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1
With chain-weights, price indexes
and quantity indexes are calcu-
lated separately for components
of GDP and therefore the differ-
ence between nominal GDP
and real GDP growth is only
approximately equal to the
change in the GDP price index.
With fixed-weights, the GDP
deflator is defined as the ratio
of nominal to real GDP and
hence the gap between nomi-
nal and real GDP growth rates
is precisely equal to the growth
rate in the GDP deflator.
FEDERALRESERVEBANKOFST. LOUIS
13
NOVEMBER/DECEMBER1998
Historical U.S.
Money Growth,
Inflation, and
Inflation
Credibility*
William G. Dewald
INTRODUCTION
A
lthough many forces affect individual
prices in the short run, the historical
record shows that in the long run
changes in the general level of prices, i.e.,
inflation, have been linked systematically
to changes in the quantity of money. The
Federal Reserve uses as its principal mone-
tary policy target an overnight inter-bank
interest rate, the federal funds rate, which
it manipulates by open market operations
that change its portfolio of government
securities, which in turn influences mone-
tary growth. Economists both inside and
outside the Federal Reserve monitor a wide
range of indicators so as to judge the
appropriateness of a monetary policy target
relative to the goals of achieving a stable
price level and sustained real growth. For
many years presidents of the Federal Reserve
Bank of St. Louis and many of its economists
have called attention to research showing
that long-term growth of monetary aggre-
gates is among the more important of these
indicators. They also have championed the
preeminence of price level stability as a
monetary policy goal to provide the best
environment for sustained economic growth
in a market economy.
The historical data reveal a consistent
correlation between long-term growth rates
in broad monetary aggregates, spending,
and inflation in the United States, but not
between such nominal variables and real
output. Data from the bond market show
that, despite inflation being at its lowest level
in decades, the Fed has not regained fully
the inflation credibility that it lost in the
1960s and 1970s.
NOMINAL AND REAL
GROWTH, AND INFLATION
The financial press and the public often
seem to believe that the way to contain
inflation is to pursue policies that reduce
real economic growth. The view that it
necessarily takes lower real growth, or
even a recession, to slow inflation is an
improper reading of historical data. It fails
to differentiate between the short run and
the long run. Sustained real output growth
depends on increases in the supply of labor
and capital, and increases in the productivity
of such inputs. Growth in demand for output
certainly influences what is produced, but
fundamental scarcities limit the aggregate
amount of how much can be produced on
a sustained basis. Furthermore, as the level
and variability of inflation increase, price
signals become fuzzier and decisions are
distorted, which would tend to decrease real
gross domestic product (GDP). Thus, one
should not expect an increase in demand
growth to increase real growth on a sustained
basis, but if at all, only in the short run. An
examination of the historical record
supports this proposition.
Figure 1 is a plot of percentage changes
over 1959-1997 in nominal GDP, real GDP,
and the GDP price index. The chart includes
year-over-year and 10-year moving averages.
The four-quarter changes—the fine lines—
remove the high frequency noise from the
data. The 10-year changes—the heavy
lines—remove the business cycle fluctua-
tions as well. The gap between nominal
and real GDP growth rates approximates
inflation, as measured by percentage changes
in the GDP price index, which are shown
in the bottom panel of Figure 1.
1
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.
FEDERALRESERVEBANKOFST. LOUIS
14
NOVEMBER/DECEMBER1998
Figure 1 reveals several regular patterns:
•Inflation trended up through
about 1980, and down
since then.
•Annual growth rates in nominal
GDP and real GDP went up and
down together.
•Annual growth rates in nominal
and real GDP were also more
volatile than annual inflation rates.
•Recessions—marked by the
shaded bars—occurred more
frequently from the late 1960s
through the early 1980s when
inflation was high and rising
than since the early eighties
when it trended down.
•Inflation typically accelerated
before cyclical peaks, but
then decelerated beginning in
recessions and extending into
the early phase of recoveries.
•In recent years inflation has been
its lowest and most stable since
the late 1950s and early 1960s,
and, atypically, it has continued
to decelerate in the seventh year
of the expansion.
