TOPICS > Economy

Interest Rates on the Rise?

May 14, 2004 at 12:00 AM EDT



PAUL SOLMAN: How are you Nick?

NICK PERNA: Good to see you.

PAUL SOLMAN: Economist Nick Perna, last week, just done meeting with the top brass at the Boston Federal Reserve Bank. The topic of discussion, as always: interest rates, which the Fed in Washington tries to manage.

NICK PERNA: For many reasons, it looks like interest rates are too low to be sustainable. They were appropriate for an economy that was growing very slowly and needed help.

They’re not appropriate for an economy that seems to have a lot of strength and so over the last couple of months, Chairman Greenspan and others have made no bones. They’ve been very, very explicit about how interest rates have to rise at some point.

ALAN GREENSPAN: The Federal Reserve recognizes that sustained prosperity requires the maintenance of price stability and the Federal Funds rate must rise at some point to prevent pressures on price inflation from eventually emerging.

PAUL SOLMAN: The main reason behind such a rise would be that economic growth is picking up. And growth raises the great historical fear of the Fed: inflation — a general rise in prices.

The problem is that when prices begin to rise noticeably, workers need higher wages just to stay even. But higher wages translate into higher production costs, which in turn lead to higher prices. This further fuels inflation.

And indeed, there have been signs of such inflation recently — in rising prices of commodities in general, oil in particular.

Inflation eventually forces the Fed — to use the familiar “driving” metaphor — to slow down the economy by raising rates and thus making spending more expensive. But the danger is that if the Fed has to slam on the brakes because it’s let the economy exceed its growth limit, the sudden stop causes economic problems of its own.

NICK PERNA: When the Fed has to put the brakes on under those circumstances by rising, raising interest rates, what happens then is that institutions, companies, individuals, bang their heads on the dashboards, people get hurt. Whereas if it’s done more gradually with lots of warning to financial markets, it’s a slower, less risky process, and we end up with smoother and actually better growth over the longer term.

PAUL SOLMAN: Let’s put this metaphor into ‘economese’ by getting graphic. Here, roughly, is the long-term growth path that economists like Perna assume our economy could follow pretty steadily if we used all our resources as efficiently as possible. But suppose we start growing a lot faster. Well, if we were already using all our resources, then at some point real growth wouldn’t be real growth at all; instead, it would simply be growth in prices.

And the longer we let such growth continue unchecked, the greater the inevitable, painful plunge. Or, to use another favorite Fed metaphor…

NICK PERNA: It was William McChesney Martin who years ago when he was chairman of the Fed said that the job of the Fed is to take the punch bowl away just when the party’s really getting going.

Just starting to have a lot of fun; everybody’s getting just a little bit of a buzz on. And of course the problem if you carry it through a little bit further is, the bigger the buzz, the bigger the hangover.

PAUL SOLMAN: That is, the longer and more severe the economic headache of a recession, such as the one we’re just coming out of.

But returning to today, you might think runaway inflation leading to another recession is hardly a clear and present danger. Nick Perna would sympathize with your skepticism.

NICK PERNA: The remarkable feature of the last 15 years is that the Consumer Price Index over these last 15 years has only averaged 3 percent or less. Now–

PAUL SOLMAN: In growth each year.

NICK PERNA: In growth each year. Remarkable! We left — we, we concluded an awful period — the ’70s — by 1980 the inflation rate had gotten up to 13 percent, measured by the Consumer Price Index. So what’s happened is — yeah — we worry about inflation — we worry that it will accelerate. Nobody’s worried about its going back to 13 percent or 25 or 30 percent, but you can do a lot of damage if it goes from today’s 2 percent to 5!

PAUL SOLMAN: Damage like mortgages shooting up, so homes become harder to sell and thus perhaps plummet in value; maybe the stock market tanking as it did after the too-rapid growth of the 90s.

The Fed is poised to slow things down because it remembers what can happen if it doesn’t, especially, says Perna, as the Bunker Hill Monument commemorating the Revolution shares the shot, in a time of war and thus high government outlays.

NICK PERNA: The government will print money to pay for guns and whatever else it needs. And also once an inflation gets started, whether it be in wartime or peacetime, then people start behaving as if there’s going to be more inflation, so they hoard cotton or they’ll hoard lard or they’ll do all those kind of things that drive prices up still further, and then when the end comes, they’re sitting on top of piles of this stuff that become worth a lot less if prices collapse.

PAUL SOLMAN: It happened time and again, right into the 20th century: punch bowls filling every few decades, with no government agency to remove them before happy hour got out of hand. In large part to manage the system, the Federal Reserve was created in 1913. And, say Perna and others, the Fed has gradually learned how to stay on the prudent path.

NICK PERNA: It can’t listen to the general who at the Battle of Bunker Hill said: “Don’t fire until you see the whites of their eyes,” because if the Fed sees the whites of the eyes of inflation, it’s already be too late.

PAUL SOLMAN: Now Nick Perna was lured into what’s called the dismal science as an undergrad at Boston College by his economics teacher. That teacher’s teacher was our next destination; Nobel laureate and textbook author Paul Samuelson, under whom Perna also studied when he reached graduate school.

Samuelson points to one major source that has been stifling inflation, the outsourcing of jobs overseas, putting downward pressure on wages, making workers afraid to ask for more.

PAUL SAMUELSON: Look to the Far East and to China and now India — the outsourcing that has taken place — this has made the American labor market a cowed, flexible labor market.

PAUL SOLMAN: Not, in other words, because jobs have willy-nilly migrated to those places, but just the fear that they are going to or might.


PAUL SOLMAN: That prompted a big question from Samuelson’s former student, Nick Perna.

NICK PERNA: Does this then mean that the fears of inflation are over-blown?


NICK PERNA: Do we need to know — can we sit at 2 percent for a long time?

PAUL SAMUELSON: Well, if you forget about inflation, thinking that something is taking care of it, then you’re going to learn the hard way that it’s going to come back.

PAUL SOLMAN: Indeed, Professor Samuelson says, the other side of the coin is that Americans seem to be getting jobs again, which might mean we’ll soon be using all our resources, so one factor sparking inflation is that we may be on our way back to full capacity.

PAUL SAMUELSON: Then there’s a second factor: the 800-pound gorilla in the global economy is China. They have been buying basic foodstuffs and metals at a drunken sailor rate, and that has, on the Chicago Board of Trade, been sending all those basic prices up until recently.

PAUL SOLMAN: Commodity prices.

PAUL SAMUELSON: Commodity prices — metals, foodstuffs, and so forth.

PAUL SOLMAN: And thus we’re back to the main worry: straying too far from the prudent long-term path.

So why hasn’t the Fed raised rates yet? Because the forces keeping prices down are also still at work as

Nick Perna demonstrated at a local Costco.

NICK PERNA: For one thing you’ve got many, many, many goods that are made overseas — most of the electronics, a lot of the hand tools down here — which means that they’re available at a lower price. I think one of the other points though is productivity. Places like this have incredible productivity.

PAUL SOLMAN: Productivity in that, with relatively few employees, retailers like this move more and more merchandise, which they force suppliers to sell for less and less, because they command such huge volume discounts.

In the end, then, the pressures that lower prices in today’s economy are battling those that drive them higher.

The Fed, criticized often in recent years for being too vigilant about inflation, has remained hands-off to date. It’s not likely, however, to let another boom like that of the 1990s take off without trying to stop it by raising interest rates eventually.