South-Western College Publishing - Economics  
Much Ado About Interest Rates
Subject Interest rates and monetary policy
Topic Monetary Policy
Key Words Interest Rates, Monetary Policy, Unemployment, Economic Growth
News Story

For many months the question of whether the Fed was going to raise interest rates has been in the news. The economy has been growing at a rate that in the past would have caused inflation to accelerate, but inflation reports showed only minor changes. April's Consumer Price Index (CPI) did show a significant jump and the Fed responded with statements that a rate hike might now be needed. Just when it looked as though the Fed's course of action was clear, May's CPI showed virtually no inflation. Many analysts are wondering what the Fed will now do.

When the Fed meets at the end of June there will be considerable pressure to raise interest rates. A hike in interest rates could end the best combination of low unemployment, low inflation, and high economic growth that the economy has been experiencing for many years. But the Fed worries that the economy is growing too fast, that labor markets are already very tight, and, consequently, inflationary imbalances are building even though inflation may not occur immediately. Another worry is that consumer spending which is driving the economy is being fueled by the rise in stock market prices. If the Fed does not raise rates, stock market prices could spiral upward even faster, creating even more growth in consumer and business demand.

The combination of strong growth and low unemployment has so far not produced inflation because productivity, output per hour of work, has risen significantly. Other important factors holding inflationary pressures down are increased competition from abroad and a decrease in inflationary expectations.

Alan Greenspan, chairman of the Federal Reserve, has recently said that the Fed was now more worried about inflation than recession. That statement has been viewed as a precursor to a rate hike at the next meeting of the Federal Open Market Committee. May's consumer price data may have once again put rate hikes on hold.

(Updated July 1, 1999)

1. What part of the Federal Reserve is responsible for deciding whether interest rates will increase?
2. How does the Federal Reserve execute a change in monetary policy?
3. What are the consequences of a rate hike for exchange rates and international trade?
4. What are the consequences of raising interest rates prematurely?
Source David Wessel, "New Inflation Report Makes Fed's Debate Over Rates Tougher," The Wall Street Journal, June 17, 1999.

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