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May l, 1997

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

Is Noninflationary Growth an Oxymoron?
by David Altig, Terry Fitzgerald, and Peter Rupert

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 0. Wilson, chief economist at BankAmerica Corp.:

Mr. Wilson views the economy as
continuing to expand too fast for
the Feds 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 ine~itably '
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
ISSN 0428-1276

stabilizing output growth near its longterm trend andone 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 oflow 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.

-

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.

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. This message has been lost as the correlation between "excessive" output growth and
changes in the inflation rate has become
enshrined in the "Phillips curve" (discussed below). However, the stability of
this relationship and the statistical regularities that underlie it are as much ap-.
parent as real. Appreciating this goes a
long way toward explaining why the U.S.
economy can safely buck the conventional wisdom and experience substantial
noninflationary economic growth.

• Some Simple Theory 5
At the most basic level, the average
price level- let's call it P- is the total
units of money required to purchase one
unit of a hypothetical, representative
real good or service. Holding the growth
rate of money fixed, a positive productivity shock that raises production in the
economy increases the private sector's
desire to hold monetary assets. This
requires the purchasing power of money
in terms of goods and services to rise
(that is, disinflation results) in order to
maintain equality between demand and
supply. Conversely, when there is an
increase in the supply of money that
does not directly affect money demand,
the purchasing power of money will fall
(that is, inflation occurs).
This is the essence of the theory of inflation: When the (nominal) money supply
grows faster than the demand for (real)
money balances, P grows, which is to
say inflation occurs.6 Thus, given the
growth rate of money (which is ultimately controlled by the central bank),
the rate of inflation is dependent on the
growth rate of money demand.7
What, then, determines money demand?
According to accepted economic theory,
part of the answer is income, which for
practical purposes can be measured by
real GDP. Because income is related to
spending, and money is held precisely
because of its usefulness in facilitating
transactions, higher income (GDP)
translates into higher money demand
(all else equal).
Thus, the simple theory of money,
growth, and inflation yields the following syllogism:
1. The price level rises less rapidly (inflation falls) when the demand for money
rises more rapidly than its supply.
2. Money demand rises when GDP
rises, all else equal.
3. Thus, holding the growth rate of
money fixed, inflation falls when GDP
rises.
Inflation that persists when output is
growing at its long-run average rate is
thus attributable to monetary growth in
excess of its demand, which, as an
empirical matter, also increases at about
the long-run average rate of GDP growth.
Temporary accelerations of output
growth beyond the normal rate will
therefore cause inflation to deviate from

its trend. However, holding all else constant, prices in this circumstance should
grow more slowly than normal, not more
quickly, as is often asserted.

-

Quarterly growth rate, percent
4.0

• Is Everyone Crazy?

3.5

If theory speaks so clearly on the relationship between growth and inflation,
why do so many people think that rapidly rising GDP is inflationary? Part of
the answer can be found by expanding
on the simple theory developed thus far.
In addition to income, the theory on the
determination of money demand identifies a second key variable: "the" nominal interest rate.

3.0

The nominal interest rate determines the
opportunity cost of holding monetary
assets. The higher the interest rate, the
greater is the loss from holding wealth in
the form of money instead of alternative,
higher-yielding nonmonetary assets. 8
Thus, an increase in market interest rates
will tend to reduce the demand for
money which, all else equal, will put
upward pressure on prices.

FIGURE!

ACTUAL AND
PREDICTED
INFLATION
Actual inflation
(CPI less food
and energy)

2.5
2.0

1.5
1.0

0.5

-

FIGURE 2 PREDICTED INFLATION
WITH AND WITHOUT
UNEMPLOYMENT

Quarterly growth rate, percent
3.5

3.0
2.5
2.0

Phi llips-curve
prediction with
unemployment"-...

1.5

There is one more piece to the puzzle.
If, at a time of expanding output, the demand for goods and services grows even
faster-as might happen if businesses
and consumers expect times to be even
better in the future - interest rates will
rise. Holding monetary policy (money
growth) constant, inflation will tend to
increase (at least in the short run) if the
negative impact on money demand from
rising interest rates dominates the positive influence of more rapid GDP
growth. Rising prices in this event are
not the result of growth per se, but rather
of demand-driven interest rate pressures
that are correlated with expanding economic activity, which in turn reduces the
demand for money relative to its supply. 9
Two related and important lessons are
suggested by this discussion. First, the
"fact" that a high level of economic activity causes inflation is not a fact at all. To
the extent that price pressures and accelerations of short-run growth are positively correlated, this relationship results
from the tendency for goods and services
demand and market interest rates to accelerate along with output, and for money
demand to decline as a consequence.
Second, the "inevitability" of inflationary pressures when GDP growth rises
substantially above trend is critically
dependent on the stability of these historical correlations. In other words, the
prediction that growth "causes" inflation

