Last week, the Federal Reserve raised its basic interest rate from one percent to 1.25 percent. In all likelihood, we can expect a similar move about every 6 weeks for the next year. Ironically, this will be bullish for financial markets in the long run.
The idea that Fed tightening can be bullish is counterintuitive. Grasping it requires an understanding of how long-term interest rates are set. Economic theory and experience tell us that the single largest component of long-term rates, such as those for home mortgages, is inflationary expectations. If markets expect one percent higher inflation, this will add approximately one percent to the long-term interest rate.
For the last several months, commodity and bond markets have clearly shown an expectation of rising inflation, which results when the Fed creates too much money. All commodity indexes are up sharply, as is the spread between long-term and short-term interest rates. Although there is little evidence of rising inflation in the Consumer Price Index, experience shows that inflationary pressures show up first in sensitive commodity prices and an increase in long-term interest rates, and in the CPI only with a long lag.
Moreover, a key reason why the CPI is not showing more inflationary pressure is that the index excludes the most important area where prices are rising rapidly: housing. Over the last year, housing prices are up over 10 percent nationwide (18.6 percent in the Northeast), according to the National Association of Realtors, compared with a 3 percent increase in the CPI. The CPI uses a measure of rent to in lieu of home prices, because this better represents the cost of housing to consumers. Using housing prices in the index would distort the cost of living because people don't buy a new house every month.
But the result is that many people, including those at the Fed, may be misled into thinking that inflationary forces are more modest than they really are. For example, my old friends Jamie Galbraith and Jude Wanniski (an odd couple if ever there was one) recently co-authored an article imploring the Fed not to raise rates for this reason. But their argument really boils down to the same Keynesian hokum that got us into a mess in the 1970s--we can't have inflation if there is high unemployment, unused capacity, etc. All this was disproved during that decade, when inflation and unemployment increased together.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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