With the economy heating up everyone expects Federal Reserve Bank Chairman Alan Greenspan to raise the Bank’s lending rate to prevent inflation.
Americans feel the inflationary pinch through higher housing, education, and energy costs.
Economists fear that rising prices could produce an inflationary spin if the economy isn’t cooled down with higher rates.
High interest rates will discourage consumers and entrepreneurs, from borrowing for new investment and spending.
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Inflation Fears Encouraging Interest Rate Hikes: What It Means For Us
With rising prices and the threat of inflation President Bush reappointed Alan Greenspan as Federal Reserve Bank Chairman last month. As chief overseer of the nation’s economy Greenspan sets the bank’s prime interest rate for loans to commercial banks. That rate controls the economy’s money supply. Given that the economy usually determines the election, a look at inflation will prepare us for likely government interest rate changes.
To understand inflation an economic review is in order. The U.S. economy is still very much a mixed bag. The recovery seems to be moving ahead with new jobs and consumer spending. Since last August over 1.1 million new payroll jobs were created, 867,000 in the last 4 months. Manufacturing and information technology jobs are making a comeback. Unemployment dropped from last summer’s high of 6.3% to 5.6%. In March retail sales surged 1.8%, their biggest increase in a year. Although imports increased $134.45 billion, U.S. exports hit a seven year record reaching $92.37 billion, a 4% increase for 2003.
But signs of weakness remain with rising prices and debt. In March food prices saw their largest increase since October of 1.5%. Oil and gas prices are at a record averaging $40 per barrel and $2.10 per gallon respectively. The rise in energy prices increases production costs meaning higher prices for goods and services. According to newly released figures for last year, 1.63 million families filed bankruptcy, a 6% increase from 2002. Mortgage delinquencies, credit card debt, and long term unemployment are up. The U.S. account deficit with other countries reached $550 billion last year. The trade deficit causes borrowing abroad.
The Federal government has helped and hurt the economy. Bush tax cuts are attributed to economic recovery. Corporate profits, business investment, and productivity are up. The largest Federal spending in history produces new jobs but also causes record deficits. Under the President’s watch the national debt rose 23%. The Iraqi and Afghan strain on the defense budget adds to the deficit. But the deficit is projected to significantly drop with higher than expected tax receipts and continued economic recovery.
How does inflation enter the economic picture? Economic theory suggests that inflation is due to an overheated economy. Rising employment, investment, and consumer spending produce more demand than supply forcing higher prices.
Sparked by the Yom Kippur War Arab oil embargo against the West, the 1970s represented an era of inflation run wild. Energy shortages produced skyrocketing production prices. Ever increasing prices passed on to consumers and business took a bite out of savings, investment, and new spending, causing a recession.
But inflation has a silver lining. Domestically rising prices produce a weak dollar overseas in comparison to other currencies. The dollar’s value has declined 12% since last year against our major trading partners’ currencies. A lower dollar encourages foreign purchase of American products and discourages domestic purchase of foreign products, reducing our trade deficit with other countries.
While a lower dollar encourages foreign investment it also makes the U.S. beholden to foreigners. Foreigners increasingly own Federal debt through the purchase of U.S. Treasury notes. Foreigners also buy up U.S. real estate.
As a trade analyst for the U.S. Trade Representative monitoring foreign ownership in 1989, it seemed like the Japanese economic giant reversed World War II’s outcome. I reported on growing Japanese investment in the U.S. Japanese economic influence in the U.S. was then highlighted by a visit by elderly Japanese Emperor Hirohito. The U.S. Trade Representative considered it ironic that the emperor who presided over the attack on Pearl Harbor, Hawaii, forcing U.S. entry into the war succeeded in economic conquest two generations later. We discovered that the Japanese owned one third of all Hawaiian real estate.
Foreign ownership of the U.S. economy makes us dependent on foreigners, including Arab oil interests. The budget deficit forces the government to turn abroad to finance debt through Treasury bonds. Foreign central banks led by China and Japan now hold $1 trillion or 25%, of U.S. publicly held debt. The U.S. account deficit with other countries financed by foreign banks grew from 1% in 2001 to 38% in 2003. If foreign banks stop buying U.S. debt the U.S. would have to make up for the loss somewhere else. Many politicians fear that China’s influence over the U.S. economy threatens our security interests in Asia. These politicians compare such influence with the Arab oil weapon which helped dictate policy against Israel during the 1973 Yom Kippur War.
