Tuesday, May 2, 2017

Spring Economic Updates

Dr. Kamran Afshar, Chamber Chief Economist, The Chamber’s Finance Committee

The FED raised its overnight lending rate by a one quarter percent on March 15. This is the second increase in this rate in three months, and it came with a promise of further rate increases in 2017.

The economy has shown steady growth in the last two years. Employment growth has been phenomenal and by now it is approaching the so-called full employment level without, as of yet, having much effect on inflation. Since the end of the recession unemployment has dropped from 10 percent to 4.6 percent while inflation, instead of rising, dropped to less than 1 percent in 2015. It recovered somewhat and ended 2016 at 2.1 percent. All of this is happening in an environment of extreme low interest rates ushered in by the FED which also more than quadrupled the supply of high powered money. Based on historical references this should have created, if not a triple digit, at least a double-digit inflation rate. Yet here we are with inflation rate of around 2 percent.

The 21st century global economy is very different from the first half of the last century’s national economies. Back then, there were a lot more stringent trade and currency barriers which significantly reduced the flow of goods and services across borders. Inflation happens when a lot of money is chasing a few goods, and open trade and exchange policies solve the problem of “few goods” since the globe is becoming the market place. This significantly reduces the chances of high inflation in a single country.

However, despite low inflation, the FED is not only raising its rates, but it is also promising more increases to come.

The reason the FED is acting now while inflation is still quite tamed is because it cannot wait for high inflation to hit before taking action. Some of us still remember Paul Volcker’s strong armed attempt to deal with the 14 percent inflation in the early 1980s. He hiked the Federal Funds rate to more than 19 percent, some 18 percentage points higher than the current rate of close to one percent! Of course, almost all economist blame Volcker’s actions for the devastating double dip recession that ensued. However, to be fair, it should be acknowledged that Volcker’s actions also did reduce the rate of inflation, however, at a very high cost to the economy.

The FED has not only abandoned its expansionary monetary policy of the past, it has been practicing a soft contractionary monetary policy since October 2014, siphoning out some of the excess money that it pumped into the economy for six years. In the face of high employment and increasing wages, and an inflation rate that has more than doubled since the election, the FED is poised to exercise tight monetary policy, to keep inflation in check.

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