South-Western College Publishing - Economics  
The Fed is Leaning
Subject Economic growth
Topic Productivity and Growth
Key Words Inflation, Productivity, Growth
News Story

Just when analysts were beginning to think that the U.S. economy was evolving into an inflation- and recession-proof economy, bad news burst that theory. The Consumer Price Index (CPI) jumped 0.7 percent in April, one of the largest monthly gains in quite a few years. The Federal Reserve's reaction to this development was to issue a statement that the Fed is so "concerned about the potential for a buildup of inflationary imbalances" that it is leaning toward raising interest rates. The Federal Reserve did not raise interest rates, nor is it certain that the Fed will raise rates in the coming months, the Fed's statement simply means that its bias has shifted.

The Federal Reserve now believes that demand in the economy is growing faster than the nation's ability to supply goods and services. Tight labor markets and historically low unemployment rates will pressure firms to raise wages and wage hikes will not be offset by productivity gains. Forecasts of an economic slowdown caused the Fed in recent months to be neutral about interest rate increases but the Fed now sees a greater risk of accelerating inflation than of the economy's slowing down.

Economists at the Organization for Economic Cooperation and Development (OECD) urged the Federal Reserve to be cautious and not react to a single month's CPI. The OECD's statement is partly based on its forecast of slower growth in the coming years. The OECD forecasts a 3.5 percent increase in 1999 and a 2 percent increase in U.S. economic growth in 2000. Other economists have echoed this belief. They point, for example, to April's 10.1 percent drop in housing starts as an indication that the economy may be slowing down.

(Updated June 1, 1999)

Questions
1. What measures are available to the Fed to raise interest rates?
2. What impact do higher interest rates have on the economy? What are the channels through which these impacts appear?
3. Suppose that the Fed raises interest rates at the same time that the economy is slowing. What are the consequences of higher interest rates in these circumstances?
Source David Wessel, "Fed Leaves Interst Rats Unchanged", The Wall Street Journal, May 19, 1999.

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