1.0

0.5
1968

1973

1978

1983

1988

1993

SOURCES: U.S. Department of Labor, Bureau of Labor Statistics;
and authors' calculations.

can rest securely only on the presumption that the impulse for growth in the
final demand for goods and services will
always outpace that for supply in periods
of rapidly expanding GDP.
This scenario, however, suggests a different perspective than the one offered
by the conventional wisdom. Although it
may be appropriate to "tighten" monetary policy in periods of high demand,
this need not be construed as an attempt
to rein in output growth. An equally
plausible interpretation is that the intent
of such a policy is to slow money
growth to match the realities of the
changing demand for monetary assets.

• The Phillips Curve:
A Reliable Rule of Thumb?
"So what?" might be a reasonable response to the discussion above. As long
as there is a stable and predictable relationship between changes in the inflation
rate and GDP growth in excess of its
long-run average, theoretical niceties are

just that: Nice stories that, although intellectually interesting, have little practical
importance for the appropriate conduct
of monetary policy. As long as abovenormal growth ultimately yields higher
inflation, the policy implication- restrain money growth- is the same
whether you surround the observation
with a simple story or a complicated one.
And, the argument goes, the case that
"above-normal" GDP growth is inevitably associated with inflationary pressures is strongly supported by two wellknown empirical propositions known as
Okun's law and the Phillips curve.
Okun 's law, named after the late economist Arthur Okun, is a rule-of-thumb
relationship between output and unemployment. In its simple form, it is no
more than a statement about the negative
correlation between output growth and
changes in the unemployment rate. 1O
From Okun's law, one might divine the
relationship between inflation and output
growth via the so-called Phillips curve.
The Phillips curve is yet another statistical rule of thumb that posits a negative
relationship between changes in inflation
and changes in the unemployment rate.
Because output rises as the unemployment rate falls (from Okun's law), the
Phillips-curve relationship suggests a
predictable (positive) connection
between changes in GDP growth and
changes in price-level growth.
Although the high-inflation, highunemployment experience of the 1970s
had caused older representation~ of the
Phillips curve to fall into some disrepute,
the incorporation of inflation expectations and subsequent statistical refinements have resulted in its resurrection as
a widely used tool for thinking about
policy. It is co=on now to hear the
Phillips-curve and Okun's-law relationships referred to as among the most reliable in macroeconomics. Because they
form the foundation for arguing that
overly robust GDP growth creates inflationary pressures, it is clear that this
opinion is widely held.
We argue that the implicit message of
modem versions of the Phillips curve"too rapid growth causes accelerating
inflation" -deserves further scrutiny.
Figure 1 compares actual quarterly inflation rates from 1963 to the present with
rates predicted by one variant of the
Phillips curve (based on JeffFuhrer's
"The Phillips Curve Is Alive and Well,"
which appeared in the March/April 1995
edition of the Federal Reserve Bank of

Boston's New England Economic Review). This particular model was chosen
because it represents a particularly careful, thoughtful, and presumably successful variant of the Phillips curve.
As figure 1 shows, the model appears to
conform quite well to the actual inflationary experience of the U.S. economy
over the past 30 years. The fact that it
was estimated for this entire period is one
of its particularly important features,
because the most common criticism of
the Phillips curve is its reputed instability
as a forecasting tool. However, another
important feature of the model is little
appreciated: The success of this version
of the Phillips curve appears, at least in
recent years, to result in large part from
the inclusion of very long lags of the
inflation rate. Figure 2 shows inflation
predictions with and without unemployment included in the specification. Over
the 1963- 93 period, unemployment rate
changes- which through Okun's law
relate inflation to output growth-do
add to the model's predictive power.
Since the late 1980s, however, the predictive value of changes in the unemployment rate is virtually zero. (Estimates are calculated through l 993:IVQ,
reflecting the last available observation
of the unemployment series before the
survey redesign.)

• Is It Time to Rethink
the Conventional Wisdom?
In light of our earlier discussion, it is not
particularly surprising that a rule of
thumb relating changes in GDP growth
relative to some notion of potential
(sometimes called an "output gap") and
changes in the inflation rate might, at
least periodically, fail to capture the
dynamics of price-level growth. The statistical relationship between output gaps
and accelerating inflation is several steps
removed from the direct determinant of
price-level pressures, which is the relationship between the growth rates of
money demand and supply. The notion
that growth causes inflation-even
growth in excess of normal levelsnever was complete because it critically
omits the "money part" of the story, and
accepted theories of money demand and
price-level determination clearly predict
that rising GDP should cause the inflation rate to fall rather than rise.
This is no~ to say that the popular view
of growth and inflation is utterly without
foundation. However, the case for a positive connection between expanding

