Inflation (Finance) ; Recessions ; Monetary policy

Darryl R. Francis

English

Research Papers in Economics

IT IS good to have this oppoi~nityto discuss with
you some of the problems confronting policymakers
during these troubled economic times, Early last year
the pace of real growth in the U.S. economy started to
slow, and in the first three quarters of 1974 the na-
tion’s output of goods and services declined. At about
the same time that output started to slow, the pace
of inflation accelerated.
From the standpoint of a policymaker trying to
formulate a strategy for stabilization policy, these two
developments appear to he in direct conflict with one
another, The slowdown in real growth, carrying with
it a threat of rising unemployment, suggests that mon-
etary and fiscal policies should be stimulative. The
quickening and persistence of inflation, on the other
hand, seems to call for monetary and fiscal restraint.
This conjunction of developments, which is called
“stagflation” by some, thus poses a dilemma for
policymakers.
The basis for the dilemma is the common belief
that inflation and unemployment can, in some sense,
be viewed as symmetrical problems. By symmetrical,
I mean opposite sides of the policy coin — when
economic policy is too stimulative, you get inflation;
when policy is too restrictive, you get increased un-
employment. In many policy discussions this dilemma
is couched in terms of the so-called Phillips curve.
During the course of my remarks I will point out
what I consider to be some major deficiencies under-
lying the notion of the Phillips curve, that is, an ap-
parent trade-off between inflation and unemployment.
Recent economic experience along with recent re-
search results suggest that we need to modify our
thinking about this relation. These recent develop-
ments in economic thinking carry important implica-
lions for stabilization strategy.
Before turning to these problems of policy formula-
tion, I would like to review briefly our recent eco-
nomic experience. As we are all painfully aware, the
U.S. economy is currently undergoing some uncom-
fortable adjustments. To provide some perspective on
recent developments I would like you to examine with
me the first chart among the set that has been dis-
tributed to you.
By way of introductory comment, I want to empha-
size the importance of keeping our perspective as we
attempt to analyze and understand our recent eco-
nomic experiences. I find charts of this type very
useful in this respect — providing a visual summary of
the U.S. economy over the last two decades. I will
return to this point later, but I feel that our current
state of economic disarray is related in large measure
to a lackof perspective in the formulation of economic
policy, both now and in the past.
Let me begin by reviewing recent trends in the
growth of the money stock, which are shown in the
top tier of Chart I. Since early 1972, the nation’s
money stock has increased at a 6.8 percent annual
rate. This rate of expansion represents a step-up from
the 6 percent average rate of increase from late 1966
to early 1972. These average rates of money expansion
for the last eight years compare with a 3.4 percent
average rate of increase during the early 1960s and
a 1.8 percent average rate of expansion during most
of the decade of the 195Os.
Look now at the second tier in Chart I, which
shows the general movement of prices over the last
two decades. I feel that the top two tiers of this chart
provide support for the proposition that inflation is a
monetary phenomenon. The general movement of
prices is closely related to the trend rate of monetary
expansion.
Page 3
Inflation, Recession — What’s a Policymaker To Do?
A Presentation by DARRYL R. FRANCIS, President, Federal Reserve Bank of St. Louis,
Before the Illinois Economic Association,
Peoria, Illinois, October 25, 1974a
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wFEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974
To understand better the recent acceleration of
prices, a shaded area has been included representing
the period when the price-wage control program was
in effect. In retrospect, it appears that controls had
the effect of keeping reported prices down in late
1971 and throughout 1972; but it should he clear that
such measures have oniy temporary effects, especially
when the rate of monetary expansion is left unchecked.
Consequently, I think the very rapid 9.0 percent rate
of price advance since late 1972 is in ‘arge part a
catch-up phenomenon following the period of controls.
Some analysts attribute the recent outburst of infia-
lion to the operation of special factors — the oil em—
hargo, the Russian wheat deal, two devaluations of
the dollar, and so on. These events are labeled as
special factors because they appear to he beyond the
control of our monetary and fiscal authorities. I find
it impossible to swallow this “special factor” explana-
tion of mfiatum. If we maintain our perspective, we
note that, in part, these special factors occurred in re-
sponse to conditions created by previous mistakes in
economic policy.
Our current energy problems are not completely
unrelated to the increased demand for energy associ-
ated with the rapid pace of economic expansion in
1972 and 1973, an expansion fueled by very stimu-
lative monetary and fiscal actions. The supply of do-
mestic energy, on the other hand, was discouraged by
implementing an economic policy of wage and price
controls. Furthermore, the worldwide inflation should
