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Where is the inflation?

Top of the Ninth

September 1, 1994


Where is the inflation?

All too frequently it is alleged that the Federal Reserve is anti-growth, and it is suggested from time to time that the Federal Reserve desires subpar economic performance so as to rein in inflation. Such statements, or attribution of such sentiments to the Federal Reserve, are inaccurate. To the contrary, I believe our actions are in the interest of a sound, healthy economy; they are pro-growth.

There is no question that the national economy has been doing reasonably well for some time now. The current economic expansion began in the spring of 1991 and thus has been under way for over three years. Strength has been especially pronounced in consumer spending on durable goods, in new homebuilding and in business spending on equipment. These are all interest-sensitive components of activity which have benefited from low interest rates. The expansion has also been accompanied by modest inflation. Recently, moreover, the expansion has gained momentum, as evidenced by large increases in employment and an acceleration in growth of real GDP.

In this generally positive setting, especially one with modest inflation, the questions I am most frequently asked are: Why is the Federal Reserve so concerned about inflation, and why has it raised short-term interest rates this year? These are, in fact, good questions because they get to some of the fundamentals of monetary policy, for which we in the Federal Reserve are responsible.

It is certainly true that inflation has been relatively benign through this expansion, and there is as yet no convincing evidence that it will accelerate soon. But not much comfort can be taken from these observations.

The indicators I have cited, in particular the inflation measures, are backward looking; they tell us what inflation has been, not what it will be in the future. Yet it is future inflation about which we are concerned and which we can influence with monetary policy. But that influence takes time.

Sound policymaking therefore requires a focus on the future. Federal Reserve monetary policy affects the economy with a lengthy lag, which implies that policy actions taken today will not affect the economy for months, perhaps many months, to come. Hence, economic policymaking necessarily involves forecasting the course of the economy if policy is left unchanged, as well as understanding how and when changes in policy are likely to affect the future course of business activity.

Of course, this is not yet an answer to one of the questions I posed at the outset, namely: Why has the Federal Reserve raised short-term interest rates this year? The answer to this question involves two mutually reinforcing views of the inflationary process. First, given the pace at which the economy was expanding and the rate at which resources were being used, it seemed only a matter of time before inflationary pressures began to build and, ultimately, inflation to accelerate. That is, experience suggests that as the economy operates close to capacity, inflationary pressures grow. To be sure, the timing between development of capacity pressures and the onset of inflation is uncertain, and it may be that this relationship is not as reliable as formerly. But it is probably unwise to ignore historical experience altogether.

In the capacity-inflation relation, the lag in the effect of a policy action on the economy is critical for, because of the lag, action has to be taken sufficiently early so that inflation does not become a more serious problem in the future. In short, responsible economic policy frequently requires action before a problem becomes apparent to all. Indeed, once it becomes a problem well entrenched and obvious to all, experience suggests that, at least with regard to inflation, it is a long and costly matter with which to deal, an experience best avoided.

A second way of looking at this issue is to note that had we in the Federal Reserve chosen to peg artificially short-term interest rates at the low levels prevailing at the outset of the year, this would necessarily have involved adding reserves more generously to the banking system than in fact was the case. In turn, this would have led to more rapid growth in money, the classic precursor of an acceleration in inflation. The point is that pegging interest rates at any particular level may turn out to be a serious policy mistake because of its implications for reserve provision and, ultimately, economic performance.

The answer to the question I posed about Federal Reserve concern with inflation draws on our understanding of economic performance. First, it is not inflation, per se, that we in the Federal Reserve are ultimately interested in, but rather long-term economic growth and sustained prosperity. Let there be no doubt about it, sustained growth and prosperity are the ultimate objectives of monetary policy.

We are concerned about inflation, but this is because history, both here and abroad, demonstrates that economies do better over an extended period in an environment of low inflation than in an environment of high inflation. That is, economies with low inflation generally perform better than those with high inflation. Experience in the United States over time makes the same point. Why this is so is not entirely clear; it may be that inflation obscures relative price changes and therefore interferes with efficient resource allocation. In any event, both economic theory and practical experience suggest that the most significant contribution of monetary policy to sustained prosperity is to bring inflation down and keep it down.