South-Western College Publishing - Economics  
The Battle May Be Over, But Only Time Will Tell Whether the War is Won
Topic Monetary Policy
Key Words Interest Rates, Economic Growth and Monetary Policy
Full Article

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Reference ID: A148388086

News Story Despite recent consumer price rises--caused mostly by higher oil prices-Fed Chair Ben S. Bernanke has expressed optimism that the Fed's monetary policy aimed at increasing interest rates over the last couple of years is working. "The economy appears to be in a period of transition," he said.

Issuing the statement at a Senate Banking Committee hearing, Mr. Bernanke described an outlook of somewhat slower economic growth, a slight increase in unemployment and a slower housing market. All of these factors should relieve inflationary pressure in the economy.

While he still left room for policy makers to hike interest rates yet again when they meet next month, Mr. Bernanke reminded the committee that the Fed's monetary actions feature lags between implementation and effect. Lags in monetary policy can be long and variable. Economists agree that major monetary policy changes usually show up in the economy within three months to two years, as economic output and employment adjust to new conditions. However, inflationary effects tend to involve even longer lags, perhaps up to three years or more. "The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook," Mr. Bernanke said. "We must take account of the possible future effects of previous policy actions--that is, of policy effects still 'in the pipeline."

Mr. Bernanke pointed to a number of economic indicators that suggested a slowdown--trends that would relieve inflationary pressures. He specifically mentioned the slowdown in the housing market, expected "restraint" in consumer spending, and small wage increases. He was optimistic that any wage increases would be largely offset by continuing productivity growth. "We think this is a pretty clear signal that Mr. Bernanke does not think the recent inflation numbers ought to have much impact on the debate," wrote Ian Shepherdson, an economist at High Frequency Economics, in a note to clients. "The key question is whether the tightening already in place is enough to slow the economy to a pace that will, over time, reduce inflation pressure. Mr. Bernanke thinks it is."

Discussion Questions:
1. Discuss how long it takes monetary policy to affect the economy and inflation and pose your own explanation of why the effects are not felt immediately.
2. Explain how interest rate increases reduce inflation.
Multiple Choice/True False Questions:
1. Monetary policy operates without any lags.
  1. True
  2. False
2. According to the article, inflation is a short-term problem.
  1. True
  2. False
Source Edmund Andrews, "Fed Chief Optimistic On Inflation", The New York Times Online, July 19, 2006.
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