L. Randall Wray, Professor of Economics, University of Missouri-Kansas City, Jerome Levy Economics Institute Visiting Senior Scholar, and Senior Research Associate, Center for Full Employment and Price Stability

     In June, a variety of newspaper headlines proclaimed Good News All Around: Largest employment losses in nine years! Retail sales down again! Home starts collapsing! Manufacturing output down for third straight month! Debt service burdens up, delinquencies and defaults rising! Even imports are down! Can we stand any more good news?

     The Fed has raised interest rates six times over the past year in an effort to slow economic growth. Mounting evidence shows the economy has slowed perceptibly in recent months. While the FOMC chose to leave interest rates alone at its last meeting (June 28), it threatened to raise them again in the future if robust growth resumes. I suspect that growth during the rest of this year will be sufficiently sluggish that the Fed will not increase rates further. However, it must be remembered that the Greenspan Fed continued to raise rates in 1989 as the economy slowed into our last recession.

     It is becoming increasingly obvious that the six rate hikes so far this year resulted from a colossal misreading of the economy by the Fed. Inflation was never around some corner or other. The US expansion was self-limiting because it was fueled by unsustainable private sector deficit spending–mainly by households that were spending more than their incomes by a record amount. Early this year, households began to retrench, cutting borrowing and spending. The Fed’s rate hikes played a role in hastening the inevitable by increasing debt service burdens. While most analysts believe the Fed can engineer a soft landing by gradually lowering rates as the economy slows, I think it is much more likely that we will suffer a Japanese-style hard landing.



     While the Fed has long been (legitimately) concerned with the “irrational exuberance” of stock market excesses, I do not believe that interest rates have been raised to cool equity prices. Indeed, if anything, I expect that concerns over effects on Wall Street have moderated Fed rate hikes. Instead, I believe Chairman Greenspan when he says he is worried about inflation and suspect that rate hikes would be discontinued if the Fed became convinced that inflation risks had subsided. This is not to say that there aren’t other forces that push the Fed to action. An active Fed is a watched Fed. Since 1989, the Greenspan Fed has changed the fed funds rate 45 times–or, on average, once every quarter. Frequent, small, interventions keep the Fed in the limelight and remind the press that Greenspan is the Second-Most-Important-Man-in-the-World.

     The Fed’s model runs something like this. High aggregate demand growth must eventually cause inflation because growth of potential supply is limited to growth of the labor force plus productivity growth. The current expansion has proceeded at an unsustainably high pace, however, inflation has not yet reared its ugly head because potential supply was, until recently, able to keep pace–partially because we began with a large stock of unemployed and partially because productivity growth has been well-above its post 1973 trend (the New Economy and all that). We are now living on borrowed time, with aggregate demand outstripping supply–as evidenced by unemployment rates that remain too low. While there is no strong evidence that inflation is accelerating, monetary policy works with a lag so it must be used preemptively. Interest rate hikes reduce borrowing and thus spending along a more-or-less smooth demand for loans curve. Interest rate effects are largely independent of the state of the economy and proportional to the size of the change.

     This model has scant empirical support and it stands on shaky theoretical ground. While there is probably some link between unemployment rates and the rate of growth of wages, there is little support for the belief that low unemployment leads to inflation. Since 1970, every case of rapid acceleration of inflation has taken place during high unemployment periods. In contrast, our low unemployment periods–during the 1960s and late 1990s--have come during periods of robust growth and low inflation. Inflation in the US has always been driven by three components of the consumer basket: energy prices, food prices, and, most importantly, imputed housing costs. (See Papadimitriou and Wray.) Note the keyword–imputed. About half of US inflation is due to the housing component of the CPI, and that does not measure what is actually happening to real estate prices. Rather, it is constructed from a survey that asks homeowners to make a guess about how much rent they might receive if they were to put their homes onto the rental market. There is no reason to suppose that this guess varies systematically with tightness in the market for labor to build new houses–or with anything else the Fed ought to be worried about.

     The notion that low unemployment and rising wages ought to cause inflation has a lot of intuitive appeal, but it ignores supply responses and price constraints. Low unemployment and strong economic growth means firms operate closer to capacity, hence, more efficiently. Firms adopt labor saving-techniques and technology. Labor productivity rises. Cheaper intermediate goods can be imported. Greater sales on a reduced markup over wage costs allow firms to maintain profits and market share in spite of higher wage costs. Cheap imports–especially in the last two decades–prevent domestic producers from raising prices. Thus, it is not surprising that there is no strong empirical relationship between low unemployment and rising inflation–and, often the correlation goes the other way because low demand causes firms to operate inefficiently, placing pressure on prices.


