South-Western College Publishing - Economics  
Stepping Up Rates?
Subject Interest Rates, Economic Growth
Topic Monetary Policy
Key Words Inflation, Interest Rates, Discount Rate, Economic Growth
News Story

Over the past months, the Federal Reserve has adopted a policy of gradually raising interest rates in an effort to reign in the economy, but that policy may change. Economic reports over the past few weeks point to rising wages, a tightening job market and price increases that are not in volatile sectors or related to oil price hikes. Policymakers have moved cautiously because historic relationships between economic growth and inflation have provided little guidance as to how much of a rate hike is needed to cool down the economy. The Fed was also afraid that large increases in interest rates would cause turmoil in financial markets. But the emerging signs of inflation suggest that the gentle nudging is not working and a more aggressive approach is needed.

A lot of attention will be focused on the Federal Reserve meeting on May 16. The Consumer Price Index for March jumped 3.7 percent, significantly higher than the annual rate for the previous months. The latest report on productivity growth shows that the rate has fallen considerably in the first quarter of 2000. Hourly compensation rose the same quarter at an annual rate of 4.2 percent and outstripped the growth in productivity. These data are all signs that the economy has not responded to previous rate hikes and analysts speculate that this will cause the Fed to bump up interest rates by one-half percent or more. Other data, such as retail sales which decreased by 0.2 percent in April, may show that consumer spending is slowing.

The Fed is hoping for a 'soft landing,' seeking to cool the economy without causing an economic slowdown. Some analysts are worried that a more aggressive Fed will push interest rates too high and knock the economy into its first recession since 1990-1991. They note that mortgage rates have jumped to 8.5 percent already and this will certainly reduce the demand for new homes.

(Updated June 1, 2000)

Questions
1. What is an active approach to monetary policy? What is a passive approach?
2. Explain why proponents of an active approach would recommend intervention to close an expansionary gap.
3. What is the impact on the economy of a decrease in the supply of money? Does it matter whether the decrease is anticipated or unanticipated? Explain.
Source George Hager, "Will Alan Greenspan and the Fed crash the economy's party?" USA Today, May 12, 2000.

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