Recently, comments from the Federal Reserve indicate that the Fed is concerned that low inflation is leading to the low economic growth that has been plaguing the country for the last 6 years. The Feds implied solution is to increase the money supply in order to spur investment and hiring. While these prescriptions follow basic Keynesian economic theory, there may be several problems with this line of reasoning.

The first one is that much of what we call macroeconomic theory has only changed marginally over the last 40-50 years or so, while the economy has changed a lot. Western economies are much more service oriented than they were 50 years ago, and there are many jobs today that didn’t even exist 30 years ago (and some that did exist that no longer do). While this might not matter much on a microeconomic level where issues of supply and demand determine price, it can matter a great deal on a macroeconomic level where the structure of an economy can impact how it will respond to various policies. In many ways, the failure of economic policy to engineer a solid recovery over seven years (The Great Depression last for 10) is a testament to an economic policy elite that has not yet figured out appropriate policies for the economic situation in which the country finds itself.

The second problem is that the Fed’s measure of inflation has changed over the years, and so economic policies that might have had an impact of ‘x’ thirty years ago, now have an impact of ‘y’ today. While deflation (negative of inflation) is highly contractionary and something to be avoided, even at the cost of stoking inflation, the Fed may not be using measurements that can be used in the context of earlier historical periods to determine the appropriate policy response.

Finally, while the Fed has generally been correct that historically, low economic growth and low inflation have tended to go together (except for that economic period in the 70’s in which stagflation reigned), the Fed may not be correct that high inflation causes high economic growth. It is not impossible that the causation works in one direction (high economic growth leads to high inflation), but not in the other direction (high inflation leads to high economic growth). If businesses don’t believe that the economy will be expanding they are not going to invest and hire.

Over the last 5 years, the Fed has been pumping money into the economy. However, due to limited investment opportunities, the money has been flowing into stocks and other securities. In short, while the stock market has increased, economic growth has remained sluggish. This is an indication that something has fundamentally shifted. Rather than simply trying more of the same medicine, the Fed should be trying to figure out policies that are more appropriate for the current economic situation, and not one that we faced 40 -60 years ago.