     The six rate hikes thus far have already hurt the economy, and the Fed might increase interest rates further later this summer. The main impact this will have on the economy will come later–hindering recovery. If the economy were strong, interest rate hikes alone would have little effect. However, let me address the belief that the Fed ought to tighten in order to raise unemployment to fight prospective inflation.

     The old “reserve army of the unemployed” argument that underlies all of Greenspan’s musings on the necessity of maintaining high unemployment rates in order to keep labor insecure holds appeal. But it is flawed. Monthly movements of the official unemployment rate make good press but provide little information. Most of those who would like to work do not get counted. Even Greenspan has argued that there are actually 10 million people who would like to get jobs–4 million more than the official count. But that is still too low–the actual number is closer to 16 million. (See Pigeon and Wray.) If we are to take Greenspan at his word, something like 10-16 million people must remain unemployed to keep inflation down. What makes this particularly disturbing is that unemployment is never equally distributed. It is always disproportionately visited on the disadvantaged–low skilled, lowly educated, minorities, last-hired-first-fired.

     It would be nice if we could convince them, and ourselves, that while it is really a shame that they can’t find jobs, they’ve got to do their civic duty by going without in order to keep the employed sufficiently insecure. But that is a lie because they are not close substitutes for the highly educated, highly skilled workers now in short supply. Yes, the US might be facing a shortage of experienced electrical engineers, but does anyone seriously believe that can be resolved by raising the unemployment rate of innercity teens, or other disadvantaged groups who are enjoying the only half decent job market in a generation and a half? I do believe that the low unemployment rates have helped to reverse declining wages at the very bottom of the labor market, but this is not going to spur general inflation, nor can rising unemployment at the bottom help to relieve bottlenecks at the top.

     The costs of unemployment far exceed the lost income that one suffers while unemployed precisely because unemployment is visited disproportionately on those who are already disadvantaged and because long spells of unemployment generate large social costs in terms of higher divorce, suicide, crime, and mortality rates. It is a principle of public policy that government should not adopt policies that cause concentrated burdens on a small subset of the population in order to generate benefits that are widely spread. If unemployment were equally shared across the entire population, then it might be acceptable to use unemployment to fight inflation, the benefits of which would be shared by those who bear the burden. However, this is manifestly not the case. Until unemployment reaches levels not seen in the USA since the 1930s, it will be concentrated in certain easily identifiable, disadvantaged, groups.

     The Fed’s policy is also based on faulty understanding of the impacts of rising interest rates–the tool used to try to increase unemployment among innercity teens. Interest is a cost imposed throughout all markets, much like an OPEC-induced increase of energy costs. Thus, the initial effect is quite similar to the effects of rising oil prices–inflationary. Business firms normally finance day-to-day operating expenses through short term loans; when interest rates rise, their finance costs immediately rise, and to the extent that they are able, they pass these along in the form of higher prices. Again, their ability to raise prices is mitigated by competition from foreign firms that are not impacted by rising US interest rates; further, they will also try to cut other costs  to compensate for rising interest costs. Over the longer run, firms might decide to reduce some kinds of spending, although so long as demand remains high it is unlikely that spending by firms will be much affected. It is ironic that the Fed stands ready to fight rising wage costs because of their supposed inflationary impacts by raising interest costs, which increases business costs in a much more direct and universal manner than do scattered wage increases.

     While conventional wisdom presumes that a primary effect of tight monetary policy is through the investment channel, there is virtually no empirical evidence that higher interest rates lower investment. This isn’t surprising, as US firms mainly use retained earnings to finance investment. (See Fazzari.) Conventional wisdom also holds that consumers cut back spending on big ticket items as interest rates rise. While there may be some impacts on origination of new mortgages, even this effect is overstated when variable rate mortgages exist as an alternative. What matters to households is the monthly payment, not the interest rate. If incomes are rising, or if debt loads are relatively small, rising interest rates have little effect because households can make their monthly payments without too much trouble. However, if rates rise enough and if households are sufficiently indebted, there is a large “net income effect”(income that is left after servicing debt is reduced). This means that interest rate effects depend critically upon the amount of debt carried.

     What all this means is that there is no nice smooth credit demand schedule. It is more appropriate to think of the process as one in which interest rate hikes eventually push households to a debt service threshold, which varies depending on debt loads. Further, the crunch, when it comes, will be much more severe when the debt load is high because default risk is increased. As credit quality erodes, banks begin to retrench even as their own balance sheets erode–making recovery much more difficult. In recent decades the heaviest debt service load was reached in the late 1980s; it is not surprising that the Fed’s attempt to engineer a soft landing in 1989 led to a deep and prolonged recession accompanied by a credit crunch that hampered recovery. Although debt service ratios today are slightly lower than those reached at the 1980s peak, this is only because interest rates are lower today (debt ratios are much higher–indeed, they are easily at an all time high). As interest rates rise in coming months, debt service ratios will rise until households are no longer able to service their debt. The coming credit crunch could be more severe than the one experienced in the early 1990s.



