Economy

Federal Reserve Decision on Interest Rates

The Federal Reserve boosted a key short-term interest rate by a quarter-point, from 1.25 percent to 1.50 percent, on Tuesday. The Fed action had been expected as analysts predicted the central bank would continue with its campaign to raise rates even in the face of last Friday's report that showed job creation slowed to a near-standstill last month.

Jared Bernstein, senior economist at the Economic Policy Institute, discussed the Federal Reserve decision, unemployment, stocks and oil prices. A transcript follows.

Bernstein joined the Economic Policy Institute in 1992. His areas of research include income and wage inequality, technology's impact on wages and employment, low-wage labor markets and poverty, minimum wage analysis, and international comparisons. Between 1995 and 1996, he held the post of deputy chief economist at the U.S. Department of Labor. He has published extensively in popular and academic journals, including The American Prospect and Research in Economics and Statistics, and is the co-author of six editions of the book "State of Working America."

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Jared Bernstein: Hear ye, hear ye. The Fed has done what we all expected them to do: raise their Federal Funds Rate by .25% to 1.50%.

Let the chat begin.

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Greenbelt, Md.: Since there are several signs of weaknesses in the economy, why is the Federal Reserve raising interest rates. Is the Federal Reserve concerned about rising oil prices and remember the last time oil prices rose, which was in the 1970's, the economy slumped into a severe recession?

Jared Bernstein: As they state in their press release today, they are clearly concerned about both. In fact, they argue (correctly) that the two issues--high oil prices and weak economy--are related. However, they obviously feel that the risks of not raising right now outweigh the benefits from keeping rates at 1.25%.

Many others--and I'm closer to that camp--think this is not a great time to slow down economic growth, for reasons I'm sure we'll get into (though the weakening job market is at the top of the list).

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Las Vegas, Nev.: Given that everyone anticipated this rate change, can we expect much of an effect on the bond and mortgage markets, or will those markets have already anticipated the rate increase?

Jared Bernstein: The markets have definitely "priced this in" meaning that as you suggest, it's been anticipated. The stock market appears to be taking it in stride, eg.

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Alexandria, Va.: Why do you think the conventional wisdom never questions the Fed's consistently conservative practice of monetary policy? Do people realize that there are alternative economic policies that could bring about full employment?

Jared Bernstein: You raise an interesting point that deserves more attention. For example, note that the last sentence of the Fed's statement today read:

We will "respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

They omit "and full employment" at the end of that sentence, even though that too is their mandate.

On the other hand, they don't consistently practice conservative monetary policy, as you suggest. In fact, they helped to accommodate full employment in the latter 1990s. And they certainly have been keeping rates low recently.

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Phoenix, Arizona: This doesn't make sense to me, if the intent of raising interest rate is curb the threat of inflation caused by un controlled growth..does the Fed believe that the economy is still growing even with the last few months of GNP being way below estimates, consumer spending falling below expectations, actual new jobs(from payroll records) being a dismal 32,000 and the economy showing all sins of no REAL recovery? won't he higher interest rates have a reverse negative effect and slow construction and home sales?

Thank you,

David

Jared Bernstein: I hear you, and I this is the challenge they were facing today. Why raise rates when the economy appears to be slowing!?

There are numerous reasons they did so. Here are a few:

• They said—in so many words—that they would raise them. If they don't, it signals to the world that the Fed thinks the economy is worse shape than they've recently maintained;

• They need a higher interest rate perch to come off of if the need for a monetary stimulus develops (like a really lousy jobs report…);

• The real interest rate equals the nominal rate minus inflation. The Fed sets the nominal Federal Funds rate, and given that consumer inflation is running at around 3%, the real fed funds rate is negative. Under such conditions, it's cheaper to borrow than not to borrow. That's highly stimulative and you don't want to be there if you think growth is adequate;

• Though this is less relevant now, if investors feel the Fed isn't aggressive enough on the inflation threat, they'll add a risk premium to long-term interest rates, and this can hurt growth.

Yet, there are probably still many economists and others who are going to be critical of this rate hike for the reasons you raise.

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Irvine, Calif.: Mr. Bernstein:

What sets of statistical data are reflecting the true state of the US economy? Unbiased by politics and representative of the whole population.

Jared Bernstein: There's so much to choose from! But I think the labor market data are the most informative of the problem with the current recovery. Though unemployment is relatively low--5.5%--in historical terms, it's still just about where it was in Nov '01 when this recovery began. We remain over 1 million jobs down from the prior employment peak in March '01. Wage growth is slowing, and, as another questioned alluded to, many families are getting by with ever higher debt levels (another reason to worry about interest rate hikes).

The effect of these weak labor market conditions can be seen quite clearly in the slowdown of consumption growth that was largely responsible for the disappointing GDP report in the second quarter (3% v. 4.5% in the first quarter).

