Nebraska

By Roy Frederick

Public Policy Specialist

Department of Agricultural Economics

University of Nebraska-Lincoln

Bold headlines will follow the Federal Reserve Board's meeting May 16. The Fed, as it is called, will raise interest rates once again.

Since last summer, the Fed has increased the "federal funds" rate five times. This is the interest rate that commercial banks charge each other to borrow funds for short periods of time, usually overnight. Its significance? Other interest rates tend to follow the Fed funds rate up and down.

Each Fed action over the past year has added one-quarter of one percent to interest rates. The last adjustment, in mid-March, brought the Fed funds rate to 6%. Speculation is that the next increase will be larger, perhaps one-half of 1%. Moreover, by year's end, the Fed funds rate may exceed 7%. That would be quite a change from the 4.75% level of mid-1999.

Interest rates are being increased because the Fed is worried about inflation. So far, the evidence of significant general price pressure is scanty. Even with higher energy prices, the current annual inflation rate is only about 4%. That is a far cry from the double-digit levels of the late 1970s. But it is also twice the inflation pace of the past four years.

Inflation causes distortions throughout the economy. That is why the Fed tries to keep it in check. For example, inflation hurts those who loan money. More generally, inflation makes financial planning difficult; no one knows what a dollar's inherent value will be in the future.

The Fed's challenge is to anticipate inflation before it occurs. Economic theories help. But projecting future developments in the U.S. economy is not all science; interpretation and perspective are important as well. That is why the Fed is often subject to second-guessing.

The Fed's current inflation concern seems to center on several factors.

Consumer spending, perhaps spurred by stock market gains, is robust. It helped the U.S. economy grow by more than 7% in the last quarter of 1999 and by more than 5% in the first quarter of 2000. Normal growth is about 3%. If economic expansion continues at roughly twice the normal rate, the nation's ability to supply goods and services may not be capable of matching consumer demand. Prices will increase.

Employee wages and salaries recently have been increasing faster than labor productivity. The Fed prefers that they increase at about the same rate.

Finally, the Fed always worries about the nation's trading relationship with other countries. The U.S. has a large and growing foreign trade deficit. Higher interest rates should discourage imports, there by positively impacting on the deficit. However, depending on the intricate interplay of several factors, a lower trade deficit may or may not help with inflation.

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