Growth & Inflation

June 20-26, 1994

By Charles Vaughan

Growth’s role in causing inflation has been inflated

We are all afraid of inflation. The burning question is: Should we also be afraid of growth?

If you have been following the media’s coverage of the economy, you probably would say yes. The ruling economic theory in the media these days is this: There is a direct, serial correlation between economic growth and the rate of inflation.

If this is true, then we are right in cheering when reports show slow to modest growth, because that means we will have inflation under control. If it is not true, well, heaven help us, because we are sailing off into the sunset on the wrong ship. That could mean we have killed a nice little recovery without cause. Or worse, it could mean we will wind up with a soggy economy and an unacceptable level of inflation. So it would seem wise to examine some hard economic data to see if this theory holds water.

Inflated correlations
Now if we look only at our domestic economy and we keep our history short enough and recent enough, our theory has a chance. But if we look back at the solid growth of the 1950s, with its moderate inflation, or the ram)and inflation of the 1970s, with its non-growth, we find a few leaks.

If we examine data from around the world, we have to man the heavy duty bilge pumps. Countries such as Singapore, Taiwan and Australia have maintained low inflation despite steady growth in gross domestic product. Many countries with high inflation rates  Greece, Hungary and Venezuela are examples  have seen rising prices despite low growth.

It would help our sinking theory if we could assume that what applies to the rest of the world does not apply to the United States. Some economists do this by explaining away any errant data. If we did this with data from other countries, leaving only the data that fits well, we would have virtually nothing left.

Growth just one factor
So where do we go from there? Perhaps it would help us to remember some of the lessons that the rest of the world knows well. Primary among these is that inflation is always a monetary issue. During the period that the Federal Reserve was fostering lower interest rates, it was also increasing the money supply significantly. Even after beginning to tighten rates, it continued to allow expansion of the money supply.  The funny thing about money supply is that it is like a piece of string.  You can let out increasing amounts of it, but you cannot push it.  Unless there is enough loan demand to take the money offered, thus pulling on the string, there is no growth.  In the present case, the money was used by the banking world to buy bonds rather than making loans.  Now that the bond boom is history and loan demand is increasing, the money is finding its way into the stream of commerce.

A certain increase in the inflation rate is almost inevitable for three reasons.  First, there is always a lag as monetary expansion filters through the economy. This is already under way.  Second, there is a rising inflationary psychology. The fear of inflation often begets a bit of defensive inflation as people figure that if things are going to cost more, they need to buy more now. We already are seeing this in some commodity prices. Third, as we saw in the 1970s, higher interest rates alone do not stop inflation. In fact, to a certain degree in the short run, they are inflationary. There is a significant time lag required before the full, deflationary impact is felt.

Unless our policy making economists stop seeing growth as the lone culprit and start focusing on important monetary policy and fiscal-control issues, we are in for some very unpleasant sailing.

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