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Southampton, UK: The Fed seems to think current oil price highs are temporary, despite the prices being driven by strong world demand rather than supply shortages - do you agree with him?

Jared Bernstein: Who knows? They've got lots of folks over there studying that stuff so let's hope they're right.

But here's a related question: if inflation is coming mostly from oil prices, how can the Fed scratch that itch? They can't do much to affect world demand for (or supply of) oil. Their weapon--the fed funds rate that they raised today--is much more appropriate when cost pressures are coming from the domestic demand side, which clearly isn't the case right now.

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Wheaton, Md.: Mr. Bernstein, doesn't the Fed's action reveal that August institution's increasingly political bent. Maybe a better way to put this is how political an action will this rate increase be seen as?

Jared Bernstein: I've been laying in wait for this question so I can paste in something I wrote earlier today about this:

Though the Fed claims not to be influenced by political concerns, this is Washington, and they're not immune to these dynamics, especially a few months before an election.

As Randall Dodd, director of the Derivatives Study Center, points out, this is their second-to-last meeting before the election. If they don't raise now, especially after signaling that they had previously planned to do so, it could be interpreted as a bold-faced attempt to boost the economy to help the incumbent president. If more bad news comes in, they can hold fast (i.e., not raise) at the next meeting with a bit more impunity, especially if they continue to warn about economic weakness, as they did in today's statement.

But there's another side to this political calculation. Despite evidence to the contrary, President Bush is running around the country claiming the economy is "strong and getting stronger." For Greenspan to contradict him by not raising today would have deeply undermined the president's credibility. Had the FOMC held fast today, imagine Bush officials trying to square this action with the president's rhetoric.

Thus, even if G-span and Co. wanted to help the president, it's not at all clear what they should do. If they don't raise, they potentially lift Bush's chances by boosting growth. Yet to do so severely undermines his message.

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Washington, D.C.: Isn't the increase in the interest rate good for savings accounts? It seems that the amount of interest earned on my savings account over the past few years has decreased DRAMATICALLY!!

washingtonpost.com: Fed Raises Key Interest Rate by Quarter-Point (Post, Aug. 10)

Jared Bernstein: It might help a bit in that regard, but this is something I've been meaning to emphasize:

0.25% is a very small increase--it's not going to make a huge difference either way. In fact, though I think they should have held fast (ie, not raised), doing so would have probably had a far greater effect on financial markets than the actual increase, since the markets were widely anticipating this hike.

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Alexandria, Va.: As a follow-up to my previous question, if you'll indulge me: But didn't Greenspan's monetary policy decisions in the later 1990s have more to do with stabilizing financial crises around the world?

Jared Bernstein: That's surely part of it, but he apparently believed the faster productivity growth regime that began in the latter 1990s meant we could have lower unemployment without inflationary pressure.

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Alexandria, Va.: How do you think the relatively weak July employment numbers will affect the presidential race?

Jared Bernstein: First of all, I'd say they were just "weak"--no relatives involved.

It depends on how the two sides handle it. It seems to me that Bush's response--continuing to argue that the economy is "strong and getting stronger"--could hurt his prospects since it doesn't comport with reality. He's also got the problem that his tax cuts have failed to generate much job creation, even that's what they were sold on (one was called the "Jobs and Growth Plan").

On the other hand, voters may want to know what Kerry will do to reverse these trends.

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Washington, D.C.: If, as is often reported in the press, population growth adds 150,000 workers to the U.S. each month (1.8 million per year and 6.3 million since 1/2001), and there are 1.1 million fewer jobs than there were in 1/2001, isn't the actual job deficit since then 7.4 million jobs?

Jared Bernstein: Something like that--this is one of the reason that the unemployment rate of 5.5% doesn't tell you all that much about the weakness in the job market. Even though the jobless recovery appears to be over (I hope!), there's still a lot of slack in the labor market, and a few good months (like we had earlier this year) haven't changed that.

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Arlington, Va.: Will the increase in interest rates do anything to help curb the increase in inflation? It seems that inflation has been rising but nothing has been happening to help consumers out and instead are being forced to pay more for goods (i.e. milk, gas) without seeing a similar increase in wages.

Jared Bernstein: If inflation is being driven up by domestic demand or by very fast wage growth, Fed rate hikes can help by slowing down overall growth. But if inflation is rising due to supply shortages or global demand, the Fed's tools are less effective.

As you mentioned, nominal wage growth is slowing while inflation is rising, and real wages have been falling for many workers over the past few months. That's one reason this rate hike was a bit controversial.

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Phoenix, Arizona: What would be the effect if next months reports i.e. GNP, jobs and consumer consumption continue at the same below expected numbers?