     The most recent evidence on inflation, from the PPI release of June 9, found that the index for finished goods prices in May was unchanged. It is true that this result was derived from large declines in the prices of foods and energy. If we exclude those, prices rose by 0.2%, or something like a 2.5% annual rate. That is exactly where measured inflation has been stuck over almost the whole Clinton expansion.

     As the BLS said in the PPI release, measured inflation for May included “price increases for passenger cars, sanitary papers and health products, book publishing, light motor trucks, cosmetics, and women’s apparel”, which “outweighed declining prices for prescription drugs, alcoholic beverages, household appliances, passenger car radial tires, and for girls’, children’s, and infants’ apparel.” So sanitary paper prices rose while prescription drug prices fell. Is that a clear case that we risk runaway inflation if the Fed doesn’t act now? If prices went up significantly across the board, we could probably all agree that there was inflation. But that is almost never the case. In reality, some prices are rising and some are falling, and the PPI or CPI weights these in particular ways based on best guesses made at particular points in time that rapidly become increasingly wrong. For example, the CPI uses relative weights based on a typical consumer basket that is updated once every decade or so, and as we move further from the update, the relative weights used increasingly misrepresent actual consumption baskets.

    It must always be remembered that the CPI and other measures of inflation are calculated from constructed indexes. They are highly imperfect measures, easily influenced by transitory events and arbitrary decisions of statisticians. Particularly during periods of rapid changes in product markets, measurement errors are large. Changes to the CPI that are below something like 4 or 5% should probably be ignored–maybe not even reported–because the noise to signal ratio is too high to provide for any reasonable interpretation. The lower the measured inflation rate, the greater the uncertainty regarding its meaning. A zero inflation target should be dismissed out of hand merely for those reasons.

     However, it should also be dismissed because there is no theoretical or empirical justification for the belief that moderate inflation is sufficiently costly to warrant concern. Certainly, there is no strong evidence that CPI measured inflation of 5% or even 10% has real costs in terms of aggregates like GDP growth, investment, or consumption. Some careful cross-country analysis has shown that inflation rates of even 40% have no discernible impact on growth; a very recent study–by economists at the BOG, no less–found that moderate inflation in the US is actually good for investment and output. (See Ahmed and Rogers as well as Bruno and Easterly.) Leaving aside the long-term historical evidence, it simply is not plausible to argue  that the US faces accelerating inflation in the current conditions that include massive excessive industrial capacity all over the globe–especially in low wage competitor nations–and a strong dollar.

     Finally, as discussed above, even if inflation is costly, it is not reasonable to fight it by raising unemployment. This is because the benefits of low inflation–if they exist–are presumably shared across society, while the costs of fighting inflation by raising unemployment are borne by specific groups. If inflation is to be fought, this must be done in a manner such that costs are shared across society–ideally by all those who share in the benefits of low inflation. I’m not sure that economists are anywhere near to formulating such policy. Given our current state of knowledge, we should move carefully. Empirical evidence for the US certainly does not support the case for raising unemployment to fight inflation, for, as discussed above, we have never experienced accelerating inflation when unemployment was low. It is particularly ironic that most analysts support frequent, disruptive, intervention by the Fed to change interest rates a quarter century after “fine-tuning” by government policy was rejected. Would anyone today support quarterly changes to federal tax rates in order to attempt to fine-tune the economy?

     Raising interest rates to fight inflation is actually a pretty bizarre policy, if you think about it. It is like a tax on borrowing that hits firms that use short term loans to pay wage bills and other day-to-day operating costs, as well as indebted households. It increases government spending on interest (reducing the current budget surplus). It increases income of those who hold financial assets–who might be expected to increase spending. Thus spending by rentiers and by the federal government actually rise, at least partially offsetting any reduction of spending by indebted firms and households. This is why interest rate effects must work mostly by causing insolvency and bankruptcy. The impacts, as discussed above, depend on the distribution and level of the debt burden, thus, are inherently difficult to ascertain.



