Inflation and Its Aftermath : ALLAN H. MELTZER

ALLAN H. MELTZER <i> is J.M. Olin Professor of Political Economy and Public Policy at Carnegie Mellon University and a visiting scholar at the American Enterprise Institute. </i>

The overstatement that characterizes much of what is called news has been directed, once again, toward inflation. Much of the recent excitement was caused by a spurt in the producer price index. This measure, heavily weighted toward prices of imports and raw materials, rose by 1% in January and February before subsiding in March. Responding to the threat, the Federal Reserve Board raised interest rates, and its members tried to seem determined when they talked about the problem of renewed inflation and their commitment to a return to price stability.

Memories of the 1970s and the recession of 1981-82 are so recent that few need to be reminded about the costs of inflation and disinflation, the latter including recession. Critics of the Federal Reserve, particularly on Wall Street, express concern that the Federal Reserve has not responded more aggressively to counter inflation. Although I have urged for many years that inflation should be eliminated totally, I find these criticisms misdirected and misplaced.

The greater risk at the moment is not that the Federal Reserve will do too little but that it has done too much. The driving force in any sustained inflation is the prior rate of money growth. Without excessive money growth, inflation cannot persist. Recently, the growth rates of all monetary aggregates have been reduced, many to the lowest rates in years. These reductions began in early 1987 and gained momentum in the summer of 1987. Money growth remained at a low rate through 1988. Since late last year, money growth has fallen further.

A recent spurt in oil prices increases the risk that monetary policy will remain restrictive too long. The oil price rise is the result of disruptions in supply, particularly in North Sea oil production. Events of this kind are distinct from the sustained inflation produced by excessive stimulus to demand.


The rise in oil prices will at most raise the price level for a few months while inflation, if unchecked, results in a continuing stream of price increases that affect a wide range of goods and services. The problem is that the effects of the oil shock will be interpreted as evidence of a sustained, or increasing, rate of inflation that requires additional monetary contraction.

The initial response to slower money growth is slower growth of spending and output. Evidence of slower growth has now become apparent.

Most measures of domestic spending on housing, autos and retail sales, and on a variety of related items, give evidence that the economy’s growth has slowed. Growth of foreign demand for our exports has slowed also in recent months.

There are rising concerns about a recession, which is defined as two quarters of negative output growth. It does not matter much for current purposes whether we face a mild recession lasting two quarters or positive, but sluggish, growth of output for a few quarters. Economic forecasters have difficulty distinguishing between these alternatives, so there is not much point in sifting through their forecasts or guessing how much the economy will slow. What we know with reasonable reliability is that the first effects of restrictive Federal Reserve policy are now being felt.


A period of slow growth, or even a mild recession, would be a small price to pay for getting the economy on the path toward price stability. The problem is that slow growth or recession is likely to set in motion forces that would, in time, lead to higher--not lower--inflation. The reason is that the Federal Reserve would be pressured from many sides to stimulate the economy by raising money growth to reduce interest rates. Concerns about farmers, bankers, Latin American debt, unemployment, thinly capitalized savings and loans and the increased government budget deficit (as tax collections fell) would be used to justify a more expansive policy.

If the Federal Reserve would respond by pushing up money growth, we would be back to the stop-go-stop policy that brought us rising inflation, rising unemployment and rising interest rates from the mid-1960s to the early 1980s. A return to this policy now would mean that the recent 4% or 5% inflation would become the floor from which inflation would rise in the 1990s. This would be a costly mistake.

The current inflation is the result of high money growth in 1986, when money growth soared under the Federal Reserve and Treasury policy of devaluing the dollar. The surge in money growth devalued the dollar, encouraged exports and stimulated domestic spending. Gradually, the increased money growth worked its way through the economy and has now emerged as higher inflation.

In my first column in this space, in August, 1987, I warned that higher inflation was the likely result of what was then called the Volcker standard, in honor of Paul A. Volcker, the Fed’s chairman when the policy was in effect. That policy was mistaken. We are now paying for the mistake.

Since 1987, the Federal Reserve has recognized that inflation can best be eliminated by steady, non-inflationary policies. In his February testimony, Federal Reserve Chairman Alan Greenspan emphasized that “maximum sustainable economic growth over time is the Federal Reserve’s ultimate objective. The primary role of monetary policy in the pursuit of this goal is to foster price stability.” And he recognized that “inflation cannot persist without a supporting expansion in money and credit.”

The problem lies not in the goals but in the implementation. The Federal Reserve has been basing its recent actions on the belief that the economy cannot grow more than 2.5% or 3% a year without causing inflation to rise. When the economy shows signs of growing faster than 2.5%, the Federal Reserve raises market rates and reduces money growth. This is the main reason for slower money growth and a principal reason for higher interest rates in the past six months and rising concerns about recession.

The Fed’s principal mistake has been to use monetary policy to accomplish multiple objectives. In 1986, the objective was devaluation even if it produced a surge in prices. In 1988, the objective was slower real growth and disinflation. The result of this shifting about is likely to be the return of stagflation--continued inflation, slow growth or possibly a brief recession.

It is encouraging to have the Federal Reserve accept the restoration of price stability as its goal and to announce targets for money growth that, if achieved, would move toward that goal. Alas, there is no sign that the Federal Reserve is trying to achieve its targets. It continues to act as if there are only two speeds--too fast and too slow. As long as that is true, stable prices will elude us.