Banking Forum for Journalists. Cosponsored by Ohio Bankers Association and Federal Reserve Bank of Cleveland

Transcription

1 Banking Forum for Journalists Cosponsored by Ohio Bankers Association and Federal Reserve Bank of Cleveland Federal Reserve Bank of Cleveland April 25,1995

2 \gerry\media2 draft 4/20/95 Common Misunderstandings about Monetary Policy, the Economy, and the Fed luncheon address by Jerry L. Jordan President and Chief Executive Officer Federal Reserve Bank of Cleveland Banking Forum for Journalists Ohio Bankers Association and Federal Reserve Bank of Cleveland Noon Tuesday, April 25,1995 Federal Reserve Bank of Cleveland

3 1 M onetary Policy, Inflation, and Economic G row th The following statements represent views of the Federal Reserve Bank of Cleveland. They are not necessarily those of the Federal Reserve System. If you would like clarification on any of these points, please contact June Gates, Public and Media Relations Coordinator, Federal Reserve Bank of Cleveland, at (216) I. The F ed s ultim ate goal is greater national prosperity. A. Real economic growth results from increases in the size and quality of the labor force, increases in the nation s capital stock (e.g. buildings and equipment) that result from saving and investment, and improvements in technology (both in the physical sense and in the organizational sense). B. Achieving price level stability is the best thing that the Fed can do to facilitate long-run real economic growth. C. Although the Fed s goal is greater national prosperity, it cannot achieve that goal through stimulative monetary policy. Creating more money cannot create real economic growth. If it could, then every country could become prosperous merely by printing lots of money. But history shows that countries that print lots of money suffer from inflation or hyperinflation, which are, if anything, harmful to economic growth. II. Inflation is a sustained rise in the general level of prices. A. Inflation is a persistent rise in the general level of prices. B. A temporary increase in one or several prices is not inflation. C. A temporary increase in the price level is not inflation. D. Even a permanent increase in the general price level is not considered to be inflation if it is just a one-time change in price level, in response to a onetime event such as an increase in a general sales tax rate.

4 2 III. Inflation is harm ful to the economy. A. Inflation interacts with the U.S. tax code to reduce saving and investment, which are essential ingredients Of real economic growth. B. Unexpected inflation redistributes income and wealth. People use resources to forecast and hedge in the hope of avoiding losses or capturing gains from the redistribution. While this use of resources is sensible for individuals and businesses facing the prospect of inflation, it doesn t do anything to raise the standard of living. If price stability were assured, these resources could be put to uses that raise the standard of living. C. Inflation makes it harder to recognize changes in relative prices. This makes it more likely that individuals and businesses will make errors when they make decisions about production levels, production methods, careers, etc. D. Uncertainty about the amount of future inflation raises real interest rates as lenders add a premium to compensate for the uncertainty. This discourages investment, reducing economic well-being. E. Inflation raises nominal interest rates. An inflation premium is demanded by lenders to compensate them for the fact that they will be repaid with dollars that have less purchasing power than the dollars that were originally loaned. The inflation premium reduces investment by people and businesses whose current income is insufficient to make the higher loan payments required by the higher interest rates, even if they expect their future dollar income to be boosted by the inflation. F. By reducing or eliminating the harmful effects of inflation, an anti-inflation policy is a pro-growth policy. IV. Inflation is not caused by too m uch real economic growth. A. Increasing the supply of goods and services doesn t by itself raise the prices of those goods and services. A basic tenet of economics is that an increase in supply of a good tends to lower the price of that good. B. If demand for goods and services exceeds the current production of the economy, prices rise. However, that inflation is a result of too much demand rather than too much real growth.

5 3 C. The mistaken belief that real economic growth causes inflation stems in part from confusion about real economic growth and nominal economic growth. Real economic growth is an increase in the physical volume of goods and services produced. It is measured as the percentage increase in output, where output is measured in dollars of constant purchasing power. Nominal economic growth, on the other hand, is an increase in the dollar value of goods and services produced. It is measured as the percentage increase in output, where output is measured in dollars of current purchasing power. Nominal growth can reflect either real growth or inflation, or both. D. If nominal growth exceeds real growth, inflation is occurring. However, achieving price stability does not require less real growth. Instead, it requires that monetary policy prevent monetary assets from persistently rising faster than the private sector s willingness to accumulate those assets. V. Inflation and grow th can be positively related in the short ru n and negatively related in the long run. A. Over the course of a typical business cycle, it would not be unusual to witness a positive relation between price-level growth and output growth. That is, at some stage in an expansion of the economy, prices may rise faster than normal as demand growth outpaces supply. Conversely, at some stage in an economic slowdown or recession, the price level might fall, or rise at a slower-than-normal rate, as demand growth weakens. B. On average, however, price increases that are faster than normal will be offset by those that are slower than normal. Thus, the short-run relation between inflation and GDP growth doesn t tell us anything about the relationship between the average inflation rate and output growth over the long run. In the long run, inflation reduces economic well-being for all of the reasons stated earlier.

