4.28.2005

Don't Touch That Short Term Rate!


So inflation is back, like a childhood friend. You can hardly believe that you can recognize it, it has been so long. There are many complaints about people my age and their savings habits. What are you expecting when we learned that prices go up and up and saving our allowance is not a good idea? Hmm? So we carry those lessons into adulthood.

And now, with a slowing economy and the jungle drumbeat of recession in the air, The Fed is going to raise interest rates again. The Fed may even raise them by more than quarter of a point at a time. We know there will be an increase of some sort because of important signals sent to the markets in the Fed statements. Increased inflation signals in the economic gauges underpin the predictions of higher interest rates. Conventional wisdom has it that higher interest rates will slow inflation down.

WRONG.

Econo-Girl has an alternative inflation solution. Keep interest rates the same or lower them.

Inflation is too much money chasing too few goods. Right so far. The thinking is that inflation is a sign of an economy expanding too fast. Econo-Girl agrees in that inflation is a sign that there are supply shocks to the economic system. And if an economy is growing at too rapid a rate
there will be much more demand for raw material and labor than there is supply, i.e. supply shock.

But inflation itself is not a sign of economic expansion. It is a sign of supply shock. So raising the interest rate will not stop inflation and will accelerate a recession and probably deepen it. The source of inflation this go round is higher fuel costs. Our American economy needs to adjust to the new cost of goods sold, prices and labor cost that go with the higher energy costs.

Once the fundamental change in supply costs is adapted to, inflation will stabilize.

There will be arguments that not slowing down the economy will trigger the first type of inflation discussed here, where more competition for goods and labor will increase prices across the board. I disagree. Extra capacity exists for both goods and labor that the competition for them will not kick in for a while. Certainly there will be enough time to see what is
happening and raise short-term interest rates then. Not now.

1 comment:

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