Growth Means Inflation: Can Anything Kill This Myth?

"I am not opposed to growth. I am opposed to inflation. They are not synonymous."

--Federal Reserve Vice-Chairman David W. Mullins Jr.

Coming from a Washington policymaker, that's heresy. For nearly 30 years, economic wisdom has held that solid growth always brings inflation. Like love and marriage, horse and carriage, and Beavis and Butt-head, you can't have one without the other.

Although a generation of economists and bond traders has accepted this orthodoxy, there is no evidence that it is true. Explosive growth may kick off inflation, and a prolonged slump can erode prices. But does a steady expansion inevitably mean a burst of higher wages and prices? Hardly.

The bond market, however, remains wedded to the notion that it does. And its inflation fears threaten to push up interest rates, choking off growth. Until the early 1970s, long-term interest rates averaged just two or three percentage points above inflation. But in the mid-'70s, bondholders were badly burned by explosive inflation. Rates soared, and by 1984, AAA corporate bonds were paying a staggering afterinflation yield of 8.4%. Real rates have been declining ever since, but even after three years of recession and sluggish economic growth, corporate rates are still above 4%, while 30-year Treasuries pay a 3.5% inflation premium.

"NO TRADE-OFF." Earlier this fall, it seemed that inflation fears were finally being wrung out of the markets. But in recent months, the economy suddenly started looking strong. And the bond market headed south, even though the consumer price index is increasing at a modest 2.7% annual rate.

No matter that oil prices are below $15 a barrel and dropping, that wages are flat, and that many manufacturers still can't make price hikes stick. No matter that Europe and Japan are mired in slumps. The U.S. economy is expanding, and bond traders "are always going to assume that growth means more inflation," says Donald Ratajczak, an economist at Georgia State University.

Yet even those forecasters who expect hefty price increases in the next year think inflation fears may be overblown. Conference Board economist Gail D. Fosler figures inflation will accelerate by more than a percentage point, to 3.9%, by this time next year. But she thinks that will be merely a return to normal levels after two years of disinflation: "There just is not the strength in the world economy to begin an inflationary cycle."

And even Federal Reserve Governor Wayne D. Angell, an inflation hawk, dismisses fears that growth must lead to spiraling wages and prices. "Over the long term, there's no trade-off," he says.

Until the late 1950s, few believed in such a linkage. But in 1958, an obscure New Zealand economist named Alban William Housego Phillips speculated that growth would produce higher wages. Phillips, an unassuming sort, never claimed any hard-and-fast relationship. And he never did a rigorous statistical analysis to prove his point.

But Phillips' idea somehow evolved into the economic equivalent of stone tablets. To this day, as soon as the economy begins a healthy expansion, hands start wringing in fear of the dreaded "Phillips curve," which is supposed to show the link to wage hikes.

There isn't much good evidence that steady growth ever really caused inflation. But more important, it may be that fundamental changes in the economy, including productivity gains and expanding global markets, are making the connection more tenuous than ever.

VIGILANCE. The stagflation of the 1970s showed that it was all too possible to have prices rising at a punishing 10% a year in a sick economy. Then, in the mid-1980s, the U.S. enjoyed moderating wages and prices even as the economy grew at a healthy 3.5% pace. After all that, you might think that people would have second thoughts about the connection. Not so.

What will it take to finally wring inflationphobia out of the markets? To start with, the Fed will have to show that it is still vigilant, probably with a bit of monetary tightening early in the coming year. Federal policymakers will have to continue reducing the budget deficit. And the markets will probably have to see a sustained period of steady, productivity-driven economic growth without runaway inflation before bond traders become believers. Maybe then they will come to understand that, with apologies to songwriter Sammy Cahn, you can have one without the other.

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