The year-over-year movements in nominal
and real GDP are matched closely in theshort
run, an observation seemingly suggesting
that policies to increase nominal GDP growth
would increase real GDP growth,too. That
short–run relationship, however, does not
hold up in the long run. From the1960s
through the early 1980s the increase in 10-year
average nominal GDP growth was associated
with a matching increase in 10-year average
inflation, but, if anything, a decrease in 10-year
average real GDP growth.Thus, increased
average nominal GDP growthin the long
run was not associated with increased real
GDP growth, but only with inflation.
International evidence supports this
finding that inflation harms long-run growth.
Figure 1
Inflation and Real Growth (Year/Year and 10-Year Averages)
Percent
25
20
15
10
5
0
-5
-10
25
20
15
10
5
0
-5
-10
1959 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97
Nominal GDP
Real GDP
61
1959 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 9761
GDP Inflation
NOTE: The bold lines are centered 10 year moving averages of the respective series.
FEDERALRESERVEBANKOFST. LOUIS
15
2
See Barro (1996) and
Eijffinger, Schaling, and
Hoeberichts (1998).
3
See Bruno and Easterly
(1996).
4
See Friedman and Schwartz
(1963).
5
Despite M2’s imperfections
as a cyclical indicator, the
Conference Board’s monthly
Leading Indicators Index
includes M2 relative to the
price level as one of its 10
components.
NOVEMBER/DECEMBER1998
Studies of other countries have identified a
small negative effect of even moderate inflation
on real growth.
2
Small differences amount
to a lot over long periods because of com-
pounding. Thus, it may notbe an accident
of history that the most highly industrialized
economies with the highest per capita income
today have had comparatively low inflation
over extended periods. With respect to coun-
triesthat have experienced inflation of 40
percent a year or more,the evidence is
unambiguous: High inflation reduces
real growth.
3
High inflation also has been linked to
cyclical instability. There was a deep reces-
sion in 1981 and 1982. This recessionwas
associated with a genuinely restrictive mone-
tarypolicy and interest rates at unprecedented
levels. The rate of unemployment built up to
more than 10 percent and inflation fell far
more sharply than most forecasters had
expected. Despite some relapse in the late
1980s, inflation has trended down sincethe
early 1980s, and real GDP growth has averaged
somewhat less than it did in the 1960s, but
this is because of lower productivity growth
and not because of recessions and unemploy-
ment.In fact, the U.S. economy has per-
formed very well relative to its potential and
better than ever in termsof cyclical stability.
The 29-quarter expansionfrom 1991:Q1
through 1998:Q2 had not yet lasted as long
as the record 34-quarter expansion of the
1960s. However, as inflation decreased from
the end of the recessionin 1982:Q4 through
1998:Q2, there were 63 expansion quarters
and only three contraction quarters, an
unprecedented era of cyclical stability in
U.S. history. It surpassedthe record of
1961:Q1 through 1973:Q4, which included
47 positive growth quartersand four con-
traction quarters. The record was not too
shabby in either case, but therewas a differ-
ence. The 1960s and early 1970swere a
period of accelerating inflation, whichlaid a
foundation for the instabilities that followed.
The 1980s and so far the 1990s have been
a period of decelerating inflation,which has
lain a foundation for stable pricelevel cred-
ibility and efficient resource utilization.
The next figures bring monetary growth
into the picture.
MONETARY GROWTH
AND INFLATION
M2 is a measure of money that Milton
Friedman and Anna Schwartz trace in their
Monetary History of the United States.
4
It is
a broad measure made up of assets having
a common characteristic: Each is either
issued by the monetary authorities, for
example, currency and coin, or is an oblig-
ation of a depository institution legally
convertible into such standard monetary
units. M2 assets can be divided into M1
and non-M1 categories. M1 components
can be used to make payments directly
(currency, travelers checks, and checking
accounts). Non-M1 components, which
can be readily turned into M1 assets,
include savings deposits, money-market
mutual fund balances, and short-term time
deposits. Such non-M1 components of M2
have become increasingly accessible to
depositors for payments in recent years.
M2, as a broad monetary aggregate, repre-
sents the essence of “liquidity,” i.e., a way
station between income receipts and
expenditures for both households and
non-financial businesses, and, as such, a
variable that would be expected to be
related to total national spending in
current dollar terms, i.e., nominal GDP.