     For quite some time, it has been clear that the dangers facing the US economy are mostly of the downside variety–and they are mostly neither the fault of the Fed nor can the Fed do much about them. The stock market boom ended long ago: The DOW and S&P have been essentially flat since last November, while Nasdaq is down substantially since March. This is not necessarily a bad thing because, as Greenspan apparently noticed, the US equity market irrational exuberance probably represents the biggest speculative bubble in all of human history. However, more importantly, it was the stock market that was supposed to be driving consumption through a “wealth effect” as richer households borrowed against capital gains to fuel high living. What no one seems to recognize is that if the market has gone horizontal, there are no capital gains to borrow against, hence, the consumption boom should be over. And, indeed, recent data do seem to indicate that spending trends are down. Recent projections have GDP growth at just 4.5% for the entire year, far below the forecasts of only a month ago. In May, manufacturing output dropped for the third straight month. Home sales fell significantly in April. The unemployment rate rose to 4.1% in May, from 3.9% in April–yes, this has something to do with competition by the Census Bureau, but the private sector’s largest employment losses in 9 years ought to give one pause.

     Many, of course, welcome all this bad news. Wall Street temporarily rebounds on every hint that the economy is faltering. The Financial Times heralded the various releases of the first week of June with the headline “Encouraging Signs: The figures suggest that the Federal Reserve may finally have raised interest rates enough to slow the US economy.” Earlier, the FT had reported in another headline that “OECD looks to Fed for sharp rise in interest rates: Big increase is needed by August to avoid global downturn, report claims.” Not to be left behind, the Wall Street Journal had suggested in a headline on June 5 that the “Fed’s Rate increases Seem to have Vented The Economy’s Steam”, with a highlight indicating that steel industry prices are “softening, while inventories are starting to pile up”. The common thread, of course is the recognition that May fears of overheating were in error. More relevantly for our purposes is the common assignment of credit for the slowdown to the Fed’s six rate hikes.

     In reality, the downturn was inevitable, with or without rate hikes. The basic problem is not monetary policy, but tight fiscal policy in the context of a large and growing trade deficit. In other words, the main contributing factor to the coming recession is the very tight fiscal policy which has meant that expansion could proceed only on the basis of unprecedented private sector borrowing. To some extent, this may have been fueled by the “wealth effect” induced by the unsustainable stock market boom. I suspect that stagnant wages over most of the past 30 years has also contributed–households really had no choice but to borrow in order to attain rising living standards. When unemployment rates dropped and remained relatively low, consumer confidence rose sufficiently that record borrowing could be achieved. However, there was little danger that this would overheat the economy–given excess capacity in the US and abroad and given the weak position from which labor can bargain both wages and prices have been severely constrained.

     Further, the boom was self-limiting because of the stance of fiscal policy–which has become so biased toward surpluses that low unemployment increases tax revenues, sucking away private sector income. The great danger is that even if the economy turns down, the budget will remain in surplus, making recovery impossible. This is exactly what happened in Japan, which maintained a government surplus for six years–and continued to run surpluses even during Japan’s horrible recession. Note also that even though Japan’s interest rate has been kept essentially at zero for more than 4 years, this has not contributed in any significant way to an expansion. This ought to give Greenspan’s supporters pause when they argue that the Fed can engineer a soft landing. We can only hope that our landing will not be as “soft” as Japan’s.


For Further Reading

Inflation and the great ratios: Long term evidence from the U.S., Journal of Monetary Economics, 45, 2000, pp. 33-35, Shaghil Ahmed and John H. Rogers.

Inflation crises and long-run growth, Journal of Monetary Economics, 41, 1998, pp. 3-26, M. Bruno and W. Easterly.

The Investment‑Finance Link, Investment and U.S. Fiscal Policy in the 1990s, PPB No. 9,1993, Steven M. Fazzari

Seven Unsustainable Processes: Medium‑Term Prospects and Policies for the United States and the World, Wynne Godley, Jerome Levy Economics Institute Special Report, 1999

Can Goldilocks Survive? Policy Note 1999/4, Wynne Godley and L. Randall Wray  

Liberal Strategies for Combating Joblessness in the Twentieth Century, Journal of Economic Issues, 33(2), pp. 497-504, June 1999, Philip L. Harvey.

Monetary Policy Uncovered, Flying Blind: The Federal Reserve's Experiment with

Unobservables, PPB No. 15, 1994, Dimitri B. Papadimitriou and L. Randall Wray

Targeting Inflation, The Effects of Monetary Policy on the CPI and Its Housing Component, PPB No. 27, 1996, Dimitri B. Papadimitriou and L. Randall Wray

Did the Clinton Rising Tide Raise All Boats? Job Opportunity for the Less Skilled, PPB No. 45, 1998, Marc‑André Pigeon and L. Randall Wray

Can the Expansion Be Sustained? A Minskian View, Policy Note 2000/5, L. Randall Wray


3775 words    6-30-2000