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D R A F T Febiuaiy 22, 1995

Growth and Inflation:
Siamese Twins or Odd Couple?

Jerry L . Jordan
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

Cleveland Business Economists Club

Noon
February 27, 1995 Federal Reserve Bank of Cleveland
Cleveland, Ohio

NOTES:
1. Jerry will be introduced at about 12:45, and the meeting will adjourn at 1:30. So, Jerry
has about 30 minutes for the speech and about 15 minutes for Q. & A.
2.

Reporters are expected to attend.

3. Jerry addressed this group on September 23, 1992 on "The Role of Structure in
Economic Decisionmaking."
4. Jerry addressed this group when they met in this Bank on February 28, 1994. He spoke
on two paradigms for managing monetary policy [estimate aggregate supply growth and
match aggregate demand growth to it; and estimate money demand growth and match money
supply to it], and on the differences in two lists of "bumper stickers."

I.

Introduction
A.

Acknowledge the introduction.

B.

Welcome the Club to the Bank.
1.

C.

Club was here last February 28.

My topic is the relationships between growth and inflation.
1.

Title is "Growth and Inflation: Siamese Twins or Odd Couple?"

2.

Siamese twins are always together, which is how some people think of
growth and inflation.

3.

In my view, growth and inflation are an odd couple. Sometimes they
are seen together, but generally they go their separate ways, and indeed
are pretty much incompatible.

2

II.

Two Basics: Inflation Hampers Prosperity, and the Fed Fights
Inflation [Very briefly fo r this audience o f economists]
A.

Inflation hampers prosperity in four ways:
1.

It interacts with the tax code to discourage saving and investment.

2.

It diverts resources to hedging activities.

3.

It shrinks an important unit of measure, wasting resources by making
measurement more complicated.

4.

It pushes interest rates up, reducing investment and shifting it toward
shorter-lived investments.
a.

This does not mean that an interest premium for expected
inflation, which increases nominal but not real interest rates,
always reduces investment. Normally, investors are concerned
with real rates, not nominal rates. However, there are two
ways that inflation expectations do reduce investment.

b.

First, an increase in nominal interest rates can restrict
investment by businesses and households that are liquidityconstrained.

c.

Second, uncertainty about the amount of inflation causes lenders
to add a real premium to interest rates to compensate for the
uncertainty, which will reduce investment.

B.

The Fed fights inflation:
1.

The FOMC’s domestic policy directive says "The Federal Open Market

3

Committee seeks monetary and financial conditions that will foster
price stability and promote sustainable growth in output."
2.

Alan Greenspan has told Congress that the mission of the FOMC is to
"ensure maximum sustainable growth by pursuing and ultimately
achieving a stable price level." (7/22/94)

3.

Greenspan has told Congress "When it comes to inflation expectations,
the nearer zero, the better." (Humphrey-Hawkins testimony, 2/22/94)

4.

Greenspan also said (2/22/94), "We will be at price stability when
households and businesses need not factor expectations of changes in
the average level of prices into their decisions."

5.

Inflation has been brought down by more than 10 percentage points
since October 6, 1979. [The CPI rose 13.3% in 1979 (Dec to Dec)
and about 2.7% in 1994 (Dec to Dec)]

6.

III.

The Fed raised the fed funds rate 7 times in the last 13 months.

Interest Rates and Inflation
A.

Did the Fed really raise interest rates last year?
1.

"Everyone" says the Fed raised interest rates last year.

2.

But, market forces determine most interest rates.

3.

The Fed controls only the discount rate and the fed funds rate.

4.

Last year, most long-term interest rates were rising before the Fed
acted.

4

B.

Why did the Fed raise the fed funds rate?
1.

Not to tighten, but to avoid becoming too easy.

2.

The Fed adjusted the fed funds rates to avoid inflationary growth of the
money supply.

3.

