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An anti-inflationary policy is a pro-growth policy

April 1, 1997


photo of Arthur J. Rolnick

Arthur J. Rolnick Senior Vice President and Director of Research, 1985-2010

An anti-inflationary policy is a pro-growth policy

Recently, I had the pleasure of appearing on the Minnesota Public Radio program "Sound Money," a weekly show dedicated to matters of personal finance. Many callers to the show had questions about how the Federal Reserve conducts monetary policy and why, at times, it chooses to raise its target rate of interest.

Not surprisingly, the public tends to follow the Federal Reserve more closely when it is moving toward a tighter monetary policy, that is, when the Fed decides to raise its federal funds rate target (the short-term rate at which banks lend reserves to each other). That is especially true now, when the economy is in the sixth year of an expansion, unemployment is low, the stock market has performed beyond the expectation of even the most optimistic bulls, and there is currently little sign of inflation.

Given these economic conditions, many commentators in the media have recently branded the Fed as "anti-growth." One pundit from the New York Times wrote: "You could almost hear the knees of financial analysts knocking as you read that the Federal Reserve will probably have to raise interest rates again next month if this rampaging monster of an economy doesn't hurry up and slow down."

Another, from the Washington Post: "Growth doesn't cause inflation. Growth doesn't cause inflation. Growth ... Well, you get the idea—even though, apparently, the Federal Reserve Board doesn't."

And this comment appeared in a Reuters wire story: "It is unconscionable to have the Federal Reserve system close off economic growth ..."

It certainly would be. And one sure way of closing off economic growth would be to allow for the pernicious acceleration of inflation. But I'm getting ahead of myself. To understand why the Federal Reserve chooses to raise the federal funds rate, and why this is a pro-growth and not an antigrowth move, I first have to answer some of the questions I heard on the "Sound Money" program, namely: What are open market operations? Does the Fed lead or follow the market? And why would the Fed decide to move without first seeing any signs of inflation? Of course, the answers to these questions are related, but I will take them one at a time.

What are open market operations? Open market operations are how the Fed adds to or subtracts money from the economy. As the nation's central bank, the Federal Reserve holds about $400 billion in government securities; by buying and selling those securities, the Fed changes the monetary base—the amount of Federal Reserve notes and bank reserves the public holds. A purchase adds to the monetary base and a sale subtracts.

The policies guiding open market operations are set by the Federal Open Market Committee, consisting of the seven members of the Board of Governors and the 12 Federal Reserve bank presidents, five of whom are eligible to vote at one time.

Does the Fed lead or follow the market? I would argue that the Fed usually follows the market. This current period is a good example. The U.S. economy is very strong, much stronger than people expected—and not just our economy, but many other economies throughout the world, generally speaking, are doing well. With an increase in the demand for loanable funds worldwide, and with credit markets worldwide, you should see rising interest rates; and, indeed, interest rates have been going up. So the Fed followed the market; the Fed let the federal funds rate rise after other rates had increased.

This discussion naturally leads to the last question: Why would the Fed decide to move without first seeing any signs of inflation? And the answer also follows from the previous question: If, in this environment of rising market rates, the Fed would artificially keep the federal funds rate low, it would have to substantially increase the monetary base. This, in turn, would ultimately cause more inflation.

One of the most robust relationships in all of economics is the long-term relationship between the growth of money and the rate of inflation. What economists have observed in different countries and under different economic conditions is that, over time, an increase in the rate of growth of money will lead to an increase in the rate of inflation.

One of the Fed's responsibilities is to control the money supply. Right now the money supply is growing a bit fast—it's above our ranges and that raises red flags. In a strong economy, where interest rates are being driven up because people want to borrow more, the only way that the Fed can fight the market and try to keep the federal funds rate artificially low is by injecting more money into the economy. And if the Fed would put more money into the economy, even if there are currently no signs of price pressures, it would eventually cause inflation.

And so I come back to the pundits who say that the Fed is obsessed with inflation and not concerned about growth. But they miss the point. The Fed is not vigilant against inflation for inflation's sake, it's just that inflation is bad for economic growth. The Fed is well aware that growth does not cause inflation (witness the previous six-year expansion with little inflation and the expansion of the 1980s), but it also knows that inflation can threaten economic growth. (I'm sure that the above critics can recall the double-digit inflation of the late '70s and would not care to revive those times.)

The US economy did not create 27 million new jobs over the last 15 years by accident. It did this, in part, because the Fed under Paul Volcker began to recognize the problems with inflation and started to bring it down, to create the right environment for economic growth. The growth of the 1980s and this decade has been characterized by low inflation, and, if this growth is to continue, the Fed will have to remain vigilant about inflation.

The proper way to view a decision by the Fed to increase the federal funds rate is not as a reaction to growth. The central bank does not have a vendetta against growth, quite the opposite: One of the Fed's goals is to provide the proper monetary environment for sustained economic growth.

If growing inflation creeps into this expansion, it will threaten economic growth on its own. At that point, everyone will agree that the Fed will have to tighten policy, but by then it will be too late. For growth to continue, the Fed must remain on guard against inflation.

In the end—and this bears repeating—inflation is bad for economic growth. And the Federal Reserve's policy, even though it's often misinterpreted, is an anti-inflation policy, which is another name for a pro-growth policy.