Economics experts: inflation question.

[trotsky]

Fed. interest rates are at historic lows. The economy is slowly growing - not too fast, but it's growing. Yet with the surge in gas prices, inflation is rearing its ugly head. Now typically with inflation, that means an increase in the prime rate, so as to contract the money supply and halt inflation. But increasing the rates would have the other effect of choking off the little economic growth we have right now, correct?

So please, help me understand how this kind of situation is handled! Are we headed into the dreaded "stagflation" again?

[WMliberal]

1. it wouldn't be stagflation

since there wouldn't be inflation. so it'd just be a stagnant economy. doesn't that make you feel all fuzzy inside and totally reassured about the direction our country?

[On the Road]

2. That is Correct

A rise in interest rates would have the effect of lowering economic growth.

This kind of intervention is most appropriate when the whole economy becomes overheated and businesses are close to capacity. They can raise prices, which leads to workers demanding increases, which leads to an inflationary spiral. That was the type of inflation Nixon faced due in the late 60's.

What seems to be happening now is a series of supply shocks. Prices go up because raw materials are scarce. That has an inflationary effect in the absence of growth. If the change is big enough, a rise in the price of a single key commodity - like oil in the 70's -- can cause inflation in the whole economy. Demand in other countries, especially China and India, is a much bigger part of world demand now.

Supply shocks do not have to be caused by natural scarcity, but can be caused by suppliers rationing production (OPEC) or government-protected monopolies, such as pharmaceutical patents.

What's happening now, I think, is a supply shock in oil, building materials, meats, and various other products. It does not have the silver lining of a robust economy that inflation in the late 60's had.

On Edit: Since cooling the US economy would not directly affect foreign demand or other causes of rising prices, stagflation is still a possibility.

[tritsofme]

3. Stagflation?

Doubtful, regardless of what some cynics might say.

We do not have "little economic growth" we have had very strong economic growth over the past 3 quarters, averaging 5.5% I believe. And expectations are generally looking for 4.5%+ for the rest of this year, and that is pretty hot.

I think the economy is strong enough to handle increases in the FFR, since we are at 46 year lows, but the problem I am having, is wondering how much of this inflation is actually due only to higher energy costs, and how much of it would dissipate if energy prices came down. The fed futures market has basically already priced in 75-100 basis points to the end of year.

Although increasing the FFR isn't going to stop rises in crude oil prices. And it is something to fear that rising interest rates coupled with rising fuel costs could hurt the recovery.

[WMliberal]

4. high gdp doesn't make for a good economy IMO

good economy to me means something like what auntie pinko said a few months ago... are americans' real incomes rising? are we getting more full-time jobs with benefits, etc created?
A high GDP without those kinds of good economic reports just means that the fatcats are getting richer while we're staying the same or becoming poorer.

[rapier]

5. notes

Please belive me that I don't want to be dismissive or condecending but your little string of 'facts', especially concerning interest rates is hopeless. Again, I do not want to sound superior nor mean any insult

Where to begin? It's almost hopeless really. While issues of money and economics and finance are FAR FAR less hard to understand than most realize still, a basic education cannot be provided in a few pithy web forum pargraphs. It is a sort of point of honor with progressives to be ignorant of money and finance. There is something to be said for that I suppose on a personal level but on a political level it has been a disaster decades in the making. Never mind 'progressives', there is NO DEMOCRATIC alternative at all to the economic/financial mess we are in which is DETERMINING our economic future. A future which is far from bright. If a malaise, or crash comes, not only will we the opposition have no real understanding of why but we will have no path out of it.

OK
"Fed. interest rates are at historic lows"
There is no "Fed interest rate". There is something called the Fed Funds rate which the Federal Reserve in essence does control and it is very low. The thing is that this rate has no meaning to you or anyone but banks.

The MARKET has been raising interest rates for six weeks at an astounding pace. A dangerous pace which might be causeing, as we speek, huge trouble in the financial realm. Long term interest rates have risen 30% in 6 weeks. This is huge. Gigantic. And of course totally off the radar of most people.

