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July 28, 2008

Why the Fed Should Raise Interest Rates


The Federal Reserve’s dilemma of preserving growth while trying to control inflation is clearly one of the toughest tightropes the Fed as walked in the past twenty years. The second quarter economic numbers, released this week, along with third quarter economic performance, will determine whether or not the Federal Reserve’s strategy was effective. I believe our policies (both fiscal and monetary) have promoted inflation with little assistance on maintaining long-term growth.

The Consumer Price Index rose in June to project a 5.5% inflation rate for the year 2008. This is up from 4.1% in 2007 and 2.5% in 2006. Apparel was the only item projected to be deflating during the year. Inflation is growing at such a rate that it is projected to be higher than the annual price increase for medical care (on of the most inflationary core items) for the first time since at least 2000 (that’s as far back as my data goes).

Despite the Fed’s efforts to aid the real estate market, housing costs are rising at a projected rate of more than 4%. This is due to the inflationary pressure being placed on interest rates, making home ownership increase. In addition to this, the rent market has seen a surge in demand with the recent rash of home foreclosures. (The author is unsure if renting costs are related to housing, but surmises it is likely).

At best, inflation will remain at 5.5%. As mentioned in an earlier article, the effects of monetary policy on the broader economy only begin to take effect after six months. Since the Federal Reserve did almost half of its interest rate cutting in January and beyond, we should be on the cusp of a second wave of inflation for the third and fourth quarters.

Don’t believe me? The seasonally adjusted annual rate change for inflation for the three month period ending on June 30th was 7.9%. In broader terms, at this rate, annual inflation figures could top 8% by late winter! The economy would have to grow nominally at a rate greater than 8% to avoid recession (inflation is deducted from the nominal GDP calculations).

The “proactive” behavior of the government to print $300 billion into our economy is not going to help either. In fact, if all is used, it could have a 0.1-0.5% effect on inflation. To make matters worse, the bailing out of key players involved in the housing recession and subsequent inflationary action, has prevented a free economy from incentivizing the threats and rewards of risk. This distortion of risk will cause a repeat in irresponsible behavior from those who did not learn from the first round of risk distortion (real estate agents).

This behavior shows that the Federal Reserve has strongly favored growth in its growth/inflation dual mandate. The time to switch and fight inflation is now.

The Federal Reserve needs to recognize that while a recession is likely to deepen in the face of higher interest rates, the reduction in inflation and prices will help consumers by increasing the purchasing power (and consumption) to power the economy forward and return to growth faster than in an inflationary environment.

While a recession is a bad situation for any economy, an inflationary economy is worse. During high inflation, consumers are faced with higher costs, specifically in necessity items such as food and energy. This, in turn, leads to decreased consumption across the board and eventually less economic growth. Inflation also causes businesses to cut back on labor costs (employment) as material and transportation costs increase. This is especially true for businesses that cannot pass on the increased cost to their customers. Inflation affects everyone!

I believe that a recession at this time in the U.S. economy would have less of a negative impact on the American people and the economy than an inflationary event. A recession would hurt those that lose their jobs through unemployment (due to lower consumer demand and less available financing), however those who keep their jobs will be eased by the drop in prices (especially food and fuel) and even if wages remain unchanged, their purchasing power will increase.

As we learned in the 1920s, recessions are an unavoidable event in any free market business cycle. The economy needs a period of time where it purges inefficiency and restructures towards improving capital returns. By “proactively” attempting to avoid recession, we are adding a number of variables to the economy that could keep us in a negative or sideways growth pattern for years.

These variables include (but are not limited to) higher inflation/prices, lower purchasing power, lower demand, lower production, lower productivity, higher interest rates, less financing available, less business investment, and ultimately lower employment. The bottom line is that an inflationary economy ultimately acts like one in recession. The only difference is that it takes a considerably greater amount of time to shake off inflation than negative growth.


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