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Will the Fed Raise Rates
Subject Federal Reserve Policy
Topic Monetary Policy
Key Words Inflation, Deflation, Monetary Policy, and Productive Resources
News Story

As the job market remains one of the key issues related to a recovery for the American economy, the question of how the Fed will respond is in doubt. When the Fed wants to stimulate the economy, it lowers rates to make borrowing cheap. When the Fed wants to slow the economy and fight inflation, it raises rates. Historically, the Fed has used monetary policy to raise interest rates soon after a recovery begins. The intent is to slow the economy down and prevent inflation. In this most recent cycle, however, inflation has not entered the economic picture as a problem, despite more than seven straight quarters of economic growth.

Federal Reserve Governor Ben Bernanke explains the lack of inflation by the fact that the current recovery has not been robust enough to take up all the "slack" created by the recession. What he means by "slack" is the millions of unemployed workers, millions more of underemployed workers, and the large amount of U.S. production equipment that is either idle or under-used. So as economic growth continues, these idle resources can be brought on line without causing inflationary pressures in the capital and labor markets, a trend which would eventually be passed on to consumers.

The Labor Department has also reported that even though total employment is growing, 145,000 fewer people were employed as of March 2003 than was originally thought. "That means there is even more slack in the labor market than we had previously thought, giving the Fed even more reason to sit tight for the next several months." according to John Silvia, chief economist at Wachovia Securities. Silvia does not think the Fed will raise rates until at least the second quarter of 2004.

The growing consensus is that the Fed will hold off on increasing interest rates; however, there is a built-in risk to this strategy. The risk is that if the Fed waits too long, and the inflationary momentum builds faster than expected the Fed may have to raise rates dramatically to stop the upward spiral of prices. If rates jump suddenly, it could have an extremely negative effect on the recovery. Nevertheless, it appears that the Fed is going to ignore the favorable job reports and continue to focus on disinflation.

"The Fed is clearly not in the mood to preempt inflation," said Paul Kasriel, senior economist at Northern Trust in Chicago. "They're going to wait, and that ultimately will have some unpleasant ramifications."


(Updated October, 2003)

Questions
1.

Define monetary policy and describe briefly how the Fed works to stimulate a lagging economy.

2. How do idle productive resources prevent inflation in a growing economy.
3. Suggest some reasons why the March, 2003 unemployment report might have "missed" 145,000 unemployed people. How does the BLS gather employment statistics?
Source Mark Gongloff, "The Fed's Gamble," CNN Money, October 6, 2003.

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