OK, the Fed just raised rates for the 10th consecutive time. Link. I was watching Chris Matthews interview Krugman and Kudlow last night and they both agreed that the Fed should not have done so. These guys agree so rarely that it really got me thinking: Is it time to adjust the way the Fed deals with a situation of good economic growth-- ie, assuming that good growth = inflation pressure?
Is there really inflation pressure out there? Hard to imagine, since Labor costs show little wage pressure. Fuel prices are clearly rising, but that leads me to my second question: Is there a fundamental difference between inflation which is driven by increased commodity prices (due to increased demand) and inflation which is driven by too much money chasing too few goods (ie, governments "printing too much money). The Fed certainly needs to tighten the money supply in order to deal iwth the latter situation, but should they do so for the former?
I’m hoping to learn something here from folks who understand the situation better than I do, so I don’t really have an answer or an opinion with regards to the two questions I’m asking-- only a suspicion that something isn’t quite right about what the Fed is doing.
Tried to buy a house lately? Seems inflated to me.
I guess if you make the argument that raising the rates won’t help counteract the effect of rising commodity prices on inflation, you could equally make the argument that it’s not going to hurt either.
But inflation pressure isn’t the only reason to raise rates. We’re still only at 3.5%, which doesn’t give the Feds much room to lower rates when the economy inevitably hits another rough patch.
There’s a very real housing bubble going on right now, and their measured approach to raising the rates is likely an attempt to cool it off before we get another internet burst.
My read on it is that most of the inflationary pressure is coming from the housing market-- although the price of gas has gone up about 20% in the past year, it’s not as significant as housing prices which have skyrocketed on both coasts.
But the problem with housing is the incredible boom in interest-only mortgages. Something like one in four mortgages in the U.S. are now interest-only mortgages, and they pretty much didn’t exist four years ago. That’s a lot of money floating around, and I suspect that in many cases the lenders will not be able to pay it back.
I’m not going to even try to answer the first question because there are way more people smarter than me that can answer that question. The Fed only has the one power to combat growth or depression and that’s adjusting the interest rate. Other than that, either an Act of Congress has to be drafted (i.e. enacting new law), or you’re asking for someone to monkey around with an otherwise free market.
As for your second question, from what I remember about my monetary policy classes, too much money = bad (typically), increased commodity prices = good typically.
In general, an increase in commodity prices is generally seen as a good thing because demand is higher, as you stated. An increase in demand usually means an increase in wages, disposible income, etc., which in turn means that more people are employed and wages are rising. Commoditized products are typically base materials which can be used to create additional products (wood, cement, steel, etc.) So, again, in a general sense, the economy can be seen as more productive.
Conversely, too much money in the economy is not a good sign. Prices increase because there is simply more money that people have to spend. Extra money is not an indicator of increased value within the economic system, like having prices rise because of demand. Likewise, increases in price do not indicate an increase in value in the economy (simply, things just cost more).
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Conversely, too much money in the economy is not a good sign. Prices increase because there is simply more money that people have to spend. Extra money is not an indicator of increased value within the economic system, like having prices rise because of demand. Likewise, increases in price do not indicate an increase in value in the economy (simply, things just cost more).
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Situations like this are what lead to a decrease in standard of living - prices rise, but incomes stay the same, thus families have less buying power. I agree that it seems to be in reaction to the volatility in the housing market. The large number of mortgages that people have assumed recently almost makes me think that banks have TOO much money to lend. However I’m still a novice at economics, so I may be misinterpreting these signs.
How short our memories are. At 3.5% the rate is still way below what it was when the last recession started. At that time the FED started lowering rates at a half a point at a time to help the economy. In a healthy economy we can stand higher rates and the FED is slowly raising the rates to fight inflation and to make sure there’s a good cushion to use when times get bad again…and you can bet they will sooner or later.
I’m not sure but I think there is a chance that even though rates are low, that the Fed has been a little loose with printing money. Maybe someone else can fill us in on this.
I agree that this is partly what the Fed is thinking, but even Krugman was skeptical as this being a good reason. Inflation in housing prices is very, very uneven across the country. It’s nuts in CA, but not so nuts in Iowa.