6 4 VI. Inflation s only cause is excessive grow th of the money supply. A. Inflation is caused by excessive growth of the money supply. B. The popular saying that inflation is caused by too much money chasing too few goods captures the essence of the process.. C. Economist Milton Friedman puts it this way: Inflation is always and everywhere a monetary phenomenon. [ The Role of Monetary Policy, American Economic Review, vol. 58, no. 1 (March 1968), p. 17.] VII. Inflation is not caused by high interest rates. A. Inflation and high interest rates often occur together, but it is the inflation that causes the high interest rates. This happens because lenders who expect inflation include an inflation premium in interest rates that they charge to compensate them for the fact that their loans are going to be repaid with dollars that have less purchasing power than the dollars that they originally loaned. B. An increase in interest rates will add to the cost of producing goods and services with borrowed money, but those cost increases are not inflationary, just as other production cost increases are not inflationary. Rising interest costs pressure producers to restrain other production costs, to reduce profit margins, or to raise prices. If some producers do boost their prices, some other prices must fall so that the average of all prices remains unchanged unless monetary policymakers allow the money supply to expand at an inflationary pace.

7 VIII. Inflation is not caused by dollar depreciation in foreign exchange m arkets. 5 A. When the dollar falls in value against foreign currencies, as it did against the Japanese yen in the early months of 1995, price increases for some imported goods are likely to follow. However, increases in individual prices do not cause inflation. Unless monetary policy itself is inflationary, those individual price increases must be offset by declines (or smaller increases) in other prices. B. On the other hand, if the falling foreign exchange value of a currency is a result of a domestic inflationary process, i.e. excessive growth of the money supply, other prices will not head lower. The declining foreign exchange value of the dollar is not the cause of the inflation. Instead, dollar depreciation against other currencies is one of the channels through which inflationary domestic monetary policy actions are reflected in a higher price level. IX. Inflation is not caused by price increases for individual goods o r services. A. Inflation is caused by excessive growth of the money supply. Since price increases for individual items cannot compel increases in the money supply, they cannot cause inflation. B. A former president of U.S. Steel Corporation put it this way: Steel prices cause inflation like wet sidewalks cause rain. [Roger Blough, quoted by Malcolm S. Forbes in Fact and Comment, Forbes, vol. 100, no. 3 (August 1, 1967), p. 18.] X. The Fed does not control all interest rates. A. The Federal Reserve s discount rate is the rate a bank or thrift pays when it borrows from a Federal Reserve Bank. The Federal Reserve System determines this rate administratively. B. The federal funds rate is the interest rate banks pay when they borrow from each other overnight. This rate is determined in the market by supply and demand. The Fed can, and does, control the general level of this rate by influencing the supply of federal funds (bank reserves). C. Most other interest rates are determined by individual financial institutions or by supply and demand in the market.

8 6 XI. The Fed cannot push down all interest rates by pushing down the federal funds rate and the discount rate. A. The federal funds rate has much greater influence on interest rates than does the Federal Reserve s discount rate. B. In general, short-term interest rates tend to move in sympathy with the federal funds rate. However, most of them are determined by supply and demand or by competitive considerations. C. In general, long-term interest rates are little affected by the federal funds rate. Long-term rates are strongly affected by expectations about how much inflation there will be over the term of the loan. If a rise in the federal funds rate encourages people to believe that the Fed will allow less inflation in the future, long term interest rates might fall in response. Similarly, if a decline in the federal funds rate encourages the belief that the Fed will allow more inflation in the future, long term rates might rise in response. XII. The direction of interest rate changes is not a reliable indicator of the stance of m onetary policy. A. Usually, people think that an increase in the federal funds rate indicates that the Fed is making monetary policy more restrictive, and a decline in the rate indicates that the Fed is making monetary policy less restrictive or more accommodative. However, these interpretations can be incorrect. B. If market forces are pushing the federal funds rate up and the Fed is resisting that rise by creating bank reserves more generously, then the federal funds rate is rising despite a more accommodative (or less restrictive) Federal Reserve monetary policy. C. If market forces are pushing the federal funds rate down and the Fed is resisting that decline by creating bank reserves less generously, or by reducing the availability of bank reserves, then the federal funds rate is declining despite a more restrictive Federal Reserve monetary policy.

9 I propose that the following document be given to the journalists (and bankers) so that they have it in hand during Jerry s luncheon presentation. I propose that Jerry explain each point to the audience by reading it and briefly elaborating on it. Each journalist will have a copy to facilitate following along, taking notes, and preparing questions for the Q. & A. session. This style of presentation is very classroom-like, which I think is the best method of achieving the goal of having the journalists leave with a clear understanding of our views. The presentation should begin with some very brief introductory remarks, which I can prepare. If we decide to do this, I would complete the outline. When it is completed, we could decide whether there is too much in it to be covered in Jerry s presentation, and whether to keep or remove the items that he would not have time to discuss. My inclination would be to leave it all in, even if it is too long to be covered in his presentation. We could also consider which items should be given the highest priorities for the presentation.