The Fed and Interest Rates
Nov. 17, 1999

Sylvia sipped her coffee as she scanned the newspaper. There was something about interest rates. She read on. At the meeting of the Federal Open Market Committee on Nov. 16, Sylvia learned, the Fed had decided to raise interest rates.

Sylvia knew that the FOMC met every few weeks to set interest rates. These meetings were usually preceded by considerable hand-wringing among the pundits on Wall Street whose greatest fear, it seemed to Sylvia, was that the Fed would raise interest rates and bring the bull run in the stock market to a crashing halt.

But this time, there was little apprehension. Despite robust economic growth and unemployment rates at historical lows, the markets did not seem to be overly concerned about an increase in interest rates. Oh, sure, said the analysts, it was possible, nay even likely, that the Fed would raise rates -- but, noted Sylvia, they appeared unperturbed by the prospect.

Didn't tight labor markets presage a surge in inflationary pressures, wondered Sylvia? The unemployment rate had fallen to levels unthinkable only a few years ago; it now stood at an astonishing 4.1%. With new jobs being created at a furious pace, wouldn't firms be forced to increase wages to attract and retain their employees? And, as businesses tried to recoup the higher labor costs by raising the prices of their final goods and services, wasn't higher inflation the likely outcome?

And then, thought Sylvia (recalling her lectures in macroeconomics with startling clarity), wouldn't a wary Fed attempt to stamp out the incipient inflationary pressures by raising interest rates? Higher interest rates, recalled Sylvia almost gleefully from her lectures, would discourage consumers and firms from taking out loans to finance spending on capital goods -- cars, houses, computers -- causing economic activity to decline and inflationary pressures to subside.

Sylvia took a deep breath. Boy, this was good stuff. She had forgotten how much she missed economics. She drank her coffee.

But, noted Sylvia, there was something missing in her analysis. After all, Wall Street had decided that the Fed was not likely to raise interest rates sharply. And, in fact, at the Nov. 16 meeting, the Fed raised interest rates by a mere 0.25%, and furthermore, indicated that they were adopting a neutral stance with regard to interest-rate changes in the near future. In other word, they were likely to leave interest rates unchanged at the next FOMC meeting.

Sylvia decided to dig deeper into her macroeconomic lore. Why was the Fed so insouciant about the prospects of higher inflation?

Turns out that productivity was the key. In recent years, labor productivity, as measured by output per hour, had grown quite rapidly. This happy circumstance meant that firms could afford to pay their employees higher wages and yet not raise the prices of their goods. As long as productivity growth remained strong, inflation promised to remain dormant.

But would productivity oblige? The Chairman of the Fed, Alan Greenspan, had noted the remarkable surge in productivity in the last few years; indeed, he admitted that he had been as surprised as anyone else by the phenomenon. But Greenspan had expressed doubts about the likelihood of continued gains in productivity -- and that qualm had probably led him to raise interest rates at the Nov. 16 meeting.

But, noted Sylvia, the increase was muted, and it was very much in line with market expectations. Furthermore, the change in the Fed's bias towards a neutral stance suggested that inflation posed no imminent threat to the economy. The stock market responded enthusiastically, with the Dow Jones Industrial Average posting a gain of about 170 points for the day.

But Sylvia was not content with the productivity explanation. Why had productivity risen markedly in the last few years, in stark contrast to the anemic growth in the 70s and 80s? It was time to take out her macroeconomics textbook. She turned to the chapter on productivity. A fresh cup of coffee in hand, Sylvia began reading. It was the perfect beginning to a weekend.