Economics 001A: Macroeconomics
Macroeconomic Case Studies
Economics 001A: M 6:30-9:15
Slowing the US Economy
The article titled ‘Fed Unlikely to Alter Course’ by John M. Berry of the Washington Post takes an interesting look at actions that Alan Greenspan his colleges of the Federal Reserve have been taking over the last 9 months to slow the economic growth of United States. The astonishing growth rate of 7.3% is fueled by an economy that is in the midst of a high tech revolution. The article also explores the contrasting view of other economists that say that the Fed has increased interest rates too much in its attempts to slow the economy.
The means by which Alan Greenspan and the Federal Reserve have chose to slow the economy is through a monetary policy, or more specifically, an increase in the national interest rate. The article states that the Fed officials have come to a broad agreement that they will keep raising the rates until growth slows to a more sustainable pace to make sure inflation stays under control. Because of the booming economy and the investment in the stock market the exchange of money has increased for goods and services, which in turn increases the price level or the quantity of money demanded. By increasing the interest rates the Fed commits itself to adjusting the supply of money in the United States to meet that rate at a point of equilibrium. If the interest rate is increased, less goods and services are demanded, and therefore will slow down the economy and reduce the rate of inflation. The article points out that as stock prices have risen over the last couple of years, so have American household wealth and consumer spending. This is precisely the cycle that Fed officials want to interrupt to slow growth before it fuels more inflation.
At the time this article was written the stock market prices had fallen sharply especially in the technology sector. But the Fed continued on the path to raise interest rates further noting that the index that they closely follow and contains a broader rage of public traded US stocks, the Wilshire 5000, is up for the year. Even though they began raising rates gradually 9 months ago, it takes almost a year for the economy to feel the full effects. In this case the results of the interest rates increased could be felt as last as the second half of 2000.
Yet the economy has not slowed down, and the demand for goods and services continues to increase as wealth does. One of the ideas that has been presented to Greenspan by the fed officials was to take bigger steps in raising the interest rates. They feel that this will decrease the money demand in a quicker fashion. In turn these actions will lead to lower consumer spending, and thus decrease the inflation rate. However, because of the erratic patterns in today’s high tech economy Greenspan is expected to stick to his pattern of more gradual increases to the interest rate. Eventually when monthly loan payments increase enough, consumers will back on purchases and investments. The article points out an example where the rate for a new 30 year fixed-rate home mortgage is up to 8.5% from 7.75% nine months ago in June. In the situation of a $150,000 home loan, this new interest rate will add almost $100 to each monthly payment. Over time the full effect of the interest rates will be felt.
One economist, James Glassman of Chase Securities takes a different look at the new interest rate. He points out that the rates that the Fed has set are fairly high in comparison to the rate of inflation as it is currently in the United States. The formula that Glassman follows examines the inflation rate when food and energy items are excluded because they are so volatile. With these items removed the rate of inflation in the US is less than 2%. As with other measurements, this rate can be subtracted from the interest rates to find a ‘real’ interest rate which consumers a paying. So in terms of 30-year home mortgage rate set at 8.5%, only 6.5% of it is what the consumers are actually paying and the rest is accounted for by inflation. Glassman goes further to point out that with inflation so low, wages aren’t going up all that fast. To be said more specifically, the interest rates are increasing faster than consumers’ wage increases. This will eventually be felt in the tightening of the American economy.
However with stock market fueling the incredible momentum of the economy, the affects of the interest rate hikes have not yet been felt, and the question has risen to whether or not the Fed’s tactics are actually going to work. However evidence is pointing back to when in 1995 the ‘real’ interest rate was close to 6.75% and the economy began to apply its breaks. Between that time in now a lot of money has been placed into the economy, and now to slow growth and inflation, the fed is using these high rates to take some of it away.
Secrets of the CPI
The article Unveiling the Secrets of the CPI by Kathleen Madicgan Focuses on exploring what exactly the Consumer Price Index is by using some recent examples from the United States economy. It delves into how the rate of inflation relates to the CPI and what tools the government uses to predict inflation. Moreover, it explores what happens when the government incorrectly predicts the rate of inflation.
The U.S. government watches the CPI as a way to determine how fast the rate of inflation is growing. The CPI is a good measurement simply because it is an index of all the goods and services used by consumers in households, and is calculated on a monthly basis. The goods and services that are actually looked at come from a survey of the past couple of years. Usually economists look at the core rate of the CPI, which excluded food and energy prices, since they fluctuate so rapidly. The article points out some examples where the corn produced in the United States could be directly affected by the weather. Also the recent oil price increases is directly related to OPEC and their choice to cut back on the production of oil. However the CPI is not a perfect measurement as Alan Greenspan, chairman of the Federal Reserve, has acknowledged. It usually overestimates the rate of inflation because the goods looked at are from previous years and do not include the addition of new products into the market. One example of this was the increase in cellular phones over in the 1990’s. The Bureau of Labor Statistics was not including them in the price index simply because they didn’t seem to fit into one particular category.
So how does the CPI relate to some of the current events in the U.S. economy? Kathleen Madigan writes about last April when the CPI was overestimated by analysts. When the CPI jumps sharply it suggests that rate of inflation is increasing. In April of 1999 the CPI jumped a sharp 0.7 percent suggesting that inflation was on the rise. At the same time market analysts anticipated that the Federal Reserve was going to increase the interest rates at the beginning of May. Because of this combination, the Dow Jones industrial average tumbled almost 200 points. If some one who borrows money in terms of something such as a home mortgage loan suddenly encounters unexpectedly high increase in inflation, the adjusted rate (the interest rate minus the inflation rate) becomes increasingly lower. Or in simpler turns, the money that is paid back to the lenders is less and less over time. Therefore more money will be injected into the economy and the wealth transfers form the people lending the money to the people borrowing the money. At this point the Federal Reserve will have to step in and raise the interest rates once again to compensate for the inflation. It is not bad for inflation to increase at a steady rate, but when there is an unusual spike in the rate, it hurts the economy because when regulating interest rates, it will take a long time to feel the full effects.
Another way of looking at how the rate of inflation is affecting the economy is in terms of the earnings of many corporations. When analysts predict the estimates for future earnings, the rate of inflation is figured into their calculations. However in the case of April of last year, the inflation rate as seen by the CPI increased unexpectedly. Therefore the earnings of many companies were overestimated, and investors may have overpaid for the price of a particular share of stock.
Conversely the bond market yields were shown as increasing to a 12 month high. This is accounted by the yield rate being correlated to the rate of inflation in the economy. As the rate of inflation increases, so will the bond yield rate to compensate for inflation. In this case it makes the bond market much more attractive to investors considering the long-term yields may be higher than other forms of investment. It is also a benefit for the Federal Reserve in the sense that as investors choose to buy bonds, it will remove some of the money supply from the economy.
Overall the Consumer Price Index is an important tool provided by the Bureau of Labor Statistics that the government looks at closely to determine the growth of the economy and value of money because of inflation. When there is an unexpected increase in this rate, the results trickle down to many outlets of the economy such as the stock and bond markets, which can be clearly seen by the sudden stock market fluctuation. In the last year the Federal Reserve began to regulate the economy by increasing interest rates because of the fear of rising inflation. Time will tell the effectiveness of these measures.