Other shorter term rates have risen almost as much. The market in speculative foreign bonds has seized up with massive losses accrueing. Higher risk junk bonds here and elsewhere are also having big problems.

The emphasis on the Fed and it's "control' of interest rates is an insane thing. It is a new faith which has no basis in fact. We are now seeing this start to be played out. Any move by the Fed to raise the Disount Rate and thru it Fed Funds is now so late as to be a joke, The market is moving without them.

Inflation and inflation expectations are playing a part in this yes, but there are other factors as well. Monetary factors, as the 'money supply has been exploding for years. There are also factors that are internal to the markets. To wit, that seize up on foreign bonds and trouble in 'junk' bonds is causing a vicious circle wherein everyone is wanting to get out which only hastens the rate increases, which makes more want to get out. ect. etc.

Rising interest rates are of course usually a signal that economic growth will slow. However it isn't a linear relationship and there can be long lags, even years. (I'm not saying that it will be years now, only that firm predictions on what will happen soon are BS. NOBODY knows)

Will there be stagflation? Or perhaps inflation or deflation. You can go nuts trying to figure that out.

[unblock]

6. not quite correct, the fed does have huge control over fed funds

you are correct in the sense the the fed does not simply "set" the rate. the fed does not always get its way, especially if its way is way against the market's way.

but the fed acts by buying and selling treasury securities just as any other player in the market does. thing is, though, the fed is by far the largest player in the market and as such has the power to affect prices.

the fed increases its control over the market by signalling its intent. in today's case, the fed has signaled that it will soon be raising rates, i.e., selling treasuries. since everybody knows that the fed will sell treasuries soon, that means prices of treasuries will drop, so everybody's unloading treasuries ahead of the fed. so prices go down, rates go up. and so the market does just what the fed does, and the fed didn't have to spend a dime.

really, the fed only has to enter the market periodically to reestablish its credibility. well, that and to actually manage the nation's debt.

every once in a while the fed wants something to happen but the market forces are too great. if this happens, the fed can either dig deep and really hit the market hard, which can be VERY expensive. or it can give up and let the market do its thing and then step in at the new level. those are the decisions that make or break central banks and currencies.

[rapier]

7. notes

Well I don't want to get lost in the details of Fed operations. If it didn't come thru, yes, the Fed essentially controls the Fed Funds rate which is the overnight interbank lending rates.

The Fed is a minor player in the totality of the daily Treasury paper market. Furthermore they do not 'play' in the regular market but rather only buy and sell thru their primary dealers, the gang of 22, and memeber banks. Their market operations overwhelmingly are carried out with only the shortest term insruments of less than 90 day T Bills.

The Feds intent to raise rates soon doesn't mean they will be selling treasuies soon, it means they will set the discount rate at a higher number, by fiat. What the discount rate is and how it operates, which was recently changed by the way is beyond the scope of any discussion here and is best left to Econ 102.

Their open market operations deal only with the shortest term paper. "Everybody's unloading treasuries ahead of the fed" implys the longer term note and bonds are effected directly by Fed operations and this is false. Starting in 2002 there was all sort of Fed blabber about 'unconventional measures" which implied acting in the note and bond market but the thing is that with total outstanding paper of over $7 trillion the Fed cannot control the market. Last summers break in the bond market was 'caused', one could say, by the markets realization that the Fed had abondoned any chance of unconventional measures involving entering the long end market directly.

The melt down in the bond market over the last 6 weeks had little if anything to do with the Feds intent to raise the discount rate some fraction of a percent during the summer. The thought is they will raise the discount rate 1/4%. One year and beyond bills and notes are up nearly a full percent in 6 weeks. There is a hell of alot going on here besides a bit of hinted at tightening by the Fed.

Greenspans Fed, especially since 1996, has moved well beyond historical bounds of prudent central bank policies. It's that "every once and awhile" which is finally meeeting "market forces are too great" now, in my opinion.