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Economic Reporting Review

June 21, 1999

By Dean Baker

Inflation and Interest Rates | Trade | Social Security | Outstanding Stories

Inflation and Interest Rates

"Is the Hot Economy Overheating?"
George Hager and Tim Smart
Washington Post, June 12, 1999, page E1

"Strong Consumer Spending Worsens Interest-Rate Jitters"
Jonathan Fuerbringer
New York Times, June 12, 1999, page B1

These articles report on concerns that the continuing strength of the economy will cause the Federal Reserve Board to raise interest rates. Both articles present the views of several economists who believe that the economy is too strong and that it would be desirable to slow it down. Neither article includes any discussion of the costs of slowing the economy, specifically slower job growth and a rising unemployment rate.

The reason that the Federal Reserve Board would deliberately raise the unemployment rate is that a rise in the unemployment rate will place downward pressure on wages. Less rapid wage growth will reduce inflationary pressures in the economy. Most people would probably consider higher unemployment and slower wage growth as serious consequences of an economic policy, which deserve some consideration. It is worth noting that all the economists cited in these articles were business economists.

The Post article also exaggerates the evidence that inflation is beginning to pose a problem. It presents an account of an economist who visited a mall and didn't see any items on sale. The economist sees this as evidence that prices are rising, an assessment which the article asserts is supported by "reams of data."

Actually, the vast majority of economic data continues to show that inflation remains under control. The GDP deflator for the first quarter of 1999 increased at just a 0.9 percent annual rate. The finished goods component of the producer price index increased by 0.2 percent in May and stands just 1.4 percent above its year ago level. The only measure suggesting any real problem with inflation was a 0.7 percent jump in the consumer price index (CPI) in April. (The CPI report for May, released later in the week, showed 0.0 inflation for the month.) This increase was driven primarily by higher energy prices, which had been unusually depressed. Even with the jump in April, the CPI stands just 2.3 percent above its year-ago level. In short, none of the main measures of prices presents any clear evidence of accelerating inflation.

"Zero Inflation in May Sets Off a Market Rally"
Sylvia Nasar
New York Times, June 17, 1999, page A1

This article reports on the release of the consumer price index for May. At one point, it discusses at some length the Federal Reserve Board's concerns about inflation: "To most Americans basking in the lowest unemployment and inflation rates since the 1960s, the notion that the Fed is fretting about a revival of inflation may seem puzzling, if not outlandish. But if the central bank waits for actual inflation to take off, analysts warn, it has probably waited too long. Fed actions may affect stock and bond prices instantly, but they take a lot longer--a year or more--to work their way through the economy."

The view of the inflationary process presented here, and the impact of the Fed's actions, is at odds with the accepted views in the mainstream of the economic profession. According to the standard non-accelerating inflation rate of unemployment (NAIRU) view, if the unemployment rate falls below the NAIRU, the rate of inflation will gradually increase.

Until recently most economists believed that the NAIRU was between 6.0-6.5 percent, meaning that if the unemployment rate fell below this level, inflation would begin to increase. The unemployment rate has now been below this range for five years, and the inflation rate has actually decelerated in this time. This has shaken many economists' belief in the basic theory.

Many economists, including several members of the Federal Reserve Board's Open Market Committee, which determines the Federal Reserve Board's monetary policy, now believe that they do not have any clear understanding of the inflationary process. (See the minutes of the February 2-3, 1999 meeting of the Federal Reserve Board's Open Market Committee,

Nonetheless, the NAIRU theory is still the most widely accepted view of inflation within the economics profession. However, this theory describes a process where inflation very gradually accelerates; it does not "take off." The accepted rule of thumb is that the rate of inflation will increase by approximately 0.5 percentage points if the unemployment rate is a full percentage point below the NAIRU for a full year. (See, for example, the discussion in the Economic and Budget Outlook, Fiscal Years 1995-99: An Update, Congressional Budget Office, 1994.)

This would mean that if the Fed let the unemployment rate stay at 4.2 percent for a full year, but the NAIRU was actually 5.2 percent, the inflation rate would gradually climb from its current range of 2.0-2.5 percent to 2.5-3.0 percent. For most people, this modest increase in the rate of inflation would not be a very frightening development.

It also is inaccurate to assert that there is such a long lead time between the Federal Reserve Board's actions and their impact on the economy. The last time the Federal Reserve Board sought to slow the economy by raising interest rates was in 1994. Between February 1994 and March 1995, it gradually raised the short-term interest rate from 3.0 to 6.0 percent. Longer term interest rates largely followed in step with this rise. The average interest rate on new mortgages rose from 6.85 in February 1994 to 8.21 percent in March 1995.

This increase in mortgage rates had the predictable effect of slowing construction, with new housing starts falling from a 1.2 million annual rate in March 1994 to a 1.0 million annual rate in March 1995. Overall economic growth slowed from a 4.8 percent annual rate in second quarter of 1994 to a 0.6 percent annual rate by the first quarter of 1995. In short, the series of rate hikes implemented by the Federal Reserve Board over this period had the effect of slowing the economy in rather short order.

Given the current state of knowledge within the economics profession, it is perhaps not surprising that most Americans would be puzzled by the degree of concern about inflation. The article does not identify any of the analysts who adhere to the view this article presents.

