Does Rate Hike Portend Inflation?

July 16, 2004
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GRAND RAPIDS — Casting a vote of confidence in the economy, the Federal Reserve raised interest rates June 30 for the first time in four years. 

The Fed’s Open Market Committee raised its target for the federal funds rate from its 46-year low of 1 percent to 1.25 percent. The Fed reiterated that future rate hikes would come “at a pace that is likely to be measured,” signaling the agency would continue to be cautious about further hikes in interest rates.

“My feeling is that the Federal Reserve action was one that was fully expected by the marketplace,” said George Erickcek, senior analyst with the W.E. Upjohn Institute.

“It was a very cautionary move,” he added.

“If I was going to make an error, I would still err on an easy money market and keep interest rates low because, in my opinion, there’s enough evidence to suggest that the economy is not yet fully on its feet.

“A rising interest rate is a good thing because it shows the economy is growing,” he added. “It’s associated with positive growth, but a lot of people kind of forget that.”

The federal funds rate is the rate banks charge each other on overnight loans. The rate influences the commercial prime lending rate, which in turn affects consumer spending and saving decisions. The recent Fed move triggered a one-quarter increase in the prime rate.

The Federal Reserve sets the target rate to influence economic activity and control inflation.

Inflation is a sustained increase in the general price level and a decrease in the real purchasing power of money. The rate of inflation is typically measured by the consumer price index.

Both inflation and interest rates are still low by historical standards, but a significant increase in inflation would have a significant negative impact on interest rates.

“If inflation did get out of control, we would see interest rates climb,” Erickcek acknowledged. “The Federal Reserve is always cautious. They do not want to be behind the game.

“When inflationary pressures start, it’s very difficult to play catch-up, so there’s the challenge,” he said. “They do not want to be accused of shutting down the economy prematurely, but at the same time they don’t want to be accused of being asleep at the switch.” 

Even with the tool the Fed has, inflation can jump on a runaway track.

“All the federal government has is only this one tool that affects the overnight rate that banks charge each other,” Erickcek observed. “When you think about it, it’s a pretty limiting tool. Indeed, all they’re really doing is trying to control inflation by trying to impact economic activity.”

Some inflation is cost-push inflation and the country has experienced some of that with rising oil prices, he said. Oil, for example, is one of those commodities tied to the sale of consumer goods because of transportation costs.

In a cost-push inflationary spiral, interest rates would be a little less effective in curbing inflation because it’s strictly about demand, Erickcek said. The Federal Reserve’s actions are geared towards demand-side factors.

He said that trying to decrease demand for economic activity by making it more expensive is not effective when expenses are already climbing on the supply side. If, for instance, oil prices continue to rise — which Erickcek doesn’t think will happen — then uncertainty and risk increase in the commodity market. 

In his estimation, it does not appear to be an environment in which inflationary fires could ignite, given employment gains in recent months, given that the unemployment level is staying about the same and given the fact that productivity has outpaced output over the last five quarters.

Improvements in productivity, coupled with global competition, continue to keep prices down, he said.

“Inflation typically occurs when productivity gains do not keep up with output — when there’s too little money chasing too few goods. We’re just not there.”

However, if China’s demand for steel and other commodities continues to grow, America may see some pressures on the supply side, but they tend to be short in duration, he noted.

In June the auto companies stepped back on their incentives, and consumers reacted by stepping away from the car lots. Sales for the month fell drastically, Erickcek recalled.

“As long as you and I as consumers will not tolerate price increases and simply continue to look for sales, I am not that worried about inflation. I think that’s one of the strongest deterrents to inflationary pressures — the unwillingness of consumers to accept price increases.”

Other factors influencing the interest rates include money demand and supply, the value of the dollar relative to major currencies, consumer confidence, government spending, global economics and political dynamics.

“Given that it’s an election year, I think it’s very clear that the Federal Reserve wants to be as quiet as possible. They do not want to do something that can be taken by either side as being partisan.”  

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