Smith Faculty Opinion Article - September 13, 2005

Wholesale Price Inflation News Is Good:
The Fed Should Not Raise Rates
By Dr. Peter Morici, Professor of International Business

Today, the Labor Department reported that producer prices rose 0.6 percent in August; however, the core inflation rate--prices less food and energy--was ZERO.

Prices for final consumer goods less food and energy fell -0.1 percent.

Given the fragile state of the economy in the wake of Hurricane Katrina, the Federal Reserve should not raise interest rates when it meets September 20.

The economy is already slowing and Katrina will slow growth further. If the Fed raises rates, it risks driving the economy into a recession.

Despite years of economic expansion, inflation outside the energy sector remains largely under control. This is not surprising, because economic growth is slowing, and outside the oil and natural gas sectors, additional productive capacity is readily available. Manufacturing and retailing continue to have much slack capacity, and skilled labor remains abundant.

Further, manufacturers continue to enjoy historically strong productivity growth and face intense competitive pressure from a growing range of Chinese and other Asian exporters. Slack capacity, higher productivity and more competition from imports have eliminated pricing power for most manufacturers of consumer goods. Look at autos and appliances.

Although unemployment is 4.9 percent, many prime working age Americans are standing on the sidelines, as the labor force participation rate is much lower today than in 2000. Wage increases have been small and barely kept up with inflation, indicating skilled labor remains abundant. Moreover, layoffs in airlines, autos and other industries hit by restructuring are adding to this readily available pool of skilled workers.

Retailing continues to be intensely competitive. Internet firms are now pressuring traditional brick and mortar stores much as imports are pressuring General Motors and other manufacturers.

Other service activities are being pressure by similar technological changes and new competition from abroad.

It all adds up to low domestically generated inflation. Most inflation results from conditions in international petroleum markets and Hurricane Katrina. Federal Reserve policy can little affect international oil markets or the weather.

Petroleum refining capacity is tight world wide, and this will continue to push up the prices for gasoline, diesel and petrochemical feedstock over time. Hurricane Katrina only exacerbated this problem.

Shortages created by the closure of the Port of New Orleans and the damage caused by Katrina are pushing up prices for building materials and some other commodities such as coffee, paper and produce. Most of these price increases are temporary and will reverse, and further increasing interest rates would have little effect on their long-term inflationary consequences.

The economy already began slowing in the second quarter, and if the Federal Reserve takes no further actions to raise interest rates, Katrina will slow economic growth further for the balance of the year. The spike in gasoline prices is already curtailing retail sales. In many ways, higher gasoline prices are doing the work of higher interests. Higher gas prices are slowing the economy, and dampening inflation for many other consumer goods.

By increasing interest rates further, the Federal Reserve risks turning an economic slowdown into a recession while doing little to quell inflation.

The Federal Reserve should pause until more is known about the full consequences of Hurricane Katrina.