August 23, 2004, 8:15 a.m.
Break the Inflation-Growth Link
. . . once and for all.

More than one economist has jumped on the inflation bandwagon of late. In reading a recent mutual fund company’s evaluation of the economy, I came across the following comment: “While most of us eagerly awaited this outcome [global economic growth], a heightened likelihood of higher inflation and rising interest rates has tagged along.”

Why do economists continue to link economic growth with inflation?

Most economic textbooks tell us that inflation is too much money chasing too few goods. Therefore, it just doesn’t make sense that a boom in the production of goods and services would lead to inflation. On the contrary, supply-siders believe that increased supply (of goods and services) should lead to lower, not higher inflation.

The other implied linkage — between higher interest rates and economic growth — makes little sense either.

Many economists have warned us that budget deficits would cause higher interest rates. Yet we have seen a swing from a $200 billion surplus to a $450 billion deficit with interest rates essentially going down, not up. More likely than not, the Federal Reserve controls interest rates, and it has said, through the Open Market Committee, that inflation is a concern and that emerging inflation will trigger Fed-induced increases in interest rates (the federal funds rate). So far, that action has been minimal. If inflation remains subdued, so also will interest rates in this Fed framework.

In the old days, money and banking textbooks would equate the Fed’s ability to create money to a circling helicopter that dropped dollar bills. People would take this money and bid up the prices of available goods and services. By definition, that was inflation. Fortunately, this analogy is what it sounds like — a fairy tale.

When the Fed controls interest rates (i.e., the price of money), it can’t directly control the quantity of money. (Note that the definition of “money” is subject to interpretation, so we have to be careful. For example, the Fed can determine its holdings of financial assets by buying or selling Treasury bills that, in turn, influence reserve balances. If we assume that Treasury securities aren’t money, but that reserve balances are money, then the Fed can “control” the money supply). If the Fed controls the money supply in this way, it cannot control the fed funds rate.

Again, in the old days, when monetarists attempted to control the money supply within targeted growth bands, the fed funds rate changed like stock quotes on the New York Stock Exchange — and the Fed still couldn’t control the money supply. The fed funds rate exhibited extreme volatility in the 1970s and early ’80s under monetarism, and relative stability during the late ’80s and ’90s under a price rule (i.e., the Fed’s focus on controlling interest rates rather than the money supply). This stability in interest rates may have also contributed to the long-term downtrend in long-term interest rates. So the helicopter analogy is now a fable, although you still might find it in traditional economics textbooks.

So, if money isn’t the independent variable, then what is? The answer is fiscal policy.

The government decides to spend money on goods and services and, in the process, adds net financial assets (savings), stimulating the economy by creating demand for goods and services. When the government runs a budget deficit — or spends more than it collects — it is increasing net financial assets and the demand for goods and services; when it produces a surplus, it is shrinking outstanding net financial assets (reducing savings), which results in a reduction in the demand for goods and services.

Since the federal government plays an important role in influencing economic growth, it can also be the villain when it comes to inflation. Excessive government spending can create inflation when that spending strains the ability of the economy to supply goods and services. One way to measure the prospect of inflation is to look at specific measures of inflationary pressures — such as capacity utilization and employment. If the government’s spending is consuming too many resources and, in the process, outbidding the private sector, then inflation becomes a problem. Monitoring these measures of inflationary pressure can provide a meaningful mechanism for economic observers to legitimately criticize fiscal policy when it is creating inflation. If the government knows to control spending when these signals are flashing red, then inflation can be controlled or minimized.

Even if there are demand pressures on domestic resources, the world’s burgeoning free-market economies may go a long way toward providing goods and services to U. S. consumers as demand rises. This external source of capacity and labor implies that inflation is a lot less likely today than it had been during previous economic expansions when supply fell behind demand. The development of free-trade relationships coupled with technological advances have reduced the likelihood of higher inflation and higher interest rates, which are once again being erroneously linked to economic growth. The recent unexpected rally in the bond market may be an early indicator of these new relationships.

Over the past few months we have had modest inflation with the latest report on both the producer price index (PPI) and the consumer price index (CPI) indicating only a 0.1 percent monthly increase in the core rate of inflation — modest by historic standards — even though oil prices have undoubtedly affected the prices of goods and services outside of the energy sector. Don’t be surprised if inflation remains low by historic standards and by a Fed policy that responds by keeping interest rates low as well.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.

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