Figure 2 plots growth rates in M2, nominal
GDP, and the GDP price index. It reveals some
regular short-term patterns in the year-
over-year data:
5
• M2 and nominal GDP growth
rates slow before and during the
initial stages of a recession.
• M2 growth turned down many
more times than the number of
cyclical peaks.
• M2 growth turned up during
each recession and early recovery
except during the most recent
instance when it continued to slow.
• M2 and nominal GDP have been
growing at similar rates between
1995 and 1998.
FEDERALRESERVEBANKOFST. LOUIS
16
NOVEMBER/DECEMBER1998
This figure reveals the major reason
why M2 has been discredited as an indicator
of the stance of monetary policy in recent
years—in the short run, movements in the
monetary aggregates, nominal GDP, and
inflation sometimes appear to be unrelated.
For example, whereas M2 growth slowed
dramatically between 1992 and 94, nominal
GDP growth accelerated. That discrepancy
produced the largest and most persistent
deviation between the growth rates in M2
and nominal GDP in many years. This
deviation has led the Federal Open Market
Committee (FOMC) and the public to place
less emphasis on the money supply targets.
Nevertheless, giving up on the aggre-
gates might be a mistake. The reason is that
there has been a close long-termfit between
M2 growth and nominal GDP growth and,
in turn, inflation. Figure 2 shows the gen-
eral upward trend in 10-year average M2
growth, nominal GDP growth, and inflation
during the 1960s and 1970s, and the gen-
eral downward trend in these 10-year
averages during the 1980s and so far in the
1990s. Such a longer-term historical rela-
tionship is presumably a reason why M2 is
one of the monetary variables for which the
Federal Reserve continues to announce a
target range in the Congressional Humphrey-
Hawkins hearings twice a year. In his
Humphrey-Hawkins testimony in February
1998, and again in July, Chairman Alan
Greenspan noted that M2 growth might be
back on track as an indicator of nominal
GDP growth and inflation, after it appeared
to have been off track earlier in the expansion.
Observations about M2, nominal GDP
growth, and inflation over the long run
support Milton Friedman’s dictum that
“inflation is always and everywhere a mon-
etary phenomenon.” The looseness of the
short-term association supports his dictum
that “lags are long and variable.” Figures
3 and 4 makes these points with data
going back to 1875.
Figure 3 shows that short-run, year-
over-year changes in these historical series
Figure 2
M2 and Nominal GDP Growth, and Inflation
(Year/Year and 10-Year Averages)
Percent
25
20
15
10
5
0
-5
-10
25
20
15
10
5
0
-5
-10
1959 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97
Nominal GDP
M2
61
1959 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 9761
GDP Inflation
NOTE: The bold lines are centered 10–year moving averages of the respective series.
FEDERALRESERVEBANKOFST. LOUIS
17
are very noisy. Yet, even on a year-over-
year basis, the association of large movements
in M2 with large movements in nominal
gross national product (GNP) and inflation
is apparent, (for example,the contraction of
monetary growth and nominal GDP growth
in the early 1930s and the associated defla-
tion). In less turbulent times such as recent
decades, however, there is no clearly discern-
able systematic short-run association between
broad money growth, nominal GNP growth,
and inflation. Of course, a change in the
price level over a year or two is not really
what is meant by inflation unless it is sub-
stantial enough to change the price level a lot.
Figure 4 shows that over the past 35
years the long upward and downward cycle
in M2 and nominal GNP growth rates and
inflation is only one of a series of comparable
long cycles in U.S. history. Following a
period of low M2 growth and deflation in
the 1870s and 1880s, there have been four
long inflation-disinflation cycles. They are
marked on the figure by troughs in centered
10-year average inflation in 1893, 1909,
1928, and 1962. In 1998, it is not known
yet whether the last 10-year average plotted
was a trough.
