TOPICS > Economy

Federal Reserve Hikes Key Interest Rate to 5 Percent

May 10, 2006 at 6:20 PM EDT

JIM LEHRER: The Federal Reserve’s decision to raise interest rates again. Our economics correspondent, Paul Solman, is with us to explain the action and the reactions to it.

Welcome, Paul.

PAUL SOLMAN, NewsHour Economics Correspondent: Nice to be here, Jim.

JIM LEHRER: First, remind us about this interest rate that the Fed actually raised today. What is it, and what does it touch?

PAUL SOLMAN: It’s the overnight rate that banks charge each other, which wouldn’t seem like it was all that important, except that all short-term interest rates are basically pegged to that, based on that — not all, but many — and therefore it means that, when they raise rates by a quarter of a percentage point, interest rates in general rise by a quarter of a percentage point: your home mortgage; your home equity loan, if it’s variable; the next mortgage you take; your car loan; and so forth.

JIM LEHRER: All right. And the Fed has done this 16 times now over the last couple of years.

PAUL SOLMAN: Right. That’s right.

JIM LEHRER: And it’s all aimed at doing something about inflation. Explain the rationale.

PAUL SOLMAN: You don’t want the economy to overheat. The famous cliche is: You take away the punch bowl before the party gets too crazy, before it gets too wild, before the economy gets overheated. People start spending too much. Their wages, they then start to ask for higher wages because prices go higher.

Inflation is just a rise in prices in general that distorts the economy, since in a market economy is based on prices, and prices signaling what we want, that’s a distortion. You hate inflation; all economies hate it.

Enough inflation, and you paralyze an economy. That’s the Fed’s main job: making sure inflation doesn’t happen.

JIM LEHRER: And the cause and effect between interest rates and inflation?

PAUL SOLMAN: Well, the idea is that, if you raise interest rates, you discourage people from spending more money. You’re going to spend less money, presumably, if you’re borrowing. A business is going to spend less money because it costs more.

The interest rate is just the price of money, right? So you raise the price of money. You slow down the economy. Thereby, you moderate, you tighten, and, therefore, you dampen inflation. That’s the whole idea.

JIM LEHRER: OK, got it. Now, the decision today — yes, thank you, sir.

PAUL SOLMAN: That’s what I’m here for.

A pair of key words

JIM LEHRER: Yes, right. OK, the decision was also accompanied with some words, you know, a statement from the Fed, and you've got that. I've got it here, too.

Now, everybody was looking for these words to figure out whether or not they were signaling something about, were there more to come of these rates, rate hikes, or was this -- they were going to take a pause? How do you read it, sir?

PAUL SOLMAN: Please, don't ask me to read it. This was a riot today. I was calling people to find out what their interpretation was. I got totally different interpretations of words that are almost identical to the words that were issued last time they met, which was six weeks or so ago.

So economic growth has been quite strong so far this year. Uh-oh. Worry about inflation there, right?


PAUL SOLMAN: However, growth is likely to moderate, the committee sees, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices. Inflation, therefore, might be likely to slow.

That's just what they said the last time. Then, they get to the crucial -- according to all of these experts here -- the crucial third paragraph: Some policy firming may yet be needed to address inflation risks.

Take a guess, Jim, as to what the key word in that sentence is.

JIM LEHRER: That means they might do this again, right?

PAUL SOLMAN: Ah, yes, but what's the key new word? There's a new word in that sentence. Some further policy firming may yet be needed to...

JIM LEHRER: Firming.

PAUL SOLMAN: No, "yet."

JIM LEHRER: "Yet," got it. Yes, sir. Got it.

PAUL SOLMAN: The key word is "yet." The not innocuous word "yet," as I'm quoting one of the experts. The "yet" downgrades the possibility of another rate hike significantly. That's what Joel Naroff says on Something else...

JIM LEHRER: But then there's a "but," OK. But then they finish the sentence, see? They go the other way.

PAUL SOLMAN: Ah, yes, yes, that's right. Yes, but the committee emphasizes that the extent and timing of any such firming -- firming, tightening, raising interest rates -- will depend importantly on the evolution of the economic outlook as implied by incoming information. That means, Jim...

JIM LEHRER: That means...

PAUL SOLMAN: They don't know.

JIM LEHRER: ... it could go either way.

