Monetary Policy

Sanjay Paul
September 1996

A version of this article appeared as Fed Passed on Interest Rate Hike; Now What? in Business Forum, Green Bay Press-Gazette, September 28, 1996.

The Fed met on Tuesday. And decided nothing.

In the preceding weeks, speculation about the likelihood of a hike in interest rates had been rife. Market sentiments gyrated almost daily as Wall Street analysts sought to divine the extent of inflationary pressures in the economy from freshly-released economic data.

What was the case for an interest-rate hike?

Simply put, the fear of an "overheated" economy. In the second quarter, the economy's output of goods and services grew at a blistering 4.8 percent. In August, unemployment fell to 5.1 percent, the lowest it has been in years. And to top it all, wages had begun to rise perceptibly as firms were forced to counter labor shortages with heftier paychecks.

These developments do not augur well for inflation. Higher wages will eventually seep through into higher prices for goods and services as businesses try to recoup the increased costs of production.

How would the Fed attempt to choke off this incipient inflation? By raising interest rates. With higher rates, consumers and firms will borrow less. Accordingly, spending on capital goods -- factories, computers, houses -- will fall, economic growth will decelerate, and wage pressures will subside.

This line of thinking persuaded many analysts to expect an interest-rate hike ranging from 0.25 percent to 0.50 percent at the Sept 24 meeting. Their case was bolstered by signs of disagreement among the Board of Directors at the Fed -- in a rare display of public disaffection with Alan Greenspan's (the Fed's Chairman) reluctance to raise interest rates earlier this year, some Board members came out strongly in favor of a raise in rates.

Yet when the Fed finally met, they decided to leave the short-term rates unchanged.

Crass politics, cried some critics. With the elections just around the corner, they said, any raise in interest rates now would put a dent in Clinton's popularity. Thus, leaving rates unchanged was attributed to Greenspan's unwillingness to queer the pitch for President Clinton.

This argument holds little water. Greenspan is under no obligation to Clinton: he'll continue to chair the Fed regardless of who gets elected in November. Moreover, Greenspan is only too aware that if the Fed's policies come to be regarded as being dictated by political considerations, the financial markets will extract a punishing revenge. If inflation does rise sharply as a result of the Fed's pusillanimity, it will be forced to enact a much steeper hike in interest rates later on -- with considerably direr consequences for the economy.

The more likely scenario is that the Fed found the evidence of incipient inflation to be less than compelling. While it is true that unemployment is quite low and wages have begun to climb, the presence of competition from abroad and gains in labor productivity at home have militated against a run-up in inflation. Furthermore, certain sectors of the economy have already begun to slow down -- leading analysts to revise their estimates of economic growth downward.

So what does all this mean for consumers and firms? With interest rates staying low, the costs of borrowing will be contained. Mortgage payments and auto loans will continue to be affordable. Businesses in interest-sensitive sectors will heave a sigh of relief.

For the moment, then, the frenzy of speculation that preceded the Tuesday meeting should abate. However, as the government releases new economic data and we approach the date for the next Fed meeting, the analysts will busy themselves once again with the question: Will the Fed raise interest rates?

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