NCPA - National Center for Policy Analysis

Are Higher Interest Rates Necessary?

May 30, 2000

On May 16, the Federal Reserve Board's Federal Open Market Committee (FOMC) raised the federal funds rate -- the interest rate banks charge each other on overnight loans -- by another 50 basis points (one-half percentage point) to 6.5 percent. Raising the cost of money to banks tends to push up the interest rates they charge businesses and consumers.

The FOMC, which has raised the fed funds rate by 1.75 percentage points since last June, justified its action as necessary to counter "inflationary imbalances." Higher interest rates and a tighter monetary policy affect the economy only with a lag of a year or so. Thus, the Fed can't wait until the Consumer Price Index is rising. Therefore, it must have indicators that forecast future inflation to guide its policies.

A recent study by the Federal Reserve Bank of New York, however, casts serious doubt on whether the Fed is capable of predicting inflation accurately. The study looked at 19 different inflation predictors, including for gold and oil prices, various commodity indexes, spreads between long- and short-term interest rates, and real indicators such as the unemployment rate. None was found to provide a consistently accurate signal of future inflation trends.

It is widely believed that the Fed is mainly concerned about the unemployment rate, even though that was one of the least accurate inflation indicators in the New York Fed study. There are no other indicators of inflation at present.

However, there is little evidence that raising the fed funds rate can forestall inflation. Economist Richard Salsman believes it actually will make inflation worse, noting that falling inflation is associated with a falling fed funds rate, and rising inflation with a rising fed funds rate.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, May 30, 2000.


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