When the central bank injects money into the system at a faster pace, we usually call this an expansionary AD policy or an expansionary monetary policy. As the above example suggests, an expansionary monetary policy should reduce interest rates, increase interest sensitive spending and AD. The rise in AD then causes firms to want to produce more. Some may also raise prices. The macro impact is a rise in real GDP and perhaps some increase in inflation.
A prudent central bank would engage in such an expansionary AD policy only if real GDP were significantly lower than potential Real GDP, that is, if there was a negative GDP gap.
If the gap exists but is very small – the central bank risks increasing real AD and GDP too much – firms would not be able to increase output in response to the rise in AD and therefore they would respond mostly by raising prices.
Thus, the smaller the real GDP gap, the bigger the risk that an expansionary AD policy would generate inflation.
If a central bank was to expand AD too much with its monetary policy, then it could quickly counteract that with a contractionary AD policy. A contractionary AD policy would imply that the central bank was removing money from the system (using an open market sale), raising interest rates, and leading to less AD.
It is possible that real world central banks make mistakes. For example, let’s suppose the following. Today potential GDP is 1000 while real GDP is 900. The GDP gap is -100. This seems like a pretty clear case of the need for an expansion monetary policy. The goal would be to move real GDP from 900 to 1000. Let’s suppose the Fed implements this policy and then finds out that the estimate of potential GDP was wrong. In fact, potential GDP was really only 950. So by accident, the Fed has moved the economy to a real GDP of 1000 – some 50 higher than potential. This should create inflation.
Let’s suppose that for the time being inflation has not increased very much. If they made a mistake about potential GDP once, then maybe they could make another mistake. Meanwhile the high GDP is being enjoyed. Firms are enjoying the increased sales. Lots of people have jobs and wage gains are improving. One might say, “if inflation is not increasing a lot, then what’s the harm?”
So it is possible that the central bank might keep policy too expansionary for too long. What is the risk of that? Here is where the long-run comes in. Inflation will eventually increase because AD is growing faster than our ability to produce. Worse than that is what happens if people come to believe that the new higher inflation rate is going to be permanent. How might rising inflationary expectations impact people?
- Higher inflationary expectations mean that workers ask for bigger wage increases. This leads to higher labor costs and lower profits for businesses. This could decrease AS.
- Higher inflationary expectations mean that banks and other lenders will want higher interest rates. This will reduce AD.
- Higher inflationary expectations mean that households and firms may become more uncertain and less confident about the future. This could decrease AS and AD.
The next chart shows you graphs of two survey-based measures of inflation expectations – one from the University of Michigan and the other from The Federal Reserve Bank of Philadelphia. You see that inflation expectations can change from year to year and decade to decade. You can see that in the late 1980s actual inflation increased and expectations of inflation followed an upward pattern. Afterward, as inflation receded, so did expectations. The following link allows you to update this data: http://research.stlouisfed.org/publications/mt/page8.pdf
The net result of the rise in inflation expectations is an economy with slowing AD, reduced output, higher costs, and even more inflation (note: once we have more fully introduced the aggregate supply sector then we will come back to this point and explain it again). This is the worst kind of economic change. We refer to such a situation as stagflation. Stagflation was severe in the U.S. in the 1970s, especially in 1974-75 and then again in 1979-80. With history as a laboratory, stagflation is often in the backs of our minds and it helps us understand why central banks are so serious about not letting inflation get out of control. This worry about stagflation has come up several times in the recent past and led to tighter monetary control that may have helped to avert the actual occurrence of stagflation (for example 1994/95, 1999/2000).
All policy makers need to understand these short-run long-run conflicts. A central bank will use expansionary policy, especially when the real GDP gap is large and negative. But it should use this policy judiciously because of the long-term impacts it can have – inflation and stagflation.
There was much pressure on the ECB to reconsider how it employed monetary policy in the years 2001-2005. Policy makers in Germany and France were amongst the loudest critics of ECB policy. Growth in those countries was quite slow – and negative GDP gaps were large. Yet, these countries had given up their currencies in 1999 to be part of the euro area. This means they freely gave up their own national monetary policies in favor of a monetary policy that fit the 13 and soon 15 countries of the euro area. While France and Germany had negative GDP gaps, the condition of the whole euro area was more balanced and there was no clear need for a euro-wide expansionary monetary policy. Furthermore, the charter of the ECB required a very narrow focus on inflation. The ECB may not employ an expansionary monetary policy if inflation is around 2% of higher. Inflation was above 2% in most of Europe and therefore there was little that the ECB could do to help Germany and France with their deficiency of AD and their sluggish economies.
