NCPA - National Center for Policy Analysis


April 16, 2008

It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage, says Martin Feldstein, a professor at Harvard University.

Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries.  In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates.  Such contractionary policies would reduce real incomes and exacerbate political instability, says Feldstein.

Rising food and energy prices can contribute significantly to the inflation rate and the cost of living in the United States, explains Feldstein:

  • The 25 percent weight of food and energy in the U.S. consumer price index means that a 10 percent rise in the prices of food and energy adds 2.5 percent to the overall price level.
  • Commodity price inflation is of particular concern now that the CPI has increased 4 percent in the past 12 months.
  • Surveys indicate that households are expecting a 4.8 percent rise in the coming year.

In lower-income, emerging-market countries, food and energy are generally a larger part of consumer spending.  A rise in these commodity prices can therefore add proportionally more to the cost of living in those countries, and therefore depress real incomes to a greater extent than in the United States, says Feldstein.

The rise in the U.S. inflation rate, and the adverse effects in emerging market countries, might be defensible if lower interest rates could significantly stimulate demand and reduce the risk of a deep recession.  But under current conditions, reducing the federal funds interest rate from the current 2.25 percent by 50 or 75 basis points is not likely to do much to stimulate demand, says Feldstein.

Source: Martin Feldstein, "Enough with the Interest Rate Cuts," Wall Street Journal, April 15, 2008.

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