South-Western College Publishing - Economics  
Inflation May Be On the Rise
Subject Job Growth
Topic Employment, Unemployment, and Inflation
Key Words

Inflation, Interest Rates, and the Federal Reserve

News Story

A quick sell-off in the stock market occurred recently as investors worried that interests rates may be rising faster than the Federal Reserve had previously suggested. Investors' fear was raised by the minutes from the Fed's policy meeting in December. The minutes, recently released to the public, suggested a growing worry about the falling value of the dollar, high oil prices, high budget deficits, and the fear of a self-fulfilling prophecy related to inflation.

According to the minutes, in what seems to be a split among members of the Federal Reserve Open Market Committee, some officials pushed unsuccessfully for an interest rare increase. Those officials wanted to drop the now-familiar Fed vow to raise rates at a "measured" pace.

"There is a notably hawkish shift in these minutes," said Richard Berner, Senior Economist at Morgan Stanley. "There is nothing new about the phenomena they are citing, but the fact that they are starting to talk about it is news." In the minutes, which are carefully edited summaries of the closed policy discussions, some un-named members fear rising prices in the future. "A number of participants voiced concerns about domestic and global financial imbalance," the minutes stated. With respect to the domestic budget, even though President Bush has vowed to cut it in half, some Fed officials expected the possibility of significant reductions as "remote," therefore adding fuel to an inflationary trend. Additionally, the falling value of the dollar relative to foreign currencies gives further cause for worry. As the dollar loses value on world markets, demand for U.S. exports rises, consequently putting upward pressures on U.S. prices.

With Greenspan continuing to explain oil prices as a one-time event with no long term effect on inflation, some officials were worried that the higher oil prices would become "embedded" in the underlying inflationary trend, according to the minutes. With oil being a major element in the pricing of many different products, it does not take long for higher oil prices to translate into higher product prices.

As each of these elements fuels the inflationary engines, some worry that a self-perpetuating upward spiral will cause people to make decisions based on the assumption that prices will rise more rapidly in the future. This, of course, is what the Fed would like to avoid. These policy meeting minutes leave little doubt that officials at the Fed will continue to raise interest rates in the months ahead. The only question now is how quickly the rises will come.

Questions
1.

Discuss the self-fulfilling prophecy referred to in the final paragraph and explain how it can add to inflation.

2. Explain how higher interest rates act to cool inflation.
3. Discuss how higher oil prices can contribute to inflationary pressures.
Source Edmund Andrews, "Fed Notes Disclose Worries That Inflation May Pick Up," The New York Times Online, January 5, 2005.

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