Inflation, Growth and Monetary Policy – A Case Study of the United States

Central bank target rates (%); data sources: FRED, ECB, Bank of England

Ever since the Great Recession, central bank rates in all major developed economies have been on historic lows. The European Central Bank (ECB), whose official sole mandate is to maintain price stability, has lowered its rate even further to 0.00 percent in March in response to consistently low inflation rates across the Euro area, and the Bank of England (BoE), whose mandate combines maintaining price stability and supporting economic growth, has lowered its rate down to 0.25 percent in August, in response to the Brexit decision. Meanwhile, the Federal Reserve of the United States (Fed), whose objectives are maximum employment and stable prices, has increased its target rate to 0.375 percent in December for the first time in several years. However, at its most recent meeting in mid-September , the Fed has been reluctant to further increase its target rate due to an ongoing slow economic recovery and inflation rates below its 2-percent target (Inflation measures the yearly increase in consumption good prices). Consistently low inflation rates despite lengthy phases of expansionary monetary policy, even in countries that appear to be back on economic growth paths, are a concern for central bankers around the globe and puzzle many observers. In this article, I take a look at the case of the United States (simply because it provides by far the best data), derive the main two possible causes and argue in favour of a rate hike in combination with additional monetary and fiscal measures.

In response to the financial crisis and the crisis of the real economy that ensued, the Fed has drastically lowered their target interest rate, the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. This was supposed to spur lending activity of the banks and hence fuel the economy and avoid deflation. Now, after eight years of interest rates near zero and with the unemployment back at pre-crisis levels below five percent, it has been argued by some that the Fed should start raising rates again in order to avoid financial instability and an overheating of the economy. However, the Fed is hesitant to do so as inflation has not increased significantly since the beginning of its expansionary monetary policy and economic growth has remained somewhat modest despite low unemployment numbers. In recent years, the short-term negative relationship between unemployment and inflation, known as the Phillips curve, seems to have progressively dissolved.

Inflation (yoy change rate of CPI, %) and unemployment rate (%); data source: FRED

This introduces the first reason why the recent monetary policy seems to fail to increase inflation rates: The unemployment rate is primarily utilised as an approximation of the output gap, i.e. the derivation of real economic output from its potential. But considering other measures for the output gap indicates that the US economy has not yet recovered as strongly as the unemployment rate might imply. Looking for example at capacity utilisation, which tries to measure the percentage of sustainable maximum output that is produced, one can observe that the US economy is now running at the same capacity as right after the recession in 2000.

Unemployment (%) rate and Unutilised capacity rate (divided by 2 to fit scaling, %); data source: FRED

Since about 1990, unutilised capacity has been steadily increasing and become increasingly detached from the unemployment rate. Since the end of 2014, unutilised capital has even been climbing, despite further falling unemployment rates. This phenomenon can partly be explained by labour force developments. For example, since 1990, the participation rate of prime-age (25-54 years) workers has been stagnating and since 2000, it has been sinking.

Labour force participation rate 25-54 years old, both sexes (% of total population); data source: BLS

The drop in participation rate of this prime-age demographic can neither be explained by an aging society nor by an increased educational attainment. More likely, it is to some extent caused by a combination of stagnating female participation rates and an ongoing decline in job opportunities for low-skilled male workers but probably also by cyclical effects. This introduces a downward bias on the unemployment rate as many individuals who are fit to work but are unemployed do not appear in the unemployment statistics (For an example of how this fact can be introduced into a monetary policy framework, see Erceg & Levin, 2014). However, it is hard to determine exactly how many of these workers should be counted as “structurally unemployed” and hence should cause only a slight downward pressure on inflation and how many of them still contribute to the output gap (That a separation between “cyclical” and “structural” factors might be misguided is pointed out by Fujita, 2014). Another measure that implies that the current unemployment rate understates the slack in the US economy is the ratio of part-time employment for economic reasons to the labour force (A factor that I have also looked at when talking about unemployment in the Euro area).

Number of workers employed part-time for economic reasons (% of the labour force); data source: FRED

While the rate of underemployed workers has been steadily declining since the end of the crisis, still one percent more of the labour force than before the crisis are working less than they would like to. That there is probably still a lack of inflationary pressure due to un- and underemployment becomes evident when looking at the development of nominal wages.

Inflation and Growth rate of Average hourly earnings of production and nonsupervisory employees (%); data source: FRED

So, inflation rates in the US might not be low despite a booming economy. It rather appears that there could still be a lot of slack in the economy that unemployment statistics tend to obscure. It is hard to tell however, how much of this is part of a cyclical phenomenon and how much of it is caused by structural changes that the Fed cannot influence with its monetary policy. In this environment, where the economy is working below capacity and there is only a low upward pressure on nominal wages, the Fed is trying to increase inflation by expansion of the money supply.