not be considered a special factor since it is related to
the rapid monetary expansion in the United States.
With a system of fixed exchange rates where the dollar
serves as a reserve currency, the rapid monetary ex-
pansion in the United States resulted in a rapid accu-
mulation of worldwide reserves, which, in turn, led to
monetary expansion and inflation in other coulltries.
Ia mnot willing to accept the special factor explana-
tion of inflation because that explanation removes the
focus from inflation as a monetary phenomenon. By
losing si~cha focus I think we are -abdicating our
responsibilities as policymakers. Pretending that the
bulk of our inflation is caused by factors other than
excessive monetary expansion runs a great risk that
the rate of monetary expansion svil] be stepped up
further in an attempt to avoid possible reductions in
real output growth currently.
An examination of recent trends in output and un-
employment (third and fourth tiers of Chart I) sug-
gests that current economic acivity is very sluggish.
Real output remains below the level of early 1973,
and since late last year unemployment has been ris-
mg. However, if we maintain our perspective, we note
that output is still up at a 3.1 percent average annual
rate from the end of the 1969-70 recession, and total
civilian employment has increased at a 2,5 percent
average rate during the same period.
Let me now turn to the issue that I raised
earlier — is it appropriate to treat inflation and
unemployment as symmetrical problems in policy
discussions? The result of such discussions is that
stabilization policy should attempt to walk a tightrope
between these two problems, providing just the right
growth of total demand so that neither inflation nor
unemployment occurs.
Recent experience is again reminding us, however,
that inflation and unemployment can emerge simuL
taneously, as we have just seen in Chart I, Inflatioll
persisting in the face of rising unemployment cur-
rently runs coullter to predictions based on the Phil-
lips curve. In other words, the Phillips curve does
not provide an adequate explanation for events as
they seem to be evolving now. At the present lime
there does not seem to be a “right” amount of total
demand that will permit the achievement of both
full employment and price stability.
To understand better the nature of the relationship
between inflation and unemployment, let us now turn
to the rest of the charts that have been distributed to
you. Chart II is a scatter diagram of the infialion~
unemployment experience of the lJnitecI States from
1953 through 1973. Each dot represents a year in that
period. The unemployment rate has ranged from a
low of 2.9 percent of the labor force in 1953 to a high
of 6.8 percent in 1958, and the average for the entire
period was 4.9 percent. The inflation rate, as measured
by the annual rate of change ill the consumer price
index, has varied between minus 0.5 and plus 8.4 per-
cent for the 1953-73 period, averaging 2.6 percent
per year. Indications are that 1974 svill record about
a 5.5 percent average j’ate of unemployment and al-
most a 12 percent advance in prices.
Examination of Chart II clearly demonstrates that
there does not exist any systematic relationship be-
tween inflation and unemployment. What we do ob-
serve is a greater tendency for the unemployment
rate to cluster about its mean than does the inflation
rate. Association of dates with the dots also indicates
that the infiatioll rate has moved progressively higher
since the mid-1960s. For all years since 1966, the infla-
tion rate has been above the average for the 1953-73
period, but the unemployment rate has not remained
Page 5FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974
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1972
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below the average, as followers of the Phillips curve
would lead us to believe.
Charts III aild IV allow us to examine the relation-
ships between inflation and unemployment relative to
the key determinant of growth in total demand — the
rate of monetary expansion. Consider first the relation-
ship between monetary growth and unemployment
presented in Chart III. Examination of this chart fails
to indicate any systematic relationship between the
two variables. In other words, the level of unemploy-
ment does not appear to bear a directly observable
relationship to the trend rate of monetary expansion as
measured by a two-year average rate of change. What
Chart III does imply is that overthe last twenty years
the level of the unemployment rate in the U.S. econ-
omy has taken on values quite independently of the
trend rate of monetary growth. Based on this cursory
examination of the data, I conclude that the trend rate
of monetary expansion over a period as long as two
years contributes little to the explanation of mov&
ments in the unemployment rate. I might add, how-
ever, that this conclusion does not deny any transitory
effects of short-run monetary accelerations and decel-
erations on employment and unemployment.
Consider now the relationship between inflation
and monetary growth presented in Chart IV. The
relationship is closer than that between unemploy-
ment and money. Nineteen of the twenty-three ob-
1965
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1954
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Prices
Co.s,~ier Pricis
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Chon II
and Unemployment
1953 -197 3 Conv~.r Pricts
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Unemployment and Money