Because M2 growth tracks all previous
inflation-disinflation cycles, it goes a long
way to avert the suspicion that the relation-
shipbetween monetary growth and inflation
is spurious. Monetary historians such as
Milton Friedman and Anna Schwartz have
recognized that the mere association of
monetary growth with inflation does not
establish the direction of causality. To con-
firm that monetary growth causes inflation,
they cite the evidence that the long-term
relationship between monetary growth and
inflation has remained much the same
throughout history, including periods when
we know that monetary growth resulted
from supply-side factors. For example, when
monetary growth accelerated in the 1890s,
as engineering advances increased gold
output, there was an associated inflation.
Gold was then a standard into which cur-
rencies could be converted. When monetary
growth collapsed in the early 1930s because
of bank failures, there was an associated
deflation.
The historical record also includes
episodes when demand pressures led the
Fed to support monetary increases. In
both World Wars I and II, Fed policies to
NOVEMBER/DECEMBER1998
Figure 3
M2, Nominal GNP Growth, and Inflation (Annually)
Percent
30
20
10
0
-10
-20
-30
1875 95
Nominal GNP
M2
GNP Inflation
85 95 1905 15 25 35 45 55 65 75 85
FEDERALRESERVEBANKOFST. LOUIS
18
NOVEMBER/DECEMBER1998
help the government finance its debt stim-
ulated monetary growth. What followed
were substantial increases in inflation.
Nevertheless, even in wartime, there is
reason to think that the Fed could have
kept a damper on inflation. When federal
deficits rose in the 1980s, but the rate of
monetary growth fell, inflation did not
rise. It fell. The historical evidence is that
when the Fed has held interest rates down
in the face of demand pressures by stimu-
lating monetary growth, inflation has
accelerated. However, in periods such as
the 1980s, when monetary growth has not
accelerated, inflation has not accelerated.
Every major acceleration in M2
growth has been associated with a major
acceleration in inflation. Likewise, every
major deceleration in M2 growth has been
associated with a major deceleration in
inflation. Accordingly, policy makers
might be making a serious mistake if the
noisy short-term movements in M2 and
inflation persuaded them that money does
not matter anymore. At a minimum,
policy makers and the public might be
wise to monitor monetary growth, mindful
that inflationary demand pressures do not
cause money growth unless the monetary
authorities passively allow that to happen.
Since the long run consists of an accumu-
lation of short runs, it follows that
sustained shifts in M2 growth are worth
noting when formulating monetary policy.
Keeping longer-term average M2 growth
and nominal GDP growth in the neighbor-
hood of longer-term real growth remains a
practical guide for achieving a stable price
level environment.
INFLATION AND INTEREST
RATES
Readers might be surprised that mone-
tary policy has been discussed to this point
without much reference to interest rates.
This approach was not an oversight.
Interest rates compensate lenders for
giving up current purchasing power and
taking some risk. One risk is that borrowers
might default. Another is that what they
pay back might have less purchasing power
than what was lent.
Despite the conventional wisdom to
the contrary, interest rates often have not
been a good measure of the thrust of mon-
Figure 4
M2, Nominal GNP Growth, and Inflation
(10-Year Averages)
Percent
20
15
10
5
0
-5
-10
1875 95
Nominal GNP
M2
GNP Inflation
85 95 1905 15 25 35 45 55 65 75 85
FEDERALRESERVEBANKOFST. LOUIS
19
NOVEMBER/DECEMBER1998
etary policy on demand growth and infla-
tion.
6
Because increases in expected inflation
would tend to raise rates, rising nominal
interest rates do not necessarily signal an
anti-inflationary (tighter) monetary policy.
Correspondingly, falling nominalinterest
rates are not necessarily a measure of a
more inflationary (easier) monetary policy.
Nominal interest rates are highly sensi-
tive to inflation and inflationary expectations.
High inflation expectations lead lenders to
demand compensation for the expected
depreciation in the purchasing power of
the money they lend, and borrowers are
forced to add an inflation premium to the
interest rates they pay.
Apart from default and inflation risk
premiums, real (inflation adjusted) interest
rates depend largely on underlying real
factors such as domestic saving and invest-
ment and international capital flows, not
on monetary growth and inflation. Thus,
regardless of monetary growth and inflation,
higher real interest rates generally reflect
increased investment opportunities or
decreased saving. That real interest rates
reflect underlying real factors is another
reason why interest rates are not a reliable
measure of the stance of monetary policy.
