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November/December 1998, 
Vol. 80, No. 6
Posted 1998-11-01

Historical U.S. Money Growth, Inflation, and Inflation Credibility

by William G. Dewald

William G. Dewald, the retiring Research director at the Federal Reserve Bank of St. Louis, focuses on the longer-term monetary relationships in historical data. He uses charts of 10-year average growth rates in the M2 monetary aggregate, nominal GDP, real GDP, and inflation to show that there is a consistent longer-term correlation between M2 growth, nominal GDP growth, and inflation—but not between such nominal variables and real GDP growth. The data reveal extremely long cycles in monetary growth and inflation, the most recent of which was the strong upward trend in M2 growth, nominal GDP growth, inflation during the 1960s and 1970s, and the strong downward trend since then. Data going back to the 19th century show that the most recent inflation/disinflation cycle is a repetition of early long monetary growth and inflation cycles in the U.S. historical record. The author also discusses a measure of bond market inflation credibility, which he defines as the difference between averages in long-term bond rates and real GDP growth. By this measure, inflation credibility hovered close to zero during the 1950s and early 1960s, but then rose to a peak of about 10 percent in the early 1980s. During the 1990s, the bond market has yet to restore the low inflation credibility, which existed before inflation turned up during the 1960s. The author concludes that the risks of starting another costly inflation/disinflation cycle could be avoided by monitoring monetary growth and maintaining a sufficiently tight policy to keep inflation low. An environment of credible price stability would allow the economy to function unfettered by inflationary distortions—which is all that can reasonably be expected of monetary policy, and is precisely what should be expected.