In last year’s strong economy, rising demand for funds was pushing
interest rates up. If the Fed had provided enough reserves to keep the
funds rate from rising, money supply growth would have been faster
than what the FOMC judged was consistent with avoiding an increase
in inflation. Simply put, the Fed was not so much tightening as it was
trying to avoid an unwise easing.

C.

Raising short-term interest rates can actually lower long-term nominal interest
rates by reducing inflation expectations.
1.

If the Fed had prevented the fed funds rate from rising last year, long
bond rates could very well be much higher now than they are.

IV.

Inflation and Real Economic Growth: The Long and the Short of It
A.

The Fed does restrain nominal growth but not real growth.
1.

Distinguish between nominal economic growth and real economic
growth.

2.

Obviously, when nominal growth exceeds real growth, the price level is
rising.

3.

It is then merely a tautology to say that the Fed must restrain nominal

growth to restrain inflation.
4.
5.

But nominal growth is of little consequence compared to real growth.
The important question is, does the Fed, in restraining inflation,
restrain real growth? In the most important sense, the answer is "no."

The long and the short of it is that inflation and real growth can be directly
correlated over the course of a business cycle even though they are inversely
correlated over the long run. Let me elaborate:
1.

The real growth rate can be directly correlated with the inflation rate
over a business cycle.
a.

At some stage in an expansion, prices may rise faster than
normal as demand growth outpaces supply growth.

b.

At some stage in an economic slowdown, prices may fall (or
rise at a slower-than-normal pace) if demand growth weakens
relative to supply growth. [This wouldn’t happen if the
contraction were caused by a supply shock.]

c.

On average, however, price rises that are faster than normal will
be offset by those that are slower than normal.

2.

However, the correlation in the short run does not tell us anything
about the long-run impact of the average inflation rate on real
economic growth and standards of living.
a.

The positive correlation over the business cycle does not prevent
higher average inflation from being associated with lower

6

average growth, or with lower standards of living, in the long
run.
C.

Real growth is harmed by inflation over the longer run.
1.

Refer to the arguments in section II. A.

2.

Some but not all empirical evidence supports those assertions.
a.

One difficulty with empirical investigations is that all output is
considered equally valuable, even if it is activity intended to
hedge against inflation or to correct for problems caused by
inflation, rather than activity that contributes to improved
standards of living.

V.

Is Bringing the Inflation Rate Further Down Good Policy?
A.

The inflation rate is already quite low. Should the Fed try to bring it down
even further?

B.

One practical problem for policymakers could be measurement accuracy.
1.

This was not important when the inflation rate was high.

2.

Now, when the measured inflation rate is low, accuracy becomes an
issue if our target is zero.

3.

Analogy: Suppose you are sailing north on Lake Erie but want to
avoid crossing the Canadian border. Not knowing your exact location
is not a problem when you are near the Ohio shore, but it is a problem
when you are far out on the lake.

4.

However, our Research Department has done work that suggests the
biases in the CPI are very small. [Mike Bryan and Steve Cecchetti,
"The CPI as a Measure of Inflation," Economic Review, 1993 Quarter
4.]

The key issue is net present value of costs and benefits from lowering the
inflation rate.
1.

Costs of reducing inflation are hard to estimate.

2.

Benefits of lower inflation are hard to estimate.

3.

However, to argue that there is a net loss from lowering the inflation
rate is the same as arguing that there is a net gain from raising the
inflation rate, unless you also argue that the effects of changing the
inflation rate are not symmetrical.
a.

It is absurd to believe that there are net gains from raising the
inflation rate. Countries that have experienced hyperinflation
did not experience golden ages of prosperity.

b.

I have not yet heard an argument that convinces me that the
results of lowering the inflation rate would not be the opposite
of the results of raising the inflation rate.

8

VI.

Conclusions
A.

The Fed opposes inflation, not growth.

B.

Restraining inflation is beneficial, not harmful.

C.

Inflation and growth may be Siamese twins within a business cycle, but they
are an odd couple in the long run.

D.

Further reduction in inflation is desirable.