"Inflation Rate Steady in May"
John M. Berry
Washington Post, June 17, 1999, page E1

"Tight Labor Market Continues Across U.S. "
New York Times, June 17, 1999, page C10

Both of these articles discuss the release of the Federal Reserve Board's "beige book," which provides a summary of economic condition across the nation. Both articles assert that the beige book shows a tightening labor market and increased evidence of inflationary pressures.

This assessment is drawn from the beige book summary, which is based on the individual accounts of the 12 member banks. The accounts of the member banks actually show the opposite. Virtually every bank district presents an account of an economy where the markets are stable or even loosening slightly.

For example, the first district bank, based in Boston , notes that "most workers' pay increases are in the 3 to 5 percent range," adding in reference to retail employment "the same 3 to 5 percent range that has existed for most of the last two years." The Richmond district reported that the growth in retail sales "has slowed compared to earlier in the year." The Kansas City Bank noted a similar slowing in retail sales.

Construction appeared to be edging downward in several regions. The Atlanta Bank observed "residential building and sales have slackened from high levels, and the longer-term outlook has weakened." The Dallas Bank characterized commercial real estate activity as "slow." It noted a concern about overbuilding of office space and, according to one of its contacts, "anything that hasn't been started is being reevaluated." Several regional banks also observed a slowdown in the number of new mortgages being issued by banks.

In short, the reports actually written by the regional banks do not present a picture of an economy facing increasing inflationary pressures. Rather, they present considerable evidence pointing in the opposite direction. For a full discussion of the latest beige book see the Financial Market Center's Beige Book Analysis and Review (written by Dean Baker),, 6/16/99.



"Lauding Trade, Clinton Urges 'Fast Track'"
William Claiborne
Washington Post, June 12, 1999, page A5

This article reports on a speech by President Clinton urging support for his trade policy. According to the article, "noting that the United States has about 4.5 percent of the world's population and 22 percent of its income, Clinton said the nation must sell its products to other nations to survive economically."

This statement is complete nonsense. According to economic theory, the ratio of the current U.S. share of world income to its share of world population has no bearing whatsoever on its need to trade.

The article later states that Clinton's speech was intended to "promote a consensus on more open trade that economists say will lead to the creation of a global middle class and a further reduction in protectionism." One of the main items on Clinton's trade agenda has been to increase protectionism by forcing developing nations to respect U.S. types laws on copyrights and patents. These forms of protectionism raise prices of books, videos, software, and pharmaceuticals by several hundred percent above their free market levels. In addition to the economic inefficiency created by the imposition of copyright and patent protection, they also lead to an outflow of billions of dollars annually from developing nations to industrialized nations. This outflow impedes the creation of a middle class in the developing nations.


Social Security

"G.O.P. Again Can't Break Filibuster Against Social Security 'Lockbox'"
Helen Dewar
Washington Post, June 16, 1999, page A7

"Steel, Oil Industry Aid Advances"
Helen Dewar
Washington Post, June 16, 1999, page A12

Both of these articles discuss aspects of the Congressional debate over the 2000 budget. Both articles make references to efforts to keep Congress from spending the Social Security surplus, through some type of 'lockbox' mechanism. It is important to note that the finances of the Social Security program will not be affected at all by any decision on spending its current surplus. See ERR, 5/31/99.


Outstanding Stories of the Week

"Once Again, Wall St. Worries About Hedge Funds"
Gretchen Morgenson
New York Times, June 12, 1999, page B1

This article examines evidence that some large hedge funds may be running into problems as a result of an apparent upturn in the Japanese economy. This upturn could have the effect of raising the value of the yen relative to the dollar. Many hedge funds had borrowed heavily in yen to buy U.S. bonds that paid far higher interest rates. If the yen appreciates by any significant amount, it could lead to enormous losses for this funds. Because many major banks have significant assets in these funds, their troubles could threaten the stability of the financial system as a whole. This was the rationale given by Alan Greenspan for arranging the bailout of the Long Term Capital hedge fund last fall.

"A Subway Line Extends to Hollywood"
Todd S. Purdum
New York Times, June 12, 1999, page A9

This article discusses the politics and economics behind the construction of a subway in Los Angeles. It notes that the subway has been enormously expensive to build and serves a relatively small and affluent population. The subway has diverted resources away from Los Angeles' bus system, which serves a far larger, less affluent and largely minority population. As the article reports, the diversion of resources from the bus system has aroused considerable opposition from community groups. Recently their efforts led to a court order to buy new buses to improve the quality of the city's bus service.

"A Case for Forgiving Biggest Debtors Their Debts"
Michael M. Weinstein
New York Times, June 17, 1999, page C2

This article discusses the argument by Harvard economist Jeffrey Sachs for granting large-scale debt relief to the world's poorest nations. The article notes Sachs' evidence that such relief is easily affordable, and can be justified not only by the poverty of these nations but also by the fact that many of the loans were in effect grants made by the United States for political purposes, not loans to promote economic development.

"New Lenders With Huge Fees Thrive on Workers With Debts"
Peter T. Kilborn
New York Times, June 18, 1999, page A1

This article reports on the rapid spread of "payday lending companies." These financial firms make short-term loans to people with bad credit records. The fees they generally charge amount to annual interest rates on loans of between 200 percent-900 percent. The rapid growth of consumer debt in this recovery has caused many people to turn to these lending companies when their access to other types of credit has been exhausted.


Dean Baker is a senior research fellow at the Preamble Center and at the Century Foundation.

Recent articles can be found on the websites of the New York Times and Washington Post.

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