In this regard, technological change in
the 1990s, coupled with the long expansion,
may have increased the return to capital
investment in the U.S. economy, and hence
the demand for capital relative to historical
experience, which would tend to increase
real interest rates. In such circumstances,
there is a monetary policy risk in under-
estimating the upward pressures on real
interest rates that result from an increase
in real investment demand. Any attempt
to attenuate such pressures by stimulating
monetary growth would risk a build up of
inflationary pressures.
Fundamentally, monetary policy is tighter
or easier not in terms of whether nominal
orreal interest rates are rising or falling,
but in terms of whether inflationarypressures
are falling or rising. As the historical figures
have demonstrated, inflation in a longer-
term sense is associated with high monetary
growth. Figure 5 shows that increasesand
decreases in inflation trends are reflected in
major increases and decreases in nominal
interest rate levels.
Figure 5 plots the federal funds rate,
the 10-year Treasury bond rate, and annual
changes in the Consumer Price Index. When
inflation held in the range of 1
1
–
2
to 2 percent
6
The faultiness of interest rates
as measures of monetary policy
in a non-inflationary environ-
ment was evaluated in Dewald
(1963).
Figure 5
Inflation and Selected Interest Rates
Percent
20
18
16
14
12
10
8
6
4
2
0
1959 97
Ten-Year
Treasury Bond
CPI Inflation
Federal
Funds Rate
61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95
FEDERALRESERVEBANKOFST. LOUIS
20
during the late 1950s and early 1960s, 10-year
Treasury bonds yielded about 4 percent. From
the mid-1960s through the early 1980s, infla-
tion trended up and so did both short- and
long-term nominal interest rates. Since then,
inflation has trended down and so have both
short- and long-term nominal interest rates.
Thus, the events of recent decades tend to
confirm that high inflation is associated with
high nominal interest rates and low inflation
with low nominal interest rates. As a corollary,
Federal Reserve policies that increase the
growth of the monetary aggregates, and
thereby inflation, would in due course also
increase nominal interest rates, despite the
myopic view that expansionary monetary poli-
cies lower nominal interest rates. Federal
Reserve policies cannot lower nominal interest
rates permanently except by actions that lower
inflation.
INFLATION CREDIBILITY
AND INTEREST RATES
Given the propensity to save, average
real (inflation-adjusted) interest rates would
tend to rise with an increase in trend real
GDP growth. The reason is that measured
real GDP growth is associated with increased
real rates of return on investment. Average
nominal interest rates tend to deviate from
the real rate of return on investment by an
amount that reflects expectations of inflation
and inflation risks. The greater the gap
between nominal interest rates and real rates
of return, the lower the Fed’s credibility is
for keeping inflation low. Thus, the differ-
ence between nominal interest rates and trend
real growth provides a crude measure of
inflation expectations in the bond market,
i.e., inflation credibility.
7
Real GDP growth (averaged over 10 years
to remove business cycle movements)drifted
down from about 4 percent during the
1950s and early 1960s to about 2 percent
during the late 1970s and early 1980s. It
then rose back up to about 2.5 percent so
far during the 1990s. Five-year average
inflation drifted up from about 1 to 2 per-
cent during the 1950s and early 1960s to
nearly 10 percent in 1980, then back down
to about 3 percent during the 1990s. The
NOVEMBER/DECEMBER1998
7
The analysis rests on the
assumption that the real rate of
interest equals the rate of growth
of real GDP, when both series
are averaged over a moderately
long period of time. This condi-
tion arises in theoretical models
in which consumers are Ricardian
and the rate of time preference
is zero. The condition that the
real interest rate is equal to the
real output growth rate arises in
theory since real GDP growth is
acting as a proxy for an equilib-
rium rate of return on invest-
ment. It would be appropriately
expressed in per capita terms.
Per capita GDP growth has
slowed more than overall GDP
growth over the period plotted
on Figure 6. Therefore, current
inflation credibility would have
fallen even more relative to its
level in the late 1950s and
early 1960s than indicated on
Figure 6, if per capita real GDP
growth had been used to proxy
the equilibrium rate of return
on investment.
