South-Western College Publishing - Economics  
When Will Interest Rates Rise?
Subject Inflation and Deflation
Topic Monetary Policy
Key Words

Inflation, Deflation, Interest Rates, and Monetary Policy

News Story

Federal Reserve governor Donald Kohn and William Poole, president of the Federal Reserve Bank of St. Louis, have taken opposing stands on the prospects for inflation and the risks of keeping the interest rates too low for too long.

Federal Reserve governor Kohn said that while there are signs that inflation is no longer falling, "the evidence is inconclusive so far." Kohn was speaking to the National Association for Business Economics when he acknowledged that lower dollar and higher commodity prices have caused some price inflation. But he went on to argue that unemployment remains high and businesses are operating below capacity. He said, "competition for jobs and for market share should remain intense," indicating that wage and price increases are not likely.

Meanwhile, St. Louis Federal Reserve Bank President Poole offered an opposing view to the current Fed worry over deflation when he explained that the risks of an unexpected increase in inflation "outweighed the risks" of an unexpected drop in inflation. Mr. Poole recently warned about the risk of interest rates staying low for too long, stating, "We do have to watch the data carefully and make sure policy does not remain accommodative beyond its time."

The views of Mr. Kohn are more reflective of the Fed's current position which favors keeping rates low to avoid the risks of deflation. This view also reflects Chairman Greenspan's risk management philosophy that errs on the side of keeping rates either too low or too high, depending on where it sees the greatest risks. Consequently, this translates into the Fed's current position of keeping rates on the low side because deflation is the bigger risk.

On the other hand, if more Fed official begin to share Mr. Poole's views on the outlook for inflation, it is likely to generate increased pressure to raise interest rates sooner rather than later. Some analysts already think the Fed is being complacent about not raising rates soon enough, as evidenced by a recent survey of members of the National Association for Business Economics. The survey found that 28% of respondents believe that interest rates are too low.

Given the Fed's current official position that the risks of inflation falling too much were "almost" balanced with the risk of rising inflation, it is certain that they will be watching the data on prices very closely over the next weeks and months to determine the appropriate policy to achieve non-inflationary economic growth.


(Updated May, 2004)

Questions
1.

Why is the Fed concerned with deflation?

2. Why does the Fed think a weak job market needs low interest rates?
3. Explain the connection between low interest rates and inflation.
Source Greg Ip, "Fed Officials Offer Opposing Views On Inflation," The Wall Street Journal, March 26, 2004.

Return to the Monetary Policy Index

©1998-2004  South-Western.  All Rights Reserved   webmaster  |  DISCLAIMER