South-Westerns' Economic News Summaries
Federal Funds Rate Will Continue to Rise
Subject Inflation
Topic Monetary Policy
Key Words

Inflation, Interest Rates, and Economic Growth

News Story

The benchmark short-term interest rate is the Federal Funds Rate, the rate banks charge other banks for overnight borrowing of excess reserves between financial institutions. The rate currently stands at 3.25 percent, up from 2.25 percent a year ago. The Fed is expected to raise the benchmark by another quarter point at the next meeting of the Federal Open Market Committee.

In a report to House Financial Services Committee, Fed Chair Alan Greenspan indicated that he believes the economy to be on solid ground and that the risk of inflation is diminishing. This statement is consistent with prior Fed positions that the current level of interest rates is still "accommodative." Recently the Fed's goal has been to keep nudging rates up until borrowing costs are no longer a stimulus to the economy and a potential source of inflation. "Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures," Greenspan said. "In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny."

Greenspan's uncertainties include rising labor costs, high and volatile energy prices and long term interest rates, which have remained low relative to the increasing short-term rates. These low long-term rates have continued to drive growth in many housing markets around the country. The Fed always worries about labor costs without increases in productivity because of the potential impact on inflation as firms pass higher costs on to consumers. With regard to the worry about higher energy prices, Greenspan noted that further increases in the price of oil could "dampen the rate of economic expansion." Still, he did not think that the high prices were currently a drag on the U.S. economy. "Everybody is adjusting to the fact that oil prices are high," he responded to a frequently asked question about why high oil prices have not stalled the economy.

On the question of low long-term interest rates, Greenspan indicated that signs of "froth" were emerging in some housing markets and that housing prices could fall. He did not think the fall in housing prices would derail the economy. "If declines were to occur, they likely would be accompanied by some economic stress, though macroeconomic implications need not be substantial," he said. Chairman Greenspan's testimony to the committee was a strong affirmation of continued economic growth and a solid commitment by the Fed to continue raising short-term interest rates.

Questions
1.

Discuss what is meant by the term "excess reserves."

2. Define the federal funds rate. How does it differ from the discount rate?
3. Why do you think the Fed continuously monitors labor costs?
Source Vikas Bajaj, "Greenspan Signals Further Rate Increases," The New York Times Online. July 20, 2005.

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