Figure 6
Long-Term Yields, Real Growth, and Bond Market
Inflation Credibility
Percent
14
12
10
8
6
4
2
0
10
8
6
4
2
0
-2
Five-Year Treasury Yield Five-Year Average
Real GDP Growth Ten-Year Average
1965 1970 1975 1980 1985 1990 19951960
1965 1970 1975 1980 1985 1990 19951960
CPI Inflation Five-Year Average
Inflation Credibility
FEDERALRESERVEBANKOFST. LOUIS
21
NOVEMBER/DECEMBER1998
five-year average of the five-year Treasury
security yield rose from 2 percent during
the 1950s to 12 percent during the early
1980s; but it then fell back to about 6 per-
cent in the 1990s. Since bond yields rose
when inflation accelerated, but real GDP
growth slowed, the influence of inflation
outweighed the influence of real GDP
growth on bond yields. Correspondingly,
when inflation decelerated, bond yields fell
even though real GDP remained stable.
The difference between the five-year
average of the five-year Treasury security
yield and the 10-year average of real GDP
growth is an estimate of the bond market’s
five-year inflation forecast, adjusted for
inflation risk. It is the height of the shaded
area in the lower panel of Figure 6. This
measure of inflation credibility roughly lagged
inflation, indicating that bond yields have
not been very forward looking in forecasting
inflation. The measure of inflation credibility
hovered close to zero during the 1950s and
early 1960s, which was credibly a zero-infla-
tion-expectations period. It under forecast
inflation from the late 1960s until the early
1980s when inflation was rising. It over
forecast inflation in the 1980s and so far in
the 1990s as inflation has fallen. It peaked
at about 10 percent in the early 1980s, but
fell to about 4 percent in recent years.
The bond market inflation forecast (or
inflation premium) over the past five years
represents a substantial gain in credibility
compared with the early 1980s, but a sub-
stantial loss compared with the 1950s and
early 1960s. In that earlier period, actual
inflation was about 2 percent, but the bond
market forecast a rate close to zero. In recent
years, inflation has averaged about 3 percent,
but the bond market has forecastabout 4
percent inflation inclusive of an inflation
risk premium. Thus, despite recent inflation
being the lowest and most stable in
decades, bond markets have seemingly not
yet been convinced that inflation is down
to stay. If the inflation premium were
eliminated, bond yields could fall to match
trend real growth, as was the pattern in the
1950s and early 1960s. That is about 3
percent, which is considerably lower than
the approximately 5 to 5
1
–
2
percent bond
yields observed in mid 1998.
Double-digit inflation and inflationary
expectations are what explain the all time
peak in security yields in October 1981 as
plotted in Figure 7. Since then, the entire
yield curve has shifted down by roughly
Figure 7
Government Securities Yield Curve
Percent
18
16
14
12
10
8
6
4
2
0
305 10 15 20 25
October 2, 1981
November 7, 1994
October 15, 1993
January 3, 1959
November 10, 1998
10 percentage points, undoubtedly a reflec-
tionof the decline in inflation and inflationary
expectations. Although marketsdo not
expect double-digit inflation today, they do
not expect price stability either. During
the 1950s and early 1960s inflation was
low and generally expected to stay low, a
condition that was reflected in long-term
rates hovering in the 3 to 4 percent range
as represented by the January 3, 1959,
yield curve on the figure. Despite the his-
torical record of an unstable price level in
the shortrun, there really was widespread
expectation of longer-term price stability
until inflation took off in the mid-1960s.
In fact,never before the 1960s had the U.S.
federal government borrowed long term at
more than a 4
1
–
4
percent rate.
During the expansion that began in
1991, the yield curve touched a cyclical
low on October 15, 1993. It then shifted
up to a cyclical peak on November 7, 1994.
Three-month bill rates had increased from
3 percent to 5.4 percent and 30-year bond
rates, from 5.8 to 8.2 percent. The latter
was presumably an illustration of increases
in long-term interest rates indicative of
rising inflationary expectations in the bond
market. Although inflation, in fact, did not
increase much during the 1990s expansion,
bond markets may well have been anticipating
a repeat of the experience of inflation
accelerating as had typically occurred in the
past.Historically, monetary policy often has
laggedbehind market interest rates in
expansions and thereby added to, rather
than damped, inflationary pressures. By
comparison, the record during the 1990s
expansion has beenvery good: An extended
period of positive real growth with
inflation held in check. Yet, with bond
rates still above the real growth trend, the
bond markets seemingly continue to
reflect the fear that inflation will rise again.
