FRBSF Economic Letter
2000-17; May 26, 2000
 Economic
Letter Index
Why Has the Fed Been Raising Interest Rates?
This Economic Letter is adapted from a keynote address delivered
by Robert T. Parry, President and CEO of the Federal Reserve Bank of San
Francisco, to the 28th Annual Northern California Financial Planning Conference
in San Francisco on May 9, 2000.
The U.S. economy's performance has been remarkable for a number of reasons.
The current expansion has lasted longer than any other in U.S. history.
And in the last four years especially, it has shown remarkable strength,
averaging 4-1/2% growth annually. Furthermore, unemployment continues
to hover around 4%, the lowest level in 30 years. Although inflation flared
up a bit in March, it has remained pretty tame overall, with the core
consumer price index (CPI) (that is, excluding food and energy) rising
2-1/4% over the past twelve months.
With all this good news, it's natural to ask why the Fed has been raising
interest rates since last summer. May 16 was the sixth time we raised
the short-term rate, for a total increase of one and three-quarters percentage
points. In this Economic Letter, I give my views on this question
and try to explain why I see risks of potential inflation in the economy.
But before I get into the national picture, let me take a moment to discuss
the economy here in the West, especially California.
Economic conditions in the West
The San Francisco Fed is headquarters for the Twelfth Federal Reserve
District, which comprises the nine westernmost states. And both the District
economy and the California state economy have been enjoying strong performances
for the last several years.
A key source of the District's strength has been California's economy,
especially the state's high-tech sector. Job growth was notably strong
in businesses like biotech, communications, and software and Internet
services development. And it was financed by record-breaking venture capital
investment, and surging proceeds from initial public offerings.
This scenario has played out even more intensely here in the Bay Area.
The jobs and investment returns created by local high-tech companies during
the year generated tremendous gains in income and wealth, which powered
robust consumer spending and helped maintain strong economic conditions
in the area--all this despite weak export demand and job losses in durable
manufacturing.
Looking forward, we find that there are some factors that could
restrain growth in this area. For example, tight labor markets and rising
real estate prices could have an effect. And uncertainty about market
valuation--especially for high-tech stocks--could damp the gains in income
and wealth that have driven consumer demand and financed business expansion.
But overall, the Bay Area's prospects look very good. Job creation remains
solid overall, With high-value sectors--such as software and Internet
applications--continuing to create substantial wealth. The area's unemployment
rate has fallen to just 2.5%. And exports of many Bay Area products have
begun to increase. In terms of the conditions in real estate markets,
construction employment continues to grow rapidly, and Bay Area home prices
are increasing at double-digit rates.
The role of productivity in the national
economy's performance
One of the key reasons that the U.S. economy has been able to grow so
vigorously with relatively low inflation for the last few years is the
remarkable surge in productivity that's related to the advances in technology.
Not so long ago, most estimates suggested that the U.S. economy probably
couldn't sustain productivity growth faster than 1-1/2%. That had been
the average from the 1970s to about the mid-1990s. But the numbers we've
seen over the last few years have led us to revise our estimates substantially.
Between 1996.Q1 and 1997.Q1, productivity grew at 1.4%, which seemed in
keeping with the preceding couple of decades. But between 1997.Q1 and
1998.Q1 it came in at an astounding 3.0%! And though the number dropped
slightly between 1998.Q1 and 1999.Q1, it soared back to 3.7% for the period
1999.Q1 to 2000.Q1.
These increases in productivity have wonderful effects on the economy.
One effect is that a faster growth rate for productivity means
that living standards rise faster. Another effect is that when productivity
accelerates, it tends to hold down inflation. This is true mainly
because increases in labor compensation tend to lag behind increases in
productivity growth. So, for a while, more goods are being produced at
the old, lower wages. But I want to emphasize that there's an important
distinction between fast productivity growth and accelerating
productivity. As I said, faster productivity growth raises our standards
of living more quickly. And that's great. And we get an initial inflation
benefit when productivity accelerates. But thereafter, if productivity
growth levels off at the faster rate, monetary policy must respond to
keep inflation at the new lower level.
The near term question is: Can productivity keep accelerating fast enough
to push inflation down further? Yes, that's possible. But it's not something
we can count on. So, even though it's clear that technological advances
are expanding the supply side of the economy, we still have to watch for
conditions that raise inflationary risks. And there are several of them.