Per your own analysis, it’s not that there’s much more money floating around, it’s that people are financing homes differently. A lot of folks got dissillusioned with the stock market in the last few years and have turned to stocks instead.
Bill Gross of PIMCO, who manages the world’s biggest bond fund, has made no secret of his view that the government understates inflation, and some investors agree. I’ve done a bit of reading on the issue but am not enough of an economist to have come down firmly on either side; in any case, I’m neither advocating nor dismissing this argument, just noting it for the thread.
The government’s measure of consumer-price inflation, BTW, does not include house prices. Instead, it has a component that tracks rents and another for so-called rental equivalence, or “the change in the implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market.” (More on this, er, fascinating subject here.) Some people consider this to be a major statistical copout on the government’s part; again, I’m neither supporting nor ridiculing.
I think it’s worth noting that the Fed’s target for the Fed Funds rate has only recently turned positive, or climbed above the annual CPI rate. (The latest increase took the target to 3.5%, while CPI has gained at an annual rate of 3.1% so far in 2005, as shown by the second sentence of paragraph five here.) In other words, until recently the target was below the inflation rate, so the real, or inflation-adjusted, interest rate was negative. That means money was free for banks in real terms, and so in that sense, the rate increases have hardly begun to bite.
Well, this is always going to be a problem in monetary unions, which is what the US is. Differing economic conditions in different regions of the monetary union are going to call for different responses by the central bank, but the central bank can only set one policy. So, inevitably, some regions are going to get screwed, with either a too loose or too tight monetary policy. It’s the old “if the US economy catches a cold, West Virginia catches the flu” phenomenon. The Fed can only set what it thinks is the best policy for the country as a whole, and rely upon the mobility of capital and labor to smooth out the effects as best they can.
As for the overall picture, the current situation is highly distorted, particularly by huge Chinese purchases of T-bills, and the Fed is right to act on the assumption that that distortion will end at some point. IMO, the Fed’s current monetary policy is still extraordinarily loose by historical standards, and tightening should continue.
Another thing to keep in mind is that by the time inflation has become obvious, it’s too late to react. Painful adjustments would have to be made; i.e., probably resulting in a crash of some sort. Slowly raising rates is the Fed’s way to moderate economic growth so the next slowdown/crash will be farther in the future.
The fact that long-term interest rates are stable indicates that the market believes that inflation is not a long-term risk. Meaning that the Fed is doing its job properly.
Kinz and Sua both make excellent points, something which I neglected to address in my earlier post. Historically, our interest rates are ridiculously low. I remember discussing this concept of having a “healthy inflation,” that is, some inflation is good. It is hard to distinguish, within a robust economy, inflation and actual growth. Note, by “healthy” I mean stable. A good economy is a predictable economy, not one that is necessarily growing, but growing and sustainable. This is one of the major reasons why the US economy has historically been so strong and why all economies compare their currency to the dollar (I meant to say “value,” but that is something completely different and didn’t want to mix terms).
Anyway, as it has already been pointed out, long term interest rates are still low. Inflationary concerns, while not trivial, still have a long way to go before we start re-thinking the Fed’s ability to regulate the economy. By slowly raising the rate, I hope Greenspan can send the right signal that will 1) encourage savings, 2) not discourage investment, and 3) ease out the housing bubble. I just hope he doesn’t raise it too much before I buy my house.
Labor costs show little wage pressure in this period. However, over the past four quarters, unit labor costs have risen 4.3 percent. This is the largest increase in nearly five years.
Even though we have not yet witnessed inflation does not mean that inflationary pressures are slackening. Obviously the housing market and debt financing remain enormous concerns. Productivity growth is also very slack. This may force businesses to either watch their margins erode or pass on the costs of doing business to their customers. Should we face a period of protracted productivity slackening, we will need room for interest rates to go down.
I think the current Fed position is actually quite neutral with respect to inflation and to the economy altogether. There are signs of improvement whose sustainability is unclear. 3.5% seems an appropriate place to be under the circumstances.
I think the Fed overestimates the effect that their modifications of the interest rates are. Labor does not have the same clout that it once had, so if the economy goes into high gear, the upward pressure on wages just isn’t what it would have been 20 years ago. Still, from the Fed’s perspective, if all you have is a hammer, then everything looks like a nail.