Thanks again, David

Jared Bernstein: Some analysts believe that if reports over the next few months continue to be weak, the Fed will hold off from any more rate hikes this year, at least before the election. That makes sense to me.

Listen carefully to their language between now and then. If they start talking about "the patch formerly known as soft" they're probably not going to raise.

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Arlington, Va.: Why is it that price controls as a way to deal with inflation is completely off the table these days when it comes to monetary policy? Wouldn't maintaining high growth be easier if it could be used at times instead of raising interest rates?

Jared Bernstein: 1) Greenspan is very much a free-market kind of guy, and he probably has nightmares about price-controls.

2) It's hard to impose price controls in a global market.

3) Inflation isn't all that high, outside of a few precious fluids, like oil and milk. Except...

4) Health care. Here's an area where we really need a national policy, as the rising price of health care is a problem on many levels. Price controls won't get to the root of the problem, which has to do with providing a basic human need through the marketplace. Anyway, much to discuss on this in a different forum!

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Washington DC: How does a change in interest rates impact job creation?

Jared Bernstein: Check out this useful graphic:

http://www.washingtonpost.com/wp-srv/business/graphics/ratehike.htm

Basically, they're raising the cost of borrowing which leads to less economic activity throughout the economy. Again,I stress that their 0.25% hike is small and that the level of the fed funds rate--1.5%--remains low in historical terms. In this sense, they are more letting up on the gas than putting on the breaks.

But there's still the question of whether this is the time to let up.

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Lyme, Conn.: Is consumer spending down? Aren't there beginning to be too many factors that are tugging on the economy to slow it down that it may, in fact, slow down too much?

Jared Bernstein: That's certainly the concern. And yes, consumer spending fell 0.7% in June, and was up only 1% in the second quarter. In their statement, the Fed seemed to attribute much of the current weakness to oil.

That's certainly part of it--if consumers are spending more on oil (largely an import) they're likely to be spending less on other stuff.

But as I've stressed throughout, I think our current problems cut a deeper than that--the weak job market is itself holding back income growth and thus consumption.

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Washington, D.C.: If we are really 7 or 8 million jobs behind where we should be, how many years is it likely to take to dig ourselves out of this hole? How long has it taken in early recessions, and how much was the job deficit in those recessions?

I note that the 1.5 million new jobs in the last 11 months, which the President has been trumpeting, does not even keep up with population growth.

Jared Bernstein: Let me see---7 million jobs down, adding 32,000 per month, hmm....about 18 years.

Just kidding (we economists are such crack ups, no?). Job growth will hopefully pick up, though this rate hike won't help in that regard. The point is that we don't have to simply replace the 1.2 million jobs missing since the recession--we have to employ those entering the labor market.

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Fairfax City, Va.: Several months ago an economist working for Goldman Sachs stated that the stimulus from the tax cuts for years 2001 thru 2003 would make 2004 and 2005 very good years economically but, by 2006 the stimulus effect would be cease to be effective and the additional debt would leave us worse than we were in 2001 - do you concur - that 2005 will be a good year and that 2006 will not be a good year?

Jared Bernstein: I don't know about those later years, but it is the case that stimulus from the tax cuts and very low interest rates helped lift the economy 2001-03 and made the recession milder than it would have been otherwise.

The problem with the tax cuts is that they've demonstrably failed to generate enough jobs. Thus, we don't have enough labor market income in the system to counterbalance the loss of fiscal and monetary stimulus.

That and the fact that we're looking a federal budget deficits as far as the eye can see...

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Phoenix, Ariz.: Do you think that a new administration that says, "they will continue middle class tax cuts and take away the tax cuts for the top 2%", really have any effect on the economy or is more consumer confidence needed to get us going?

Jared Bernstein: A stimulative tax cut targeted at middle and low income families might actually be needed in coming quarters if things fail to pick up, but it's got to be short-lived (see deficit comment to last response).

Re consumer confidence, it was actually up at the last reading, though I doubt it will stay there. Right now, you're better off watching what consumer do (ie, are they spending) vs. what they say.

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Arlington, VA: On the rising healthcare costs issue; couldn't one way to control rising costs in healthcare be to regulate the price of prescription drugs? I think this is done in Canada, and drug companies still make a profit there, just not such an outrageous one as here in the U.S.

Jared Bernstein: Good idea!

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Irvine, CA: Mr. Bernstein:

This is a follow-up:

What happens after a person lost a job more than six months and dropped off the official unemployment list? Is the unemployment number cumulative?

If I quit a company and start my own company, how do the statistics show my economic activity?

Jared Bernstein: If they're still actively seeking a job, they're still counted as unemployed. In fact, about 20% of the jobless have been so for at least six months--that a recessionary level.

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Jared Bernstein: Well, thanks all--really great questions, and I'm sorry I couldn't get to them all.

Visit our website at www.epinet.org

--Jared Bernstein

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