South-Western College Publishing - Economics  
Rising Rates
Subject Interest Rates
Topic Monetary Policy
Key Words Interest Rates, Inflation, Economic Growth
News Story

The Federal Reserve raised interest rates for the fourth time in the last 6 months, a move that was generally expected. With economic growth surging at nearly 6 percent in the second half of 1999, Federal Reserve policymakers raised rates to cool off the economy and prevent inflation. Consumers and businesses will face higher borrowing costs for everything ranging from credit card purchases to mortgages. Most analysts supported the gradual approach that the Fed is using. Some felt that rate increases were not warranted, while others voiced the opinion that the rate increase was too small.

Fed officials announced that it was concerned that increases in demand will exceed the growth in potential supply, even with significant increases in productivity. Labor shortages or shortages in productive capacity would result in higher wages and prices, thus triggering inflation. The Federal Reserve Open Market Committee stated, "Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."

The increase in the Federal Funds rate to 5.75 percent and the increase in the discount rate to 5.25 percent were followed quickly by increases in the prime-lending rate by leading financial institutions. Many credit card balances, home equity loans and consumer loans have rates tied to the prime rate, so borrowers will feel the effect of the Federal Reserve policy quite soon.

Some economists argue that the rate hike was not needed. The Employment Cost Index rose 3.4 percent in 1999, a slight decrease from 1998. Labor market data show that labor costs do not appear to be accelerating. There has been an increase in consumer prices but this is largely the result of a doubling of oil prices.

The question troubling most analysts is whether the Fed will continue to raise interest rates especially at the next meeting of the Open Market Committee, on March 21st.

(Updated March 1, 2000)

Questions
1. The Federal Reserve is focused on preventing inflation. Who gains and who loses when inflation increases?
2. What role does the Federal Reserve Open Market Committee play in implementing monetary policy?
3. What are the costs of making a mistake - increasing interest rates when there is no underlying inflationary pressure?
Source John M. Berry, "Fed Hikes Interest Rates," The Washington Post, February 3, 2000.

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