However, a global economy forces interdependence and cooperation, discouraging countries from taking negative actions like the recall of U.S. debt. Such actions will likely harm their own economies.
Mr. Greenspan argues that foreign central bank ownership of U.S. debt is small when compared to total trade volume in U.S. debt markets. Most foreign holdings are short term notes, not the long term notes that influence the Federal Reserve Bank’s monetary policy. The purchase of U.S. dollars and debt provides countries with hard cash to purchase the American technology feeding their economies. Our trade partners will not disrupt the U.S. economy, if for no other reason than to protect their own investments. Many developing economies, including Israel, link their currency to the dollar, still the world’s most stable currency.
With the economy heating up everyone expects Greenspan to raise the Federal Reserve Bank’s lending rate to prevent inflation. That rate has been at a 45 year low of 1% since last June to encourage economic recovery.
The Federal Reserve Bank’s low interest rate affects the home mortgage market, allowing for the highest home ownership rate in U.S. history. With low rates the average mortgage payment consumes only 21% of household budgets. Expected mortgage rate increases of one or two percentages above the current 6% will not significantly affect home purchase affordability.
Low lending rates cause banks and corporations to borrow against the 1% Federal Reserve Bank rate and purchase Treasury Notes with a guaranteed 4% return rate. Such practices discourage investment in the private sector and harms government fiscal soundness.
Economists fear that rising prices could produce an inflationary spin if the economy isn’t cooled down with higher rates. At the next Federal Reserve Bank meeting this month it is anticipated that Greenspan will raise rates.
As controller of the money supply, the Federal Reserve Bank exercises economic power. By increasing the interest rate the money supply is restricted, discouraging business and consumer borrowing. A higher rate raises the dollar value warding off inflation. But the dollar’s rise also makes American products abroad expensive, discouraging foreign purchases and investment. By restricting the money supply the Federal Reserve Bank ensures that an overheated economy doesn’t get out of whack with skyrocketing prices.
What does inflation mean for Americans? Impending inflation implies an overheated economy ripe for cooling down. While rising prices make our money worth less they also are a symptom of a booming economy with more demand than supply. If not restrained, inflation reduces our purchasing power forcing us to cut back consumption.
Americans feel the inflationary pinch through higher housing, education, and energy costs. Higher interest rates on home mortgages can price many home buyers out of an already tight market. Higher mortgage rates mean higher income requirements for home purchases and monthly mortgage payments. If we endure skyrocketing tuition bills with low inflation you can imagine what high inflation will do to our education budgets! As big consumers of transportation, rising energy costs will force Americans to reduce travel.
Senior citizens, while being somewhat cushioned with social security cost of living increases, could still see their savings depleted from higher prices. Older citizens and on fixed incomes, could find it difficult to satisfy basic needs if inflation rises greater than retirement income. Rising prices hit seniors hardest, forcing them to struggle with rapidly rising housing, food, transportation, and healthcare costs. If healthcare costs have skyrocketed with low inflation you can imagine what rising inflation will do to senior healthcare budgets!
Putting a lid on rising inflation through interest rates hikes may not be a total economic fix. High interest rates will discourage consumers and entrepreneurs, from borrowing for new investment and spending. Investment and spending cutbacks diminish job growth.
A higher dollar value through higher interest rates could increase employment outsourcing. Employers may take advantage of greater purchasing power abroad to satisfy labor demands at the expense of American workers. As a result American workers in key outsourcing industries could loose their jobs to foreign workers.
Higher interest rates may not resolve skyrocketing healthcare and energy costs caused by new consumption.
A strengthened dollar with high interest rates and a tighter Federal money supply could increase the trade deficit by making foreign goods cheaper. However, most manufactured products are already produced overseas, and therefore consumers should benefit from greater purchasing power abroad.
A strengthened dollar overseas might increase inflation in countries like Israel, who peg their currencies to its value. It will also increase costs of American imports.
Greenspan has been hesitant to raise interest rates, awaiting economic recovery from the past recession. But with fears of inflation he will likely hike the Federal Reserve Bank’s lending rate this month. With economic growth expected to hit an annualized rate of 4%, an interest rate hike may remedy looming inflation and sustain economic recovery. We anxiously await rate hike decisions to determine our economic vitality.