GDP and inflationary pressures was
always contingent on the presumption
that demand pressures inevitably arise as
a normal characteristic of the rapid expansion phases of a business cycle. The
operationalization of this presumption
has traditionally come from reportedly
reliable and stable relationships between
changes in inflation and measures ofreal
activity. But the reliability and stability
of these relationships are sufficiently
suspect to draw into question their usefulness in thinking about policy today.
The recent economic environment of
rapid growth and nonaccelerating inflation has left many people puzzled. But
such a scenario is clearly possible from a
theoretical standpoint: If accelerating
inflation and presumed output gaps went
together in the past, that is certainly no
guarantee they must do so now or in the
future. Furthermore, the simple statistical framework underlying the conclusion that an acceleration of price-level
growth must follow from an acceleration
of output growth "beyond capacity" is
not as compelling as is often assumed.
It is an opportune time to reevaluate the
language of monetary policy discussions. As with the inflationary episode in
the 1970s, conventional rules of thumb
have been hard-pressed to account for
recent events. Perhaps the information
revolution brought on by rapid advances
in computer technology has broken
down many of the traditional macroeconomic regularities that have informed
our thinking about economic policy, resulting in an absence of money demand
pressures that once may have accompanied output growth above levels considered normal. (Perhaps the answer is as
simple as a significant change in the
"normal" rate of GDP expansion.)

In any event, it is incumbent upon economists and policymakers alike to strive
to co=unicate a deeper understanding
of how various shocks to our economy
affect output, unemployment, and inflation. Rules of thumb that equate rapid
output growth with accelerating inflation
do more than create bad advertising for
monetary policies aimed at pursuing
price stability. They enshrine as theory
statistical connections that are, at best,
indirectly connected to the ultimate
determinant of price-level growth, which
is to say the demand and supply of
money. As such, they retard a more
informed public discussion of monetary
policy and make the job of the policymaker that much more difficult.

• Footnotes
1. Gordon Matthews, "Brace Yourself: I 0
Out of 10 Economists Expect Fed Hike,"
American Banke1; May 19, 1997.
2. Art Pine, "Wary Fed Decides against Interest Rate Hike for Now," Los Angeles Times,
May21 , 1997.

3. "Potential" GDP growth is typically taken
to be synonymous with "long-run average"
GDP growth. Economists often refer to this as
the "steady-state" rate.
4. [n equilibrium, supply equals demand.
More specificaLly, we are describing a condition in which prices rise precisely because money would be in excess supply if
they didn't.

nominal stock expressed in terms of"purchasing power": How many units of goods
and services can be purchased with the stock
of money? For example, suppose that the
stock of money, M , is $5 million, and the
price level , P, is 2. Because the price level is
the number of units of money required to purchase one unit of output, the real stock of
money (in units of output) is 5/2 = 2.5.

7. This statement-which implicitly invokes
the economist's standard "all-else-equal"
clause-is not meant to minimize the difficulties inherent in controlling the money supply.

5. More detailed accounts of the simple, and
thoroughly standard, theory discussed in this
section can be found in almost any introductory economics textbook. See, for example,
Alan Stockman, Introduction to Economics,
Fort Worth: Dryden Press, 1996, chapter 27.

8. To be a bit more precise, opportunity cost
is typicaLly measured as the difference
between the return on short-term Treasury
securities and a measure of the return on a
particular monetary aggregate, such as M2 .
For a recent discussion of the operational
relationship between money and opportunity
cost, see John B. Carlson and Benjamin D.
Keen, "M2 Growth in 1995: A Return to Normalcy?" Federal Reserve Bank of Cleveland,
Economic Commenta1y. December 1995.

6. A simple example clarifies the distinction

9. There is another possible source for rising

between nominal and real variables. Suppose
that the money supply consists solely of dollar
bills. The nominal supply of money would
then just be the number of doLlar bills in circulation. The real money supply would be the

interest rates: rising expectations of inflation.
The role of inflation expectations can significantly complicate the simple theory presented here and make things difficult indeed
for monetary policymakers.

Federal Reserve Bank of Cleveland
Research Department

P.O. Box 6387
Cleveland, OH 44101
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Please send corrected mailing label to
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Material may be reprinted provided that
the source is credited. Please send copies
ofreprinted materials to the editor.

10. For a more complete discussion of
Okun's law, see David Altig, Terry Fitzgerald,
and Peter Rupert, "Okun 's Law Revisited:
Should We Worry about Low Unemployment?" Federal Reserve Bank of Cleveland,
Economic Commentary. May 15, 1997.

-

D avid Altig is a vice president and economist, and Teny Fitzgerald and Peter Rupert
are economists, at the Federal Reserve Bank
of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

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