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Wealth of Nations 
Why the Fed Has to Be Careful in Raising Rates
The Fed needs no reminding that Japan's financial authorities pushed their economy back into recession in 2000 by tightening too soon. by Clive Crook .... The American economy has come to a turning point in the current business cycle: Next week, responding to signs of rising inflation, the Federal Reserve Board is expected to raise interest rates by at least a quarter of a point. Most likely, this will be only the first of a series of increases over the course of the next year to 18 months. It is quite a switch. Less than a year ago, financial markets were alarmed about the risk of deflation—a trend of falling incomes and prices, very difficult to reverse once started. Now they are preoccupied with the opposite. What happened to change the outlook so abruptly? The main thing is simply that the economy is stronger right now than many had expected. Spare productive capacity, the main source of downward pressure on inflation, has been whittled away. How far, exactly, is debatable, and uncertainty over the extent is complicating the Fed's calculations. The Fed's own measure of capacity utilization in manufacturing stands at less than 80 percent, a figure that implies plenty of room for further growth in output without the risk of rising prices. But manufacturing is nowadays only a small part of the overall economy. In any case, many economists think this measure is unreliable; they argue that some of the supposedly idle capacity is actually obsolete equipment. If so, the true margin of spare capacity is a lot thinner. Other measures say that the margin in manufacturing has, in effect, all but disappeared. Even if spare capacity does remain, bottlenecks in supply seem to be giving producers new leverage over prices. Opinion on the Fed's policy-making committee seems to be divided on this crucial question of how much spare capacity remains in the domestic economy. However, other factors are involved as well. In addition to the unexpected strength in the domestic economy, global conditions are also helping to push prices up. Economic growth has revived worldwide during the past year, notably in Japan, and even, to a smaller extent, in Europe. China continues to power along, sucking in goods and raw materials from the rest of the world. All of this activity has pushed up the prices of internationally traded commodities, and that rise in turn has increased the costs facing American business. This trend is worsened, from America's point of view, by the slide in the dollar. Overall, and measured in depreciated dollars, prices of global commodities have risen 22 percent over the past year. The shift is not concentrated in any particular market, but rather across the board. The price of oil, reflecting both global demand and fears about the security of supplies from Saudi Arabia, has risen by 20 percent. The price of agricultural commodities has gone up by 18 percent and the price of metals by more than 30 percent. Tighter markets at home and abroad have now begun to push up the prices that American consumers pay. These prices have risen by just over 3 percent over the past year—hardly an alarming rate of inflation as yet, but still a marked acceleration. Admittedly, by excluding goods whose prices tend to be volatile—food and energy—the "core" rate of inflation comes down to less than 2 percent. But it would be wrong to draw too much comfort from that. Global conditions and the continuing security fears in the Middle East mean that there is plenty of future upside risk on commodities prices; the dollar probably has further to fall; and with labor markets starting to get tighter at home, there is every chance that the recent rises in core and non-core inflation will together feed through to wages, and hence to prices more generally. This prospect helps to explain why the markets think it so likely that the Fed will raise interest rates next week. Inflation, though higher than of late, is still low by historical standards. And interest rates, by those same historical standards, are not just low but extraordinarily low. So is there any real reason for concern as the Fed switches gently back to a tightening mode for monetary policy? So long as the market for oil remains reasonably stable, the main danger during the next 18 months is unlikely to be inflation in its own right. It is instead that the policy switch may go wrong, perhaps through no fault of the Fed's. The problem is that the pattern of this economic recovery is so unusual. That makes the lessons of history less helpful to the Fed than one could wish. And a main peculiarity of the current upswing is that the recovery, strong as it has seemed at times, is in fact quite fragile. So holding the recovery on its present track of rapid growth and mild inflation is going to test all of Alan Greenspan's skill. You get a sense of the Fed chairman's dilemma from his most recent speeches, in which he has striven to sound more hawkish on inflation, yet calm and unworried at the same time. It is a difficult balance to strike. So far, he has managed to stay on his feet. In recent weeks, he has coached the markets to expect a Fed-directed rise in short-term interest rates starting about now. This prospect has already been priced into bonds (long-term yields have risen) and stocks (prices are down a bit lately); but neither of those adjustments has looked remotely like a panic. In this way, through prices dispersed across financial markets, a gentle tightening of monetary conditions has begun even before the Fed raises its benchmark rate. That rise, when it happens, is really just a matter of ratifying the tightening already brought about by recent pronouncements from Greenspan and the Fed's other governors. If the chairman and his colleagues can keep this strategy up, all will be well. But can they? Greenspan is only too aware of the difficulties. The oddest thing about the recent slowdown and subsequent recovery has been the strength of consumer spending throughout. Over the past four decades, household saving has averaged around 2 percent of national income. Up until the late 1990s, households always spent less than they earned. But for the past five years they have spent more than they earned—to the tune of 2 percent of national income each year. The counterpart of this borrowing spree is a remarkably rapid buildup of debt. Low interest rates help to explain why household borrowing has been so high for so long. During the slowdown, this was what the Fed wanted. The priority was to buoy consumption and keep the economy moving. As spare capacity shrinks and inflation pressures slowly build, the challenge is to curb this borrowing with higher interest rates—but without causing consumers to panic about their accumulated debts, thus tipping the economy back into recession. A particular source of uncertainty is the housing market. House prices have risen strongly in America since 1998, and especially in the past year. Again, exceptionally low interest rates (together with disappointing rates of return on other forms of saving) are the main cause. According to various measures, American housing is now significantly overpriced in relation to earnings. An orderly adjustment to normal ratios would see house prices pause while incomes and prices in general caught up. That is what the Fed is hoping for. Too abrupt a rise in interest rates, however, especially if combined with other surprises tending to rattle consumer confidence, might see house prices fall. That would make Americans feel suddenly poorer, especially those who had borrowed imprudently to pay for their overpriced houses. Demand might then fall sharply, and in circumstances that would make the fall difficult to stop. Interest rates, even after the prospective rise, will still be low—too low to be cut dramatically. And the government's budget deficit is already too big to be increased any further: Follow that course, and a different kind of panic would ensue. Conceivably, therefore, monetary and fiscal policy could both be defeated if the economy is unlucky over the coming months. The Fed needs no reminding that Japan's financial authorities pushed their economy back into recession in 2000—a downswing that lasted another three years—by tightening too much and too soon. In an economy without debt, there is a lot of distance between inflation and deflation, and monetary policy has plenty of room for maneuver. But in an economy with lots of debt, with households and companies financially overstretched, inflation and deflation are not so far apart. Monetary policy is much more boxed in. Too abrupt a rise in interest rates, combined with one or two bad surprises in the outside world (leading contender: another big oil-price shock) could make that situation all too obvious. All of which underlines the importance of gently steering expectations about interest rates in the right direction. Fed chairmen cannot work magic, but they can at least avoid hitting the markets with bad surprises on interest rates. That is one mistake that Greenspan is unlikely to make.
What do you think? Discuss this article in the Politics & Society conference of Post & Riposte. More from National Journal. More on politics and society in Atlantic Unbound and The Atlantic Monthly. Clive Crook is a columnist for National Journal and the deputy editor of The Economist. This column appears every week in National Journal, a weekly magazine covering politics and government published in Washington, D.C. For information on National Journal Group publications, see NationalJournal.com. Copyright © 2004 by The Atlantic Monthly Group. All rights reserved. |
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