U.S. economy is Federal Reserve’s concern

By Michele Moore
Special to The Desert Sun
July 7th, 2004

The Federal Reserve Board made its long-anticipated interest rate policy announcement June 30, raising the Federal Funds rate by one-quarter of a percentage point. But beware of a little-noted point: some of the factors that the Fed is mandated to control are currently beyond their control. That’s because the Fed is but one financial institution in an increasingly integrated global economy, facing different problems than in the past, but still operating with yesterday’s tools.

The Federal Reserve has direct control only over one interest rate, the Federal Funds rate, which is an overnight lending rate to banks. This is an excellent indicator of Fed intentions; in practice, however, market interest rates tend to lead changes in Fed policy. To this point, market interest rates have already risen significantly over the last 11 months.

Additionally, Fed policy has to balance competing mandates -- to promote economic growth and to inhibit inflation. Fighting inflation tends to inhibit economic growth, and vice versa, placing the Fed in a delicate balancing situation.

However, the Fed must also pay careful attention to global economic forces. These forces may help explain why the Fed has been so slow to raise rates in the face of both robust economic growth in the United States and an apparent pickup in inflation.

For much of the 1990s, the United States experienced rapid economic growth with little increase in inflation. But from 2000 through 2003, the global economy tipped away from economic growth. Restarting growth while staving off deflation became the Fed mandate for this most recent period.

With robust economic growth now returning to the United States, the Fed balance seems to have shifted back to fighting inflation, but the balancing act this time is more complicated.

And here’s the key point: If inflation is being driven in some measure by forces external to the United States, then sacrificing growth in the U.S. by raising interest rates to fight global inflation will only work if it slows global demand. Otherwise, prices could continue to rise while growth in the United States slows. In the 1970s this phenomenon was known as "stagflation."

The Federal Reserve has shown finesse in balancing competing forces over the last 20 years. There is no apparent need to worry about stagflation yet. But despite short-term certainty that rates will rise, be cautioned that things may not be what they seem when it comes to Fed policy.

Pulling the levers that the Fed has available will only be effective if the broader global implications are understood. The only thing certain going forward is that the future will bring fresh challenges.

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