This European story is interesting for all of us. It shows how strongly some countries feel about inflation. Germany and France felt so strongly about never letting inflation get out of control that they were willing to join a monetary union whose main focus seems to be to keep inflation low. In creating the bank charter for the ECB, the founders were convinced that it is VERY important to keep inflation low and stable. Germany and France believed that in 1999. But later in 2002 they wished that their central bank could be more responsive. They wished that their central bank was not so rule-based. They wished they had a central bank that was more short-run AD oriented.
Only with more time will we know whether Germany and France were made better off by not having a choice of a more aggressive counter-cyclical policy. Another interesting by-product of this less active monetary policy is that it has caused countries to think about non-monetary solutions to their economic problems. In the case of Germany and France much has been written about the overall inflexibility of their labor and product markets. Some economists believe that their real problems are not monetary in origin and that the real long-run solutions do not involve monetary policy. More will be said about labor and product market flexibility in the note on employment.
Another international application was China in 2004. Concerned that the economy was growing much too fast and might be on the verge of a stagflation cycle, China decided to raise some key interest rates and to directly control the amount of loans granted. China is an interesting case for many reasons. First, its central bank is not independent. Second, China is a communist country that is very slowly transforming to a market economy. Third, it is a developing country that is rapidly growing. The last factor explains why it is possible that potential real GDP could be growing as fast as 8% per year (compared to less than 3% for most industrial countries). But when it grew faster than that, policy makers in China were like policy makers anywhere – they worried about stagflation. The article on page 4 of the Financial Times on August 11, 2004 was titled, “Industrial growth in China slows again.” Reading the article you find that it slowed to an annual rate of 15.5%! The slowdown was the result of auto and aluminum production growth coming down from earlier growth of more than 30% per year. Clearly, China has been the “Ferrari” of world economies. The article clearly agreed that the slowdown was beneficial and was a proper way to avoid a later “hard landing.”
Who cares or who should care about Fed policy? It is possible that there are some companies whose main challenges are so internal or so focused on their closest competitors that Fed policy seems very far away from their bottom lines. But there are plenty of other firms who would benefit from being central bank watchers.
The uncertainty we all share about Fed policy was illustrated in an article in the Financial Times on 8/12/04 page 3, “Damned if you do and damned if you don’t, but Fed stays on track.” The gist of the article is that the Fed decided to raise the fed funds rate by a quarter of a point to 1.5%. At a Kelley alumni meeting to honor Buck Klemkosky a few days before this announcement, we met some Wall Street guys who were all abuzz about what the Fed was going to do. One guy who trades 10-year government bonds was really hoping the Fed would raise rates – he was tired of bond prices rising against his best previous judgments and hurting his gains. So he was pretty happy to see the Fed raise rates. I think he made some money on that prediction.
But here is the question – why were these guys predicting rates would rise and then they fell? The rate rise prediction largely came from the earlier growth in the overall economy and from worries that the Fed was getting more worried about AD rising too much and causing higher inflation. So why was the 10-year note rate not rising earlier? The answer is that the Fed doesn’t control that rate. It is a market rate. That rate was falling presumably because inflation was not picking up (as many people had expected) and there seemed to be a lull in economic activity that reduced loan demand in the summer months. So market rates were falling against prediction.
Here’s another question – if the economy was slowing down in the summer months and inflation was not showing any clear signs of permanently rising, then why did the Fed go ahead and raise rates in August? The article suggests that the Fed believed that the slowdown in the economy was going to be temporary. They fully expected strong economic growth and loan demand to resume and this means that inflation may increase. The Fed seems to be focused on the longer-term rather than month-to-month fluctuations. That is probably a good thing.
This little story underscores a few things:
- First, it shows that people are paying a lot of attention to the Fed.
- Second, they don’t always get their predictions right and one reason is because market interest rates don’t always behave in the way the Fed wants them to.
- Third, the Fed really does focus on inflation, though at times it uses other factors to guide its policies.
- And finally, it shows that all of us who care about the future course of interest rates have quite a challenge ahead of us because the economy is so volatile, fluid, and complex.