-market more than 10 percent and inflation fell far mutual fund balances, and short-term time more sharply than most forecasters had deposits. Such non-M1 components of M2 expected. Despite some relapse in the late have become increasingly accessible to 1980s, inflation has trended down sincethe depositors for payments in recent years. early 1980s, and real GDP growth has averaged M2, as a broad monetary aggregate, repre- somewhat less than it did in the 1960s, but sents the essence of “liquidity,” i.e., a way this is because of lower productivity growth station between income receipts and and not because of recessions and unemploy- expenditures for both households and ment.In fact, the U.S. economy has per- non-financial businesses, and, as such, a formed very well relative to its potential and variable that would be expected to be better than ever in termsof cyclical stability. related to total national spending in The 29-quarter expansionfrom 1991:Q1 current dollar terms, i.e., nominal GDP. through 1998:Q2 had not yet lasted as long Figure 2 plots growth rates in M2, nominal as the record 34-quarter expansion of the GDP, and the GDP price index. It reveals some 1960s. However, as inflation decreased from regular short-term patterns in the year- the end of the recessionin 1982:Q4 through over-year data:5 1998:Q2, there were 63 expansion quarters and only three contraction quarters, an • M2 and nominal GDP growth unprecedented era of cyclical stability in rates slow before and during the 2 U.S. history. It surpassedthe record of initial stages of a recession. See Barro (1996) and Eijffinger, Schaling, and 1961:Q1 through 1973:Q4, which included Hoeberichts (1998). 47 positive growth quartersand four con- • M2 growth turned down many traction quarters. The record was not too more times than the number of 3 See Bruno and Easterly shabby in either case, but therewas a differ- cyclical peaks. (1996). ence. The 1960s and early 1970swere a 4 See Friedman and Schwartz period of accelerating inflation, whichlaid a • M2 growth turned up during (1963).