PAUL SOLMAN: A cameraman just said.

JIM LEHRER: Right, but there's...

PAUL SOLMAN: My cameraman just said, "They don't know."

A guessing game

JIM LEHRER: So there's no consensus from the people you talked to? And I noticed on the wires there's no consensus. Some people said, oh, well, they're signaling a pause. This may be the last for a while. And then others said, no, no, no, no, just the opposite. So take it any way you want.

PAUL SOLMAN: You know, I've got two guys. One person said: This is a contradiction of what he said, Bernanke said before the Joint Economic Committee of Congress at the end of April. Another person said: No, I think it's entirely consistent with what he said.

David Jones, who's been on this show many times, said, if that isn't -- the sentence I just read -- a Greenspan-ian sentence, I don't know what is. So, I mean, Greenspan-ian meaning impenetrable.

JIM LEHRER: All right.

PAUL SOLMAN: I talked to Robert Solow, the Nobel laureate yesterday. He said that Bernanke -- he was talking about Bernanke and sizing him up -- he speaks more clearly than Greenspan. He lacks the squid ink that Alan is able to emit while swimming away from you. So, apparently, he may have more squid ink than people thought he had.

JIM LEHRER: So what you're seeing is -- at least the folks you talked to today and yesterday are saying there's not that much different -- there is no Bernanke era under way? It's still a continuation of the kinds of things and words that Greenspan used?

PAUL SOLMAN: Well, that's right, although most people said: Look, it's too soon to tell.

JIM LEHRER: Too soon to tell, OK.

PAUL SOLMAN: Give him a free pass for six months and so forth. But, yes, one person referred to him -- I can't remember who it was, but some eminent economist -- as a Greenspan acolyte. And I think that was William Greider, called him a Greenspan acolyte.

Other people said, look, the key job he has to do is to seem like he is like Greenspan so he doesn't panic markets. He gave an offhand comment to the White House correspondents dinner to a correspondent from CNBC. She mentioned it on the air. Hey, the markets went crazy for a few minutes. They were actually starting to trade behind her...

Hanging on every word

JIM LEHRER: And let's explain that. What he seemed to be signaling was that there may not be any more interest rate hikes, right? I mean, that's what he seemed to be saying, that he had said just...

PAUL SOLMAN: Right, but some people -- that's what some people interpreted him to have said in front of Congress. He now says to her in an offhand comment, she says, that he was being interpreted unfairly as dovish, that means letting the economy go too easily.

So, suddenly, she just reports this offhandedly on the air. She's about interview somebody -- the head of the Chicago Fed -- and the traders behind her drown out her interview because they start trading on this information. That's how dicey it is being a Fed chairman.

JIM LEHRER: All right. Explain that, why these words -- whether they're spoken informally by the Fed chairman or in an official statement like this -- means so much to so many people?

PAUL SOLMAN: Well, the world markets -- there's billions, trillions of dollars traded on the world markets. What else do they have to go on?

If the Fed, which as you can see, can just by willy-nilly raise rates by a quarter of a percent, that changes the equation for every security, every IOU, every debt instrument that's out there in the world, I mean, certainly anything that's denominated in dollars. So there's billions riding on this.

So, you look. You try to read the tea leaves. You try to read any single indication you can. If the Fed chairman is tipping his hand...


PAUL SOLMAN: ... that's a big deal.

I talked to Volcker back in the early '80s, who is off the record now, at this point, and he said: I can't say anything. I say one word -- and, you know, I gave a speech last night, he said, and the market went down 50 points today. And 50 points was a lot in the early '80s.


PAUL SOLMAN: He was just frustrated.

Making the right bet

JIM LEHRER: Yes, but for today, finally, what this is all about, following up on your point just now, is that people are trying to now see or guess, for investment reasons, what they may do when they meet again in June. Are they going to raise the rates another quarter point? Are they going to take a pause? And there's no consensus on that bottom line, right?

PAUL SOLMAN: No, right. But the betting is that they might take a pause. It's slightly less likely that they'll take a pause after today's signal than it was yesterday, but the betting is that they're still likely to take a pause, but they might then raise rates again, afraid of inflation in the future.

JIM LEHRER: Mr. Solman, it's been a pleasure doing business with you tonight. Thank you.

PAUL SOLMAN: Mr. Lehrer, me, too.