Fed Chairman Alan Greenspan

The US Federal Open Market Committee of the Federal Reserve decided today to raise its target for the federal funds rate by 25 basis points to 3-1/2 percent.

Background

The Federal Open Market Committee (FOMC) of the US Federal Reserve is expected to raise the federal funds rate another quarter point to 3.5 per cent on Tuesday, and to signal that it will continue to raise rates at a measured pace.

The positive US economic outlook which will have been bolstered by an encouraging second quarter growth report and last Friday's strong July employment report means that the central bank is focused on inflation risks.

The Fed is focusing on returning interest rates to a neutral level consistent with sustainable growth and controlled inflation.

The FOMC is watching unit labour costs, which are seen as the most important determinant of overall inflation pressures. It is however not easy to forecast unit labour costs, owing to the difficulty of forecasting productivity growth.

Productivity trends

The New York Times says that ten years ago, Alan Greenspan, the Federal Reserve chairman, broke with conventional wisdom and correctly recognized that the United States had entered an era of faster growth in productivity.

It was a huge shift that allowed the Fed to encourage faster economic growth and increased prosperity without significant inflation.

But as Mr. Greenspan prepares to retire, probably by early January, the Federal Reserve faces a slowdown from the torrid pace of productivity in the past several years.

As shown by the big jump in jobs during July, up 207,000 from June, and the more than 1.3 million jobs added this year, the pool of unemployed workers is dwindling and wages are rising faster than productivity. The big question for the Federal Reserve is whether the lull is simply a return to the average pace since 1995 or a return to the doldrums that prevailed from the early 1970's to the early 1990's.

With economic growth strong and labor costs rising, Fed officials are all but certain to raise short-term interest rates on Tuesday to 3.5 percent and to increase them again to at least 4 percent by the end of the year as they grope toward a neutral monetary policy.

The issue of productivity growth lies behind much of the debate. If output climbs more slowly than labor costs, companies will be under pressure to raise prices. If output rises in line with labor costs, whether because of new technology or new ways of doing business, wages and employment can rise without contributing to inflation.

Productivity growth has slowed sharply in the last year, but Fed officials and most outside specialists said this was to be expected. Productivity often surges in the early part of an economic recovery, as companies rush to meet higher demand but are still too nervous to add workers, and then slows as employment picks up.

The issue for Fed officials is the long-term trend.

The New York Times says that from about 1973 to 1995, productivity rose an average of 1.5 percent a year. But the pace nearly doubled after 1995, to almost 3 percent, as major advances in technology spurred big drops in the cost of computing power and companies invested heavily in information technology.

Productivity growth shot up to 4 percent a year from 2001 through 2004. Employers shaken by the recession of 2001 and then uncertainties tied to terrorism and war sought and found ways to increase production without hiring workers. And because many companies overspent on technology in the 1990's, they were able to generate new efficiencies without additional investment in the years that followed.

The superheated productivity, which caused anemic job growth for three years, appears to be ending.

According to the Bureau of Labor Statistics, hourly wages for nonfarm businesses climbed at an annual rate of 10.2 percent in the fourth quarter of 2004 - the biggest jump in almost five years - and by 6.3 percent in the first three months of this year.

Unit labor costs, or the cost of labor for a given amount of output, went down in 2001 and 2002 but have climbed sharply since the middle of last year.

So far, productivity has remained strong - 4 percent in 2004, for the third year in a row, and 2.9 percent in the first quarter of 2005.

Fed economists say they believe the normal rate of productivity growth in the new era is about 2.5 percent.

But Mr. Greenspan recently cautioned that predictions were difficult, because the pace of productivity growth depends heavily on the pace of technological innovation.

"Over the past decade, the U.S. economy has benefited from a remarkable acceleration of productivity," Mr. Greenspan told the Senate Banking Committee last month. "But experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology."

Mr. Greenspan and other Fed officials have noted that there are some possible red flags. One measure of technological innovation is the drop in prices for computing power and communications.

Those declines have been much smaller in recent years than they were in the boom years of the late 90's. According to the Commerce Department Bureau of Economic Analysis, which prepares the government's growth statistics, technology prices are falling much slower now than in the 1990's.

Prices for computer equipment, adjusted for increases in processing power, plunged by more than 23 percent a year from 1995 through 1999. But since 2000, the declines have slowed to about 10 percent - roughly where they were before the big productivity boom.

Inflation data positive

The recent inflation data has been encouraging and there has been no indication that the FOMC expects aggressive action will be needed.

However, with spare capacity in the economy fast diminishing, the risk of mistakenly raising the federal funds rate too high contributing to a slowdown in growth is seen as less serious than the danger of calling a halt to rate increases prematurely and possibly allowing inflation to accelerate.

A measured pace of rate increases means that, if the Fed did raise rates to a level that started to impact growth in the economy, the effect should be fairly modest.

Compounding the need to continue raising the fed funds rate, the fall  in long-term interest rates over the past year is seen as offsetting the FOMC's efforts to tighten overall financial conditions in the economy.

A rise in long-term rates may lead policymakers to conclude that they need to do less tightening of short-term rates.

Low long-term rates have boosted the US housing market, a matter of increased concern within the Fed. The strength of the property market has added to the Fed's determination to continue raising rates.

Futures markets suggest that the FOMC will raise rates again in September and November bringing the federal funds rate to 4 per cent. Many forecasters expect further rate rises in December and into 2006.