HOW TO GET AND KEEP
INFLATION CREDIBILITY
What could the Federal Reserve do to
enhance its inflation credibility, and thereby
allow long-term interest rates to stay low
and prospectively fall further? Most impor-
tant, the Fed should continue to keep inflation
low by limiting the rate of monetary growth.
A practical goal would be to get back to
the low inflation and low interest rates of
the late 1950s and early 1960s. One way
to persuade markets that low inflation is
here to stay is for the FOMC to focus more
sharply on the desired outcome for inflation
by following several other countries that
have legislated specific low inflation targets
for their central banks. This list includes
Australia, Canada, New Zealand, and the
United Kingdom, as well as Portugal,
Spain, and Sweden. Whether or not such
efforts are directly responsible, the fact is
that these countries have had considerable
success in bringing inflation down and
keeping it down.
A second proposal comes from econo-
mists who have argued that credibility
would be enhanced if there were an
announced policy rule (with respect to
the federal funds rate or monetary growth)
and the Fed acted on the basis of that rule.
The advantage of a rule is that markets would
know in advance how the Fed would react
to deviations of nominal spending, inflation,
or other variables from specified targets.
A third proposal made by Dewald
(1988) is that federal budget offices base
their budget projections over a 5- to 10-
year horizon not on their own inflation
assumptions, but on longer-term inflation
forecasts from the Federal Reserve. Since
the Fed has the power to influence inflation
over the long term, why not relieve the
budget offices of the responsibility for
making an independent assessment of
future inflation as they make their budget
projections? Not only could the budget
offices benefit, but also every business,
state and local government, and household
could benefit from having confidence that
the Fed would act to keep inflation as low
as it had forecast. Lars Svensson (1996)
has proposed that the Fed make its own
announced inflation forecasts an explicit
policy target. By using a forecast as a
guide to policy, the Fed would be focused
on this objective, but not blind to other
things going on in the economy that influ-
ence inflation.
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An environment of credible price sta-
bility has a high payoff in a market economy.
The historical evidence examined in this
article supports the conclusion that risks
of starting another costly inflation-disinfla-
tion cycle could be avoided by monitoring
M2 monetary growth and maintaining a
sufficiently tight monetary policy to keep a
damper on inflation. Having achieved the
lowest and most stable inflation environment
in many decades, the Federal Reserve has
an unusual opportunity to persuade mar-
kets that it will continue to keep inflation
low and, in principle, eliminate it. An
environment of credible price stability
would allow the economy to function
unfettered by inflationary distortions—
which is all that can be reasonably expected
of monetary policy, but precisely what
should be expected of it.
REFERENCES
Barro, Robert. “Inflation and Growth,” this
Review
, (May/June 1996),
pp. 153-69.
Bruno, Michael, and William Easterly. “Inflation and Growth: In Search
of a Stable Relationship,” this
Review
(May/June 1996), pp. 139-46.
Dewald, William G. “Monetarism is Dead: Long Live the Quantity
Theory,” this
Review
, (July/August 1988), pp. 3-18.
_______. “Free Reserves, Total Reserves, and Monetary Control,”
The Journal of Political Economy
, LXXI, 1963, pp. 141-53.
Eijffinger, Sylvester, Eric Schaling, and Marco Hoeberichts. “Central
Bank Independence: A Sensitivity Analysis,”
European Journal of
Political Economy
, Vol. 14 (1998), pp. 73-88.
Friedman, Milton, and Anna J. Schwartz.
A Monetary History of the
United States
, 1867-1960, Princeton University Press, 1963.
Svensson, Lars. “Commentary: How Should Monetary Policy Respond
to Shocks While Maintaining Long-Run Price Stability?—Conceptual
Issues,”
Achieving Price Stability, A Symposium Sponsored By the
Federal Reserve Bank of Kansas City
, August 29-31, 1996, pp. 209-27.
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