UaompIoy~tnti~’e 19531973 umemploymeet a.t.
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servations fall in either the lower left or upper right
quadrant. The relatively loose fit does indicate other
factors have an influence on the movement of prices
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Prices and Money
1953-197 3 Coes~ flier Prhes
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Page 6FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974
in a given year. But when we talk about the “problem
of inflation”, I think it is safe to say that the funda-
mdiltal cause is excessive money growth, and the
cure is to slow clown the rate of money expansion.
After examining these three charts I conclude that
a sustainable low level of unemployment cannot be
obtained for the “purchase price” of a higher rate of
infiatioll. It should be pointed out, however, that for
short periods a relationship between inflation and un-
employment may exist, but the experience of the last
four or five years has provided evidence casting seri-
ous doubt on the validity of the Phillips curve re1a~
lion over the longer run.
Whether or not there is a systematic and lasting
trade-off between unemployment and inflation is not
just an academic question. The presence or absence
of such a trade-off carries important implications for
stabilization policy. If there is no trade-off, but policy-
makers act as if one exists, any attempt to use ag-
gregate demand policies to achieve unemployment
below the rate dictated by the forces of supply and
demand will result in accelerating inflation.
On the basis of evidence presented in these charts,
the implication is that monetary policy should be
formulated with an eye toward controlling inflation,
for this is the variable that is systematically related
to the rate of monetary growth. The trend growth of
money, in turn, is subject to control by the monetary
authorilies.
Monetary actions do have an effect on unemploy-
ment, but this effect is transitory in nature. From
early 1952 to the fall of 1962, when monetary growth
averaged 1.8 percent, unemployment averaged 4.9
percent of the labor force; from the fall of 1962 to the
end of 1966, when money accelerated to a 3,8 per-
cent rate of growth, unemployment also averaged 4.9
percent. Since 1986, with money rising in excess of 6
percent per year, unemployment has averaged 4.7
percent. On the other hand, accelerating money
growth was accompanied by accelerating inflation.
This experience leads me to conclude that the un-
employment rate should not serve as a guide tomone-
tary policy.
If aggregate demand policies are to be formulated
with a primary focus on the price level, other policy
tools are required to deal with the problems of un-
employment. I think that the sooner we realize the
limitations of conventional macroeconomic policy in
reducing unemployment, the better off we will be.
And this realization also implies that we must look
to employment policies, rather than aggregate de-
mand policies, as a means of dealing with the prob-
lerns of unemployment.
By employment policies I mean Federal govern-
ment actions geared toward improving the efficiency
of operation of labor markets. The government can
take steps to encourage improved job skills and can
assist in the dissemination of infonnatioll relating
to job openings. Certain structural impediments to the
efficient operation of our labor markets should be
removed or modified, siich as minimum wage laws
and restrictions on occupational mobility. Further-
more, I feel that our whole system of unemployment
compensation deserves closer study to see if the sys-
tem actually diminishes the incentive to work while
encouraging seasonal fluctuations in the demand for
labor.
By way of summary, I have raised some questions
about the symmetrical treatment of unemployment
and inflation in the formulation of stabilizalioll policy.
When there appears to be a conflict of goals, the
policymaker has to choose more of one to get less of
the other. That, at least, is the advice that flows from
the tradition of the Phillips curve. And, I might add,
experience shows economic policy has been formu-
lated in that way, with varying emphasis on unem-
ployment and inflation, depending on prevailing
circumstances.
If unemployment over the longer run is recognized
as depending primarily on the real forces of supply
and demand in labor markets, and inflation is recog-
nized as depending primarily on the trend growth of
money, then our policy strategy has to be modified
accordingly, I feel the evidence supports the conclu-
sion that monetary policy should be formulated with
a longer-term focus. Such a focus implies that infla-
tion, rather than unemployment, should serve as the
primary guideline for aggregate demand policy. This
is not to say that we as polieymakers should ignore
unemployment; rather, long-term benefits to society
will be greater if we hold to a relatively stable path
of monetary growth than if we react to every wiggle
of the unemployment rate. The chief contribiition
that aggregate demand policies can make to our em-
ployment goals is the avoidance of sharp shifts in
policy. The past mistakes of aggregate demand policy
in this regard are all too familiar.
Page 7

Inflation, recession - what's a policymaker to do?

http://research.stlouisfed.org/publications/review/74/11/Recession_Nov1974.pdf

Inflation, recession - what's a policymaker to do?

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