South-Western College Publishing - Economics  
Soft Signs
Subject Soft Signs
Topic Fiscal Policy
Key Words Interest rates, unemployment, soft landing, CPI
News Story

The Federal Reserve has raised interest rates a total of 6 times and 1.75 percentage points over the last year in an attempt to bring the economy to a "soft landing." A soft landing occurs when the economy cools down enough so inflation is not a problem, but doesn't slow down enough to drive the economy into a recession. Getting it right is tricky because the response of the economy to interest rate hikes is uncertain both in magnitude and in timing. There are signs that the economy is slowing, but it will take as much as seven more weeks of data to confirm that the economy has really slowed.

The economic data that the Federal Reserve will be closely watching include the employment report, retail sales and the consumer price index. The employment report is crucial, since Alan Greenspan, Federal Reserve chairman, believes that the labor market is very tight and that significant wage increases followed by retail prices will result unless the market eases. The Conference Board's index of help-wanted ads posted its sharpest drop in two and a half years in May and new claims for unemployment benefits rose in June; both are signs of a weakening labor market.

Consumer spending accounts for two-thirds of Gross Domestic Product. The Fed believes that consumer spending buoyed by a rising stock market has fueled the current expansion and a moderate decrease would not be unwelcome news. Both the Conference Board's index of consumer confidence and the University of Michigan's consumer sentiment survey fell slightly and as consumer confidence ebbs, a decrease in retail sales follows.

There is much concern over the consumer price index (CPI). Economists focus on the "core" inflation rate, a measure that excludes the volatile energy and food sectors and there is some evidence that the core rate may be accelerating. Economists warn that inflation can accelerate even in an economic slowdown, and according to one economist, every increase of more than 0.5 percent in the measure of core inflation has meant a recession.

(Updated August 1, 2000)

Questions
1. How does an increase in interest rates affect home sales, construction and the sales of durable goods?
2. How does an increase in interest rates directly affect other sectors of the economy? What are the indirect effects?
3. In light of your answers above, why is the magnitude of the effect of an increase in interest rates on the economy uncertain? Why is the timing uncertain?
Source George Hagar, "Economy signals slowdown," USA Today, July 5, 2000.

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