These are the risks that have led the Fed to follow a course of gradually
raising short-term interest rates.
What are the inflation risks in the economy?
One potential area of inflation risk involves the relationship between
faster productivity growth and the levels of "equilibrium" real
interest rates--that is, the rates that bring supply and demand in the
economy into balance, so that output equals its potential level. Here's
what happens--higher trend productivity growth actually raises the level
of equilibrium real interest rates in the long run.
How does this work? Faster productivity growth increases the profitability
of various investment projects that firms might undertake. This means
they'll bid more aggressively for financing. And that will raise equilibrium
real interest rates. Simple models suggest that the increase in the equilibrium
rate is about equal to the increase in the growth rate of trend productivity.
In reality, this response will depend on a number of factors, including
how fiscal policy and foreign economies respond when U.S. productivity
growth rises. For example, if government spending is fixed, so that it
does not increase in response to a productivity shock, the budget surplus
will rise and the equilibrium rate will increase by less than it would
otherwise. Even though it may be difficult to determine how much the equilibrium
rate has risen in response to any particular productivity shock, it is
pretty certain that the equilibrium rate will rise to some extent. If
the Fed tried to hold real rates at their old levels, we'd be contributing
to an inflationary monetary policy.
Another area of risk is the growth in demand. We've seen a real pickup
in demand for U.S. products from abroad--real GDP growth in the rest of
the world rose to around 4-1/4% last year from less than 1% in 1998. And
it's projected to be almost as strong this year.
Here in the U.S., businesses and consumers have been spending at a phenomenal
pace. In 1999, business fixed investment jumped 7% in real terms (adjusted
for inflation), while real personal consumption expenditures soared 5-1/2%.
And this spending actually accelerated in the first quarter; on the business
side, real fixed investment rose by more than 21%, and on the consumer
side, real expenditures jumped by more than 8%!
Consumer spending especially appears to have been fueled by the very
large increases in equity values in recent years. Now, that doesn't mean
that the Fed has set its sights on some kind of goal for the stock market.
We're not so concerned about why consumer demand is so strong.
What we are concerned about is that demand--for whatever reason--may
be outstripping supply.
This brings me to another inflationary risk. One consequence of the fast
pace of growth since 1996 is that labor markets in the U.S. have now become
very tight. With the unemployment rate currently at just under 4%, it's
no wonder we hear stories about how hard it is for some firms to find
people to fill jobs. Labor markets as tight as this eventually can lead
to faster increases in labor costs and therefore to higher price inflation
than we've seen so far. In fact, we saw a noticeable jump in the first
quarter employment cost index, a broad measure of labor compensation that
includes wages, salaries, and benefits.
The final risk I want to mention is one that's made front-page news lately.
And that's the run-up in energy prices. At the end of 1998, OPEC cut back
on its production, and that drove oil prices to the highest levels we've
seen since the Gulf War. But the good news is that OPEC did agree
recently to increase production somewhat. Overall, then, we expect only
a modest effect, because oil prices appear to have fallen back from their
highs in March.
How should the Fed respond?
Now, with these inflationary threats, what's a reasonable course for
the Fed to follow?
Well, it's risky just to sit back and wait for an upward trend in inflation
to show up before we do something, because monetary policy affects inflation
with a long lag. To my mind, the March pickup in core inflation is worrisome,
but it's by no means conclusive. It is too soon to tell if this is the
beginning of a more sustained upward movement, especially since the April
core CPI data came in at a moderate rate. But it does seem pretty clear
that we've reached a stage where inflation is no longer falling.
And we certainly don't want to abandon our goal of achieving price stability.
At the same time, we need to proceed with some caution, because there's
a fair bit of uncertainty about the economy's behavior right now. Most
forecasts--including my own--have predicted a sustained rise in
core inflation for a couple of years. But we haven't seen it yet. And
that makes me less confident about the old relationships between the growth
of the economy and the level of the unemployment rate and the effect on
inflation. Given these considerations, I think the cautious approach of
gradually increasing short-term interest rates since last summer has been
appropriate. And I would characterize the most recent increase, which
was 50 basis points, as in keeping with that approach. Going forward,
we will continue to aim policy at keeping this remarkable expansion on
track without risking our ultimate goal of price stability.
Robert T. Parry
President and Chief Executive Officer
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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