South-Western College Publishing - Economics  
Will the Fed Move Faster on Short-term Rates?
Subject Federal Funds Rate
Topic Monetary Policy
Key Words

Energy Prices, Value of the Dollar, and Productivity and Wages

News Story

The Federal Reserve's ability to maintain its stance on raising interest rates at a measured pace hinges on three important economic uncertainties: energy prices, the value of the U. S. dollar, and the American worker's productivity and wages.

In the area of energy, oil prices soared to $55 a barrel in the fall of 2004. The uncertainty surrounding future oil prices raises questions about how long the Fed can continue its gradual pace of interest rate increases. Historically, higher oil prices affect the prices of many goods and services, creating inflationary pressure. If oil prices do result in higher prices, the Fed may have to move more quickly to reduce inflationary dangers.

Since President Bush was re-elected in November, the dollar has declined sharply against the euro and other major foreign currencies. Many analysts think the dollar needs to fall even further to make American exports cheaper and foreign imports more costly. However, if the dollar plunges steeply, the Fed could be forced to change its policy of gradually increasing rates. First, with imported goods becoming more costly, American manufacturers would face less competition to hold prices down and inflationary pressures would remain.

Secondly, foreign investors may require higher interest rates on Treasury bonds and other government securities to offset the potential loss of value in their portfolio of American assets. The bulk of these portfolios are in the form of Treasury bills, notes, and bonds that finance the U. S. federal budget deficit.

A final factor in determining Fed policy could be trends in productivity and wages of American workers. Average labor costs have been climbing in 2004 because of increasing labor demand. As the economy experiences growth, firms hire more workers. If they continue to hire, wages could increase further and cause what economist refer to as cost-push inflation.

One important offset to increased wages is the fact that productivity has risen along with the wage increases-this productivity helps to hold down inflationary pressure. If productivity begins to slip, inflationary pressures will increase and the Fed will face additional pressure to raise rates.

Although these scenarios have not yet played out, the uncertainty of their effect on future prices does suggest that the Federal Reserve may have to move on interest rates more quickly than Fed officials seem to have planned.

(Updated February, 2005)


Discuss the notion of cost-push inflation. Do you see any examples of potential cost-push inflation occurring in the U.S. economy today?

2. Explain why the falling dollar makes exports cheaper and imports more expensive.
3. Discuss the offset between increased wages and worker productivity. Why do you think that U.S. workers have become more productive in recent years?
Source Edmond Andrews, "Fed Panel Lifts Rates and Says More Increases Are Probable," The New York Times Online. December 15, 2004.

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