South-Western College Publishing - Economics  

To Raise or Not to Raise
Subject Monetary Policy, Inflation
Topic(s) Monetary Policy, Inflation
Key Words Monetary Policy, Federal Reserve, Inflation, NAIRU, Interest Rates
News Story

When is the inflation coming? The economy is growing at a rate that in the past would have caused much anxiety on the part of the Federal Reserve. Economic growth is over 4 percent for the past year. Many economists, including Laurence H. Meyer, a governor of the Federal Reserve, believe that this growth rate, given productivity and labor force growth, should cause wages and prices to increase. The data do not support this belief. Although wage costs are accelerating, prices have not kept in step and profits are at healthy levels.

The Council of Economic Advisers and the Congressional Budget Office have estimated the NAIRU, the non-accelerating rate of unemployment, to be between 5.4 and 5.8 percent. When unemployment drops below this rate, there is pressure on wages to increase. Cost-push inflation theories then translate changes in wages to changes in prices. Each year that the unemployment rate is below the NAIRU, about one-half percent is added to inflation according to some estimates.

Some economists are questioning the Fedís decision to hold interest rates constant in light of these pressures. There are some reasons to hold the line. The economy might be on the verge of cooling itself and therefore any downward pressure might turn a soft landing into a recession. There is some fear that a significant hike in interest rates might produce a major decline in the stock market. Other worries, such as the impact of a decline in the U.S. economy on Asian financial markets, are also reasons to avoid interest rate hikes.

Some increase in interest rates will likely come this year. The evidence is that inflation is reversible and an increase in prices could be reversed without a recession. The big uncertainty is the reaction of the stock market.

Questions
  1. Suppose the Federal Reserve decided to increase interest rates by selling bonds to the public. Describe the mechanism that would result in higher interest rates?
  2. The article talks about possible lags in the implementation of monetary policy. What are these lags? How would they affect the efficacy of monetary policy?
  3. How would an increase in productivity reduce inflationary pressure?
Source Peter Passell, "The Fed is trapped between expectations and reality," The New York Times, May 7, 1998.

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