Through monetary policy, the Federal Reserve can take action to help steer the U.S. economy towards full employment in times of economic booms and recessions. On November 24, the Organization for Economic Cooperation and Development (OECD) declared that the Fed will need to raise interest rates next year to counter the economic boom that the U.S. is experiencing. The report stated that the Fed will need to act to decrease spending and lower inflation.
The question arises as to why the Fed even needs to take action, particularly when the macro-economic self-correction mechanisms would probably pull the economy back towards full employment. According to theories of self-correction, during an economic boom inflated resource prices would cause the SRAS to shift left. However, this correction would most likely not occur in a timely fashion and would cause increased inflation. Economic correction of the boom through monetary policy therefore becomes a more desirable option.
The aggregate demand curve is equal to government spending, consumption, investment, and net exports. The increased interest rates will cause a decrease in the amount of investment occurring in the U.S. economy because firms and individuals will borrow less at the higher rate. This decrease in investment means that the AD curve will shift left (Diagram 1). When the AD curve shifts left, there will be a decrease in real output and lower inflation than before.
Another factor causing the AD curve to shift left also results from the higher interest rates. At the higher rates, foreigners will shift there savings to American banks to earn more interest. These savers create an increased demand for dollars, which in turn causes dollar appreciation. Dollar appreciation means that U.S. goods in foreign markets will increase in price, leading to a drop in exports. The decrease in net exports, which is a component of the AD curve, is another reason why the AD curve will shift left with the higher interest rates.
While the report by the OECD was issued in late November, it was approved for publication on October 8th- before the Asian economic crisis. Those recent events caused the OECD to slightly revise its predictions on the anticipated actions of the Fed. The group now expects the Fed to raise its interest rates sometime in the first half of 1998, rather than at the beginning of the new year. Also, it anticipates a rise of half a percentage point, instead of the three-quarters of a point increase in the interest rate that it had predicted earlier.
The OECD altered its predictions because the recession in Asia will also impact the AD curve. Because economic turmoil in Asian nations mean that they will buy less American goods, net exports will decrease. This will slow growth in the U.S. GDP and reduce the risk of inflation because of the weakened trade sector. The OECD recognized the fact that the original numbers that they gave, combined with the recent economic crisis in Asia, might shift the AD curve too far to the left because of the double impact of increased interest rates (and its consequences) and decreased net exports. As shown in Diagram 1, this could force the U.S. into a recession.
Many economists are predicting that the Fed will leave interest rates alone for the time being because the full impact of the economic turmoil in Asia has yet to be felt. It would seem very wise to wait until the impact of the crisis is known- of at least can be predicted with certainty- before the Fed substantially raises interest rates.
The last time that the Fed raised interest rates was on March 25, 1997. However, the long term interest rates and other market rates are lower since the spring. The restrictive effort has been undone. One reason for this might be the recent efforts for a balanced budget by congress. The government is trying not to spend money that must be borrowed. Just as heavy borrowing by the government will drive up interest rates, a substantial decrease in borrowing might exert a downward pressure on interest rates.
The OECD views the biggest risk of inflation as being the labor market. The U.S. unemployment has held below 5% since April. With such low unemployment there will be upward pressure on wages. As labor is an input cost, this upward pressure will increase prices of products overall. This will lead to an overall increase in inflation. However, if the contradictory monetary policy and/or Asian economic crisis have the anticipated impact on the economy, then the leftward shift of the AD curve should check this inflationary risk.