South-Western College Publishing - Economics  
Are We Playing Catch-up?
Subject Inflation
Topic Monetary Policy
Key Words

Inflation, Interest Rates, and Monetary Policy

News Story

After months of a stable federal funds target rate at 1 percent, the Fed finally increased the target rate slightly to 1.25 percent. The Fed established this increase in response to accumulating data suggesting that inflation has begun in the economy. Some say the increase is late in coming and that inflationary pressures are fairly well established. The Fed, they say, has waited too long to engage their tighter monetary policy.

The Fed's critics are pointing out that when inflation begins and prices on goods and services begin to rise, price increases tend to feed on themselves and rise even higher. This is the textbook case of a "self-fulfilling prophecy." The problem, critics say, is the long-term monetary policy of the Fed, dating back several years.

"We believe that inflation has returned," said Mr. Alan W. Kral, portfolio manager at Trevor, Stewart, Burton & Jacobson in New York. "And the cause of it has been an over expansive monetary policy for almost 10 years. "

"I believe the Fed is behind the curve because the economy continues to be strong and the inflation rate is creeping up and will continue to creep up," said Henry Kaufman, a New York economist. "The Fed's plan to raise interest rates gradually may be good for the economy," said Kaufman, "but [it] is not designed to put the system back into balance in terms of constraining inflation itself."

"Everyone recognizes that holding the Fed funds target rate below the inflation rate is a recipe for accelerating inflation, because it creates an incentive for people to go out and buy things and finance them at relatively low rates," said Paul Kasriel, director of economic research at the Northern Trust Company in Chicago. "That act tends to drive the prices of those goods and services even faster. That was the predicament the Fed got itself into in the 1970's and spent a long time remedying. Now the Fed is in the early stages of squandering some of the gains that chairman Volcker made in eliminating inflation during the 80's."

If these recent critics' insights are on target, analysts will be watching to see how well Chairman Greenspan and the Fed plays the game of catch-up in the battle against inflation.


(Updated September, 2004)

Questions
1.

When Kasriel says, "That act tends to drive the prices of those goods and services even faster," he is referring to a concept that economists call demand-pull inflation. Define demand-pull inflation.

2. If you were to side with the critics in this article, what would you do to curb inflation?
3. Another type of inflation is cost-push inflation. Define cost-push inflation.
Source Gretchen Morgenson, "As Greenspan Chases Inflation, Critics Shout Faster," The New York Times Online, July 1, 2004.

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