The Federal Open Market Committee issued a press release on August 8, 2006 to announce that the federal funds rate will remain steady at 5¼ percent. The decision broke a string of 17 straight increases. The central thrust of the monetary policy is an attempt to reign in inflation, and the decision to leave the federal fund rates unchanged was made due to fears that the previously strong growth in the economy in the first half of the year was stagnating due to high energy costs and a perceived threat that the housing bubble may soon burst. Foremost on the minds of the FOMC was controlling inflationary pressures.
The primary economic conditions that affected the FOMC decision were the continued high cost of oil and gasoline, and consumer slowdown as a result of high interest rates. In addition, the cautionary approach that was taken by the Federal Reserve might have had a good deal to do with the uncertainty in the Middle East amid a continuing war in Iraq and the violence between Israel and Hezbollah.
The FOMC at the time predicted a slowdown in inflationary pressures, and the fact that they chose not to increase the federal funds rate may indicate that they believe they have already taken enough steps to forestall the problems. In their August release they also indicated an expected moderation of inflation. (Anyone who has watched the price of gasoline skyrocket 20 cents over the past two weeks should be tended to immediately; they may have ruptured an abdominal muscle after reading that forecast.)
Unfortunately, there is no universal agreement on exactly what economic conditions cause inflation, though the general consensus views inflation as a result of one of two possibilities. Prices tend to rise either when the supply of money available outpaces the production of goods, or when there is a sharp increase in productivity costs. The latter explanation is best suited for the inflationary pressures facing America now as businesses across the board find they must increase prices in order to offset rising energy costs. Cost which, as many of us predicted then and know for certain now, were manipulated downward last election season.
Although it may be the conventional wisdom to suggest that all consumers are hurt by inflation, in most cases wage earners have tended to keep up with inflation. Those who tend to be hurt the most by inflation are people on a fixed income who lose their purchasing power more extremely as a result of having no recourse to increase earnings. Those with savings accounts also typically tend to suffer when their interest rate doesn’t keep up with the inflation rate.
When inflation is expected and the central government moves to contain it, the effects on the economy can run the gamut depending on how far off-base the expectations ran from the reality. The most obvious effect on an economy being manipulated to deal with the expectation of inflation is usually employment.
When dealing with inflationary pressures the Federal Reserve doesn’t just look toward the above effects however. Often mentioned, but rately understood is the impact that the continued lag the US has experienced in world trade has on our economy. A very interesting article by Joe Richter titled “US Trade Deficit Narrowed to $64.8 Billion in June” sheds some light on this aspect of US economics. The article argued that the US trade deficit had narrowed in June because of record shipments of American goods to overseas customers. At the same time, however, the trade deficit with China reached its third highest level ever. Richter goes on to point out that American lawmakers blamed this number on China using artificial means to keep its currency weak. The trade deficit suffered as a result of high energy prices spurring American consumers to purchase more fuel-efficient cars manufactured in Asia countries. (How dare they!) Almost lost amid the statistics and quotes was the intriguingly unsubstantiated assertion made by uncredited economists that “the trade deficit is unlikely to deteriorate much further”. This article lends further credence to the concept that the American economy is precariously balanced between domestic and global forces. Because high energy prices are increasing costs to businesses across the board, the average American has less spending power than he did just a year ago. This in turn has created a demand for more fuel-efficient vehicles of the type not manufactured by American automakers. The trade deficit figures exhibit firsthand how monetary policy can be affected by economic conditions not easily controlled.