If you ask a strict free-marketeer who sets interest rates, the answer you're likely to get is, of course, "The market." Most everyone else, though, assumes it's the Federal Reserve. So, much of the concern over Wednesday morning's announcement of the Consumer Price Index number for May is concern not just over what the CPI reveals about possible inflation, but concern over what the Fed thinks the CPI reveals.
Technically speaking, the strict free-marketeer has a point, since the Federal Reserve does not actually determine the federal funds rate (that's the rate everyone's referring to when they wonder whether the Fed will or won't raise rates). What the Fed does is set a target for that rate, which then tends to fluctuate around the target. But since the Fed controls the money supply for the United States, ultimately what it says, goes. Naming the target is essentially as good as hitting it.
The question before the Fed right now is supposedly whether to raise that fed funds rate a quarter of a point, from 4.75 percent to 5 percent. Back in October 1998, in response to the Asian crisis and the Long-Term Capital meltdown, the Federal Reserve cut interest rates three consecutive times. At least in part as a response, the stock market boomed, and the U.S. economy took off, driving growth above 4 percent and unemployment down to a near-historic low of 4.2 percent. But there have been increasing signs--most notably a CPI number last month of 0.4 percent--that above-average growth is beginning to have an inflationary effect, just as it's supposed to. That, in turn, has made the bond market very nervous--driving long-term interest rates above 6 percent--and put pressure on the Fed to demonstrate that it's being vigilant about inflation.
As has been well-documented, Fed chair Alan Greenspan, whose early reputation was as a fierce inflation hawk, has become more comfortable with the idea that technological improvements in the way U.S. companies do business have had a direct impact on corporate productivity. Higher productivity, all other things being equal, means lower inflation, because companies can reap profits without raising prices. So the economy can grow faster without inflation than it could ten years ago.
What that doesn't mean, though, is that the economy can grow faster without inflation forever. Even if we live in the New Era, the old rules still apply, even if they've been modified some. The past three years have represented an extraordinary, almost idyllic period of high growth, rising wages, low unemployment, and nonexistent inflation. But in addition to benefiting from the impact of new technology, the United States has also benefited from some old-fashioned factors, including falling commodity prices, cheap goods from abroad as a result of troubled economies, and low oil prices. It's still not exactly clear whether the world economy has turned itself around, but it'd be foolish to imagine that everything was always going to remain exactly as the United States wished it to be.
The point is that the Fed's next move will be, and should be, to raise interest rates. That's true whether or not tomorrow's CPI number is good or bad. Of late, you've been able to hear the occasional guest on CNBC say that if the Fed does raise rates, that's a bad thing for the stock market. But by now most people expect the Fed to raise rates. More than that, secretly everyone wants the Fed to raise rates, not by a lot, but just enough to show that it's awake. Cheap money is fun for a while, but eventually it comes back to haunt you. Over the past six months, we've often heard that in this Goldilocks economy, we have nothing to fear from inflation. It's more likely now that in this Goldilocks economy, we have nothing to fear from a small hike in interest rates.