Fed sails uncharted waters

Economy: Six interest rates hikes haven't cooled the surging economy, and more are expected.

May 18, 2000

IF Federal Reserve Chairman Alan Greenspan needed any confirmation that the U.S. labor markets are tight, he could have seen it at last Sunday's Orioles game. A plane buzzing the ballpark dragged a Red Lobster banner advertising not its latest dinner special but jobs at its Owings Mills restaurant.

If the impact of five previous rates hikes is any indication, the Federal Reserve's larger-than-usual rate increase on Tuesday is not likely to slow the nation's surging economy. All measures of demand -- from new equipment orders to housing starts -- are stronger than they were when Mr. Greenspan began his rate hikes a year ago. Even more puzzling are unemployment levels, which are at their lowest in three decades. Wages, reflecting the shortage of skilled workers, are beginning to rise. Mr. Greenspan frets publicly that upward pressure on wages will ignite an inflationary cycle.

Classic economic theory holds that higher interest rates reduce borrowing, which reduces investment and debt-financed consumption. In response to the Fed action, banks raised their prime lending rate -- what they charge their best customers -- to 9.5 percent, its highest level since 1991. If theory holds, the higher rates should slow consumption and reduce overall demand, lessening the upward pressure on wages. Mr. Greenspan believes the most dangerousinflation pressures will then subside.

The Federal Reserve's challenge is to find the interest rate threshold that reduces the economy's current powerful momentum. Interest rate hikes are notoriously slow-acting economic brakes. It is clear that the nation's central bankers believe more increases may be needed this summer.

Raising interest rates too high may precipitate a recession. Unfortunately, even for Mr. Greenspan, whose deft monetary policy has created an unprecedented 10-year recovery, it's difficult to tell in these economic waters what level of interest rates will choke, rather than help, the economy.

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