This leads to the second reason why the Fed’s policy seems to fail. Contrary to what is often said (even in Economics programs), unless they literally print money and drop it in the streets, central banks do not directly control the supply of money but can only incentivise banks to create it. But ever since the crisis, banks choose to hoard a large part of the cheap money that they can lend from the central bank in Federal Reserve deposits and other safe havens. This becomes apparent when one looks at the money supply statistics provided by the Federal Reserve Bank of St. Louis.

St. Louis Adjusted Monetary Base, M1 Money Stock and M2 Money Stock ($ billion); data source: FRED

During the crisis, the money provided by the Fed, the “Monetary base”, defined as the sum of currency in circulation and deposits held by banks and other depository institutions in their accounts at the Federal Reserve, surpassed the actual supply of the most liquid form of money, defined as “M1” (the sum of currency held by the public and transaction deposits at depository institutions). This relation has remained in this remarkable situation to this day. It is probably caused by a combination of tighter regulation that constrains bank lending and the fact that, even at historically low interest rates, there is not a high demand for borrowing due to fundamental developments and growth perspectives (I have touched on some of them in my last Economic Article about growth).

However, the supply of M1 has still increased quite substantially since the crisis. But it appears that this money is not used for consumption, but for the purchase of assets. House price inflation has already almost reached its highly elevated pre-crisis level (For a short summary of house price developments in various countries, see this article from July) and, in recent years, seems to react more strongly to changes in money supply than consumer price inflation.

Inflation, House Price Inflation (Purchase only) and Growth Rate of M1 Money Stock (%); data source: FRED

This problem is aggravated by high inequality, as the wealthy have a higher propensity to save. In a very recent IMF working paper, Alichi et al. (2016) point out how an increasing income polarisation has lowered aggregated consumption substantially. This implies that, if the Fed continues to stick to its low-rate monetary policy, it might risk creating the next asset price bubble. Furthermore, as interest rates drop, banks and especially insurance companies might be compelled to put their money into evermore risky investments in order to achieve a certain yield.

In conclusion, two possible reasons can be identified why the inflation rate that the Fed targets with its policy has not yet been met. First, The US economy might still be weaker than it appears when looking at unemployment numbers. However, this probably is partly caused by structural reasons that the Fed cannot influence with its monetary policy (such as workers that are unfit for the labour market, demographic developments and effects of the digitalisation). Second, the new money that is created is to a large extent not used for consumption but for investment in assets and hence does not cause inflation but asset price inflation and thus can lead to the creation of new bubbles.

The following measures are worth considering in this situation: An increase of the target rate in order to stabilise a financial system that has still not fully recovered since the last crisis, to avoid the creation of new bubbles and to give the Fed room to act when the next crisis hits. In order to still meet inflation targets (the president of the Federal Reserve Bank of San Francisco, John Carroll Williams, has recently even proposed a higher target) and to spur consumption and wage growth, the Fed could directly increase the money supply by printing it and handing it out to the consumers, a process dubbed “helicopter money”. The more fundamental problems of a stagnating economy can only be tackled by the US government. Improving the bargaining positions of middle class workers, an increase in the minimum wage and a more progressive tax system could help to channel the money to those who have a higher propensity to consume. Additionally, increased investments in education can lower the structural unemployment rates in the long run.

To a certain extent, these findings can also be extended to the ECB and the BoE. However, they also face different challenges with the ECB trying to make a fundamentally misconstructed monetary system work (see Stiglitz, 2016) and the BoE having to steer through pre-Brexit uncertainty.

As a final thought, just as with economic growth, there is no natural law that predetermines the optimal inflation rate at 2 percent. A look at the last 300 years shows that in fact the US inflation rate has very rarely averaged 2 percent. And not all of the times that it has not were marked by economic disaster.

Decennial average of inflation (%); data sources: McCusker (1992), FRED



Alichi, Ali, Mr Kory Kantenga, and Mr Juan Sole. (2016). Income Polarization in the United States. International Monetary Fund Working Paper, 2016.

Erceg, C. J., & Levin, A. T. (2014). Labor force participation and monetary policy in the wake of the Great Recession. Journal of Money, Credit and Banking, 46(S2), 3-49.

Fujita, S. (2014). On the causes of declines in the labor force participation rate. Research Rap Special Report, Federal Reserve Bank of Philadelphia, 6.

McCusker, J. J. (1992). How much is that in real money?: A historical price index for use as a deflator of money values in the economy of the United States. American Antiquarian Society.

Stiglitz, J. (2016). The Euro: And its Threat to the Future of Europe. Penguin Books Limited.

written by Jonas


Author: Jonas Send

I analyse current topics that interest me in opinion pieces and share my research in economic articles.

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