Interest Rates On Way Up As Inflation Holds Steady
October 29, 1999
by Irwin Stelzer
THREE of the world's leading central banks are preparing to raise interest rates. The monetary policy committees of America's Federal Reserve, the Bank of England and the European Central Bank have all signalled their intention to jack up rates next month.
The business communities in all 13 countries that will be affected are very unhappy indeed.
A great many economists have also been stirred to argue that the stodgy old central bankers do not understand that the world has changed. They contend that it is now possible for an economy to grow rapidly, even during periods of full employment, without triggering inflation. Technology is increasing productivity faster than wages are rising and globalisation has forced American manufacturers to forgo price increases lest they lose markets to foreign competitors. Historic relationships between such things as the unemployment rate, the inflation rate, interest rates and other variables no longer exist. Monetary authorities should sit back and enjoy this "new paradigm" rather than panicking and raising interest rates.
In its more modest form this tale acknowledges the presence of all the dynamic forces of technology and international competition that so capture the imagination of the New Paradigmists. But it concludes that they have altered rather than obliterated the old relationships between key economic variables. Thus, a tight labour market can still trigger wage increases and, eventually, inflation, but the tightness will have to be greater and persist for a longer time before it is reflected in higher prices. So a close watch must be kept on inflation indicators, but no action is required - at least, not yet.
There is more to this tale, either in its robust new paradigm form or in the more modest version that seems at times to appeal to Alan Greenspan, the Fed chairman. Let us start with the 1980s, when Michael Milken financed the takeover artists who restructured big American companies. By enabling these entrepreneurs to sell so-called junk bonds, Milken gave them the means of ending the long-standing separation of management and ownership of America's companies. Until then, widely scattered shareholders were powerless to prevent managers from granting themselves salaries and perks that bore no relationship to their performance. But the new owners, loaded down with debt, had to improve efficiency or go bust. Most did the former.
Meanwhile, what Milken was doing for the competitive sector, a shift in public policy was doing for the monopoly sector. Airline deregulation brought a sharp drop in air fares and proved so popular thatderegulation spread to other industries. Deregulation in telecommunications led to price wars and forced service providers to accelerate the introduction of new, cost-reducing technology.
Natural-gas prices were next on the deregulation list, and they, too, plummeted. Electricity prices have also fallen since that industry was at least partly deregulated.
Then there are the benefits that have been brought in by the internet, which has begun to lower distribution costs in many industries by eliminating the middleman. At first this was confined to a few products, but now these efficiencies are being found in previously unsuspected places.
Just last week, for example, the city of Pittsburgh decided that it did not need investment bankers to sell $ 55m of its bonds. So next month Pittsburgh will conduct an online auction in which some 750 institutional investors will be encouraged to buy bonds directly from it. Pittsburgh will save about $ 1m in commissions, and its citizens will save an equal amount in taxes. Other cities and businesses that need to raise capital are sure to take advantage of this new, possibly lower-cost, technique.
We should also note that these technological and structural changes are not temporary: they are irreversible. Put differently, the entire cost structure of American industry and business has changed. Better still, producers of goods and services are being forced to pass on these new lower costs to consumers - and will be, for ever more.
This is because international competition can only intensify. Transport and communication costs are dropping like stones, broadening the market reach of the world's producers.
Consumers are increasingly knowledgeable and tough-minded. A growing number of them are shopping on the internet for bargains and an increasing number of traditional retailers are responding to that threat by lowering prices in their shops and entering the e-commerce arena.
This is the story of those who think it would be a mistake for the Federal Reserve, the European Central Bank and the Bank of England to raise interest rates next month. But although each and every component of that story is correct, interest-rate rises may nevertheless be in order.
The reason is simple. We know that the powerful forces of deregulation, technology, international competition and corporate restructuring exist and that they will continue to have a downward effect on prices. But we also know that there are forces creating pressures in the opposite direction.
Soaring asset prices - of shares and homes - have encouraged consumers to shop until they drop. Low interest rates have encouraged businesses and families to borrow record amounts of money. The supply
of money is rising and the supply of available labour is falling. Real hourly wages and the cost of medical insurance have turned up. So have producer prices. The Opec cartel has succeeded in doubling oil prices. Rising protectionist sentiment, scheduled to explode in demonstrations against free trade at the Seattle trade-opening round next month, may dilute the restraining effect of foreign competition on domestic prices - as may the falling dollar, which makes foreign goods more expensive in America and makes it easier for domestic producers to raise prices.
The question, then, is not whether the forces working to keep prices down exist. They most certainly do. The question is whether they have sufficient power to offset the forces working in the opposite direction. That we do not know.
All this means that we must continue to rely on Greenspan's informed intuition as to the balance of inflationary and counterinflationary pressures. That is no bad thing.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.