Smith Faculty Opinion Article - September 19, 2005

Why the Fed Should Not Raise Interest Rates
By Dr. Peter Morici, Professor of International Business

The Federal Reserve Open Market Committee meets on Tuesday to decide whether to raise interest rates for the eleventh consecutive time. Although the Fed wishes to return interest rates to a more neutral position, strong evidence is emerging that growth is slowing and inflation poses no serious threat.

Moreover, the full impact of Hurricane Katrina on the economy remains vague and uncertain economists have been forced to revise their forecasts more than once with new revelations about the damage and chaos wrought by state and federal dysfunction. A pause in the upward adjustment in interest rates for one or two Fed meetings would give the economy a much needed breather. Raising short-term interest rates further would raise the cost of rebuilding.

Economic growth fell to 3.3 percent in the second quarter. Consumers have been supporting the recovery, in the absence of robust business investment, by spending ever larger shares of disposable income and borrowing against the equity in their homes. By July personal savings sank into negative territory consumption exceeded income by $59 billion and recent jawboning by Chairman Greenspan will tighten bank lending practices. At the same time, rising gasoline prices have taken a bite out of retail sales, which shrank precipitously in August, and consumer confidence is tanking.

Meanwhile pricing dynamics in the economy have changed radically over the last twenty years. Energy has become a much smaller share of industry and consumer spending, and productivity growth has been so profound that makers of final goods and services are absorbing rising energy and material prices. Competition, intensified by imports and the internet, compels firms to turn productivity gains into lower prices even General Motors has finally conceded that point.

Over the first eight months of 2005, the retail price of gasoline rose 35 percent as compared to 19 percent during the comparable period in 2004; yet, the core consumer price index prices less energy and food increased at a 2 percent annual rate over the first eight months of 2005 as compared to the 2.2 percent over the same period in 2004.

If energy prices are having a profound effect on prices throughout the economy, evidence is nowhere to be found but in government consumer price statistics. The prices we pay at the mall just don't indicate general inflation is heating up with gas prices.

Over the first eight months of 2004, consumer prices did increase at a 3.9 percent rate annual rate as compared to 3.3 percent for all of 2004; however, higher energy prices drove those numbers up, not the prices of non-energy goods. And importantly, oil crude prices are stabilizing in global markets, and gasoline and other energy prices will recede as Gulf refining and natural gas production come back on line for gasoline, that process began the second week of September according to prices tracked by the Department of Energy.

As energy prices recede, the overall consumer price index will moderate to well below three percent, and move toward the pace of the core consumer price index2 percent. Two percent is considered price stability in the arcane world of central bankers and economists.

A close look at recent productivity, labor force and wholesale price data offer key insights into what is happening.

Productivity among non-financial companies is advancing at a torrid pace a 6.8 percent annual rate in the last quarterly report. Meanwhile skilled workers remain abundant wages are not keeping up with inflation and unit labor costs have been reasonably steady for more than 30 months.

At the wholesale level, prices for resources such as petroleum, which are determined in international markets, have jumped a lot in recent months, but prices for intermediate goods have moved up less, and for final goods even less.

Businesses would like to translate their productivity premium into higher profits but more intense competition from imports and structural changes wrought by the internet wont let them.

Want evidence that the outlook for non-energy prices is very favorable: in August, wholesale prices for final consumer goods, less energy, fell -0.2 percent, even as gasoline prices were rocketing.

Further, higher interest rates cant undo the consequences of Hurricane Katrina but they can increase the cost of rebuilding lost industrial capacity. Raising interest rates certainly wont much influence international oil markets.

Falling retail sales and consumer confidence indicate the mood of the country is turning sour. The Fed need not contribute to pessimism, as it did during the administration of the first President Bush, by enforcing high interest rates at the wrong time.

By raising interest rates in an economy already slowing and buffeted by Hurricane Katrina, Mr. Greenspan needlessly risks driving the economy into recession, something he did accomplish for the first President Bush.

Simply put, inflation provides little justification for the Fed to raise rates further, and slowing growth and the uncertainty created by Katrina should compel the Fed to stand pat. Higher interest rates could turn an economic slowdown into a recession.

The sixty-four dollar question is: Can Mr. Greenspan learn from history? In particular, can Mr. Greenspan learn from his own mistakes?