Alarmed by signs that the U.S. economy is overheating, the U.S. Federal Reserve Board this week raised U.S. interest rates by half a percentage point. The move reflects a shift in sentiment at the U.S. central bank. While the bank’s top officials appear to have accepted the idea that information technologies have transformed the U.S. economy, inflation fears are once again resurgent. The concern now is ensuring that the economy can be slowed without crashing. It promises to be a high-wire act.
The U.S. economy continues to blaze ahead. It is currently in its 109th consecutive month of growth, a record for the postwar era. Gross domestic product expanded at an annual rate of 5.4 percent in the first quarter. Unemployment has reached a 30-year low of 3.9 percent, industrial production is up 6.1 percent over a year ago, and operating capacity is just above 82 percent. Prices are edging upward, although the consumer price index was virtually flat in April.
While close scrutiny of the numbers suggests that there might still be room for noninflationary growth — most economists believe that 84 percent capacity is the point at which demand outstrips supply and prices rise — the Fed is taking no chances. The problem is that its margin for maneuver is shrinking.
Since price indexes showed big gains earlier this year, the burden of proof has shifted in the debate over U.S. economic fundamentals. “New Economy” theorists assert that new information technologies have created a new economic dynamic that allows much higher growth without inflation. Productivity growth and the downward spiral in the unemployment rate are the twin pillars of this argument.
Traditional inflation-hawks counter that the business cycle may have been dormant, but it is not dead. Demand pressures are sure to push up prices eventually, and that moment is rapidly approaching. The recent figures have strengthened the latter argument, and the Fed’s thinking has shifted as a result. (The approach of the campaign season may also be a factor: The last thing the Fed wants to do is raise rates during an election and risk looking partisan.)
The Fed has raised interest rates six times in the last 11 months, pushing them to their highest point since January 1991. Clearly, these moves have had little effect on the roaring economy. This time, the Fed raised rates half a percentage point, in contrast to the five previous quarter-point hikes.
But in a clear indication of the difficulties faced by U.S. policymakers, the markets welcomed the interest-rate increase, and then shrugged it off. The Dow Jones Industrial Average gained 1.17 percent while the Nasdaq electronic exchange posted a 3.05 percent increase. The markets had already factored the rate hike — even this large one — into their calculations.
Cracking that confidence is the hard part. Doing it without causing a crash landing — as happened in Japan in 1990 — requires a delicate touch. And far more is riding on those skills than the reputation of the esteemed chairman of the Federal Reserve, Mr. Alan Greenspan.
U.S. interest rates influence the world economy in three ways. First, as consumer of last resort, U.S. domestic demand has spurred production worldwide. By one estimate, the U.S. market accounts for more than half of the growth in exports by East Asian countries (excluding Japan). A slowdown in the U.S. would ripple — if not race — through them as well. Other countries, such as Mexico, would also be hard hit.
Rising U.S. interest rates have a second kind of impact. Other countries will be forced to raise their own interest rates to compete for investment funds. While that will hurt local industries that must borrow money, the alternative is losing out in the race to attract foreign capital. Not surprisingly, Latin American stock markets fell on news of the Fed move, fearing that local businesses would be hit by the new investment environment.
Third, raising interest rates is almost certain to raise demand for the dollar and increase its value on foreign exchange markets. This means that debt servicing for many countries will become more expensive — at a time when their chief export market is shrinking. Thailand, Indonesia, Brazil and Poland are some of the potential victims of a debt crisis.
The policymakers at the Fed are well aware of the dangers they face. The only certainty is that they must act now. Delaying only allows the distortions to get worse and increases the risk of a hard landing. The markets’ subdued reactions to this week’s moves mean that more will follow.
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