Modest rate increase will help keep economy on growth curve
Should we be alarmed by the recent hike in interest rates? Since the relatively modest hike by the Federal Reserve is not likely to have a big impact on economic growth, the short answer is "no." While some analysts characterize the Fed's action as similar to someone who takes the punch bowl away at a party, it's probably more accurate to see it as moderating punch consumption so the party will last longer. If people consume too much too quickly, the party will spin out of control and be short-lived. We'll jeopardize economic growth if inflation leapfrogs forward.
Economics is not an exact science, so at best the Federal Reserve can only estimate the productive capacity of the economy. It's influenced by a number of factors, including labor supply, amount of capital, and productivity. If the economy continues to make gains in productivity - such as those supported by technological advancements - it will grow at a faster rate than was estimated.
It's possible for the economy to grow at a stronger rate without causing demand to outstrip capacity. If this is the case, then the Fed is restraining growth unnecessarily by raising interest rates. In other words, it has taken away the punch bowl.
But if technological advances have not led to a sustained increase in growth, the story changes. Under this scenario, the economy probably can't sustain strong growth for an extended period of time without rekindling inflationary pressures.
Let's go back to our party analogy. Since people can be hard to control once they've had too much to drink, the best way to handle the situation is to remove the punch bowl. More often than not, this leads to a rather painful withdrawal, aka a hangover.
The same holds true for inflation: It can be difficult to control once it has gained momentum. And since economics isn't an exact science, the Federal Reserve doesn't know precisely what degree of change in interest rates will dampen inflationary pressures without causing a recession. As a result, it often increases rates more than it needs to, pushing the economy into a recession.
Perhaps because we've forgotten how destructive inflation can be, we're willing to risk an increase in inflation in order to sustain strong economic growth. Just like when we forget how painful a hangover can be and drink too much punch the next time.
When inflation rises, money doesn't buy what it used to, so our ability to consume is greatly reduced. We often find it's a struggle just to maintain our standard of living - never mind improving it.
Inflation also has a negative impact on business decisions. Since prices serve as an indicator of supply and demand for a particular product, the price mechanism is particularly important in a capitalistic system. Rising prices indicate that supplies are scarce, letting businesses know it's time to increase output. A decline in prices indicates an oversupply, letting businesses know it's time to cut back on production.
Unfortunately, inflation throws a wrench into the price/supply-and-demand relationship. Businesses don't know whether prices are increasing because supply and demand are out of sync, or because there's an overall increase in prices throughout the economy.
Perhaps the Federal Reserve was just acting cautiously when it raised interest rates earlier this summer. It didn't take the punch bowl away completely; it just reduced the amount of punch available.
With unemployment rates low, business profits high, and the stock market reaching new levels, the party certainly seems to be in full swing. Maybe the good times can last a bit longer if we moderate our intake.