South-Western College Publishing - Economics  
Half Full or Half Empty?
Subject Interest Rates
Topic Monetary Policy
Key Words

Interest Rates, Inflation, and Economic Activity

News Story

Evidently the Federal Reserve continues to expect the economy to grow in future months, since it raised short-term interest rates once again in early August and implied that it would continue to raise rates modestly in the months ahead.

This rate hike comes at a time when employment and economic growth has slowed somewhat. Fed chairman Greenspan refers to this period as a "soft patch" in the economy that would prove to be temporary. He said the expansion was still "self-sustaining," hinting that the Fed will likely to continue its current strategy of gradually increasing interest rates from their lowest levels since the late 1950's.

By raising rates now, in the face of weak job growth and only modest inflation, the Fed seems intent on stopping price increases before troublesome inflation can become a reality. Even with signs of sluggish growth, consumer prices are climbing faster than the Federal Reserve would like to see.

Cost-push inflation seems to be a culprit as total labor costs are increasing, due in large part to increasing health care costs. Fed officials watch labor costs closely, since they regard labor costs as one of the most important indicators of inflationary pressure. But the Fed attributes most of the blame for the recent economic slowdown to increasing oil prices-another important source of cost-push inflation. Greenspan and other Fed officials consider increased oil prices to be transitory and expect crude oil prices to return to more typical levels in the near future.

Facing a sluggish economy and increasing consumer prices leave Fed official little room to maneuver. In fact, some analysts suggest that the Fed would break the pattern of increasing rates if the next round of consumer spending and business investment data are weaker than expected. "We honestly believe that the Fed is unsure as to whether the economic glass if half-full or half-empty," said Richard Yamarone, director of economic research at Argus Research. Yamarone predicted that the Fed would wait until after the presidential election to raise rates again. The Fed has described its monetary policy as "accommodative," meaning that its policy still focuses on "cheap money." Even after the interest rate increase, the federal funds rate is at a mere 1.5 percent. The Fed appears to remain committed to maintaining price stability while remaining silent about a response to slumping growth or employment.


(Updated November, 2004)

Questions
1.

Discuss the link between higher interest rates and less inflation.

2. Define a "cheap money" monetary policy and give some recent examples of the effects such a policy can have.
3. Define cost-push inflation.
Source Edmond Andrews, "Fed Raises Rates and Hints at More Increases Ahead", The New York Times Online, August 11, 2004.

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