On August 22, the Federal Reserve’s Open Market Committee decided to leave interest rates unchanged. Their press release summed up the reasons:

• Recent data have indicated that the expansion of aggregate demand is moderating toward a pace closer to the rate of growth of the economy’s potential to pro-duce. The data also have indicated that more rapid advances in productivity have been raising that potential growth rate as well as containing costs and holding down underlying price pressures.

This shows that nobody slings jargon like the Federal Reserve. It also shows that the Fed sees the pace of growth moderating. That’s what they’ve been aiming to accomplish over the past year of interest rate hikes.

Yet, just three days later, the U.S. Commerce Department issued an estimate of Gross Domestic Product (GDP) growth for the second quarter. The figure was 5.3% above inflation. Since summer 1999, the economy has grown 6% above inflation, the fastest rate since 1984. This rapid growth comes in the tenth year of the current expansion, already the longest in U.S. history. If the economy is slowing down, the GDP accountants haven’t heard the news.

Why Slow It Down?

We’ve got a good thing going. Nine and a half years of expansion, unemployment at a 30 year low, growing productivity, Federal budget sur-pluses, and, if you don’t count oil, little inflation. Why slow it down?

Because the Federal Reserve and most economists just can’t believe that something this good can last. The economy is clearly at full capacity. This means that available resources are fully employed. Land, machinery and especially people are working full tilt producing goods and services. There are help wanted signs in every shop window.

Since there are no more unemployed resources to put into production, the economy should be able to grow only as fast as those resources grow. That means that the growth of the economy is limited to growth in the number of people available for work (the labor force), plus growth in the tools they have to work with (the capital stock), plus increases in the amount that labor can produce using those tools (productivity). Economists add these up and get some-thing like 3.5% per year.

Suppose people, businesses and governments try to increase their purchases of goods and services by more than that amount. That’s fine if there are unemployed resources to put into production. Production can grow more than 3.5%. With no unemployed resources, though, the amount people try to buy is more than what can be produced. A bid-ding war is likely. Businesses, desperate to take advantage of sales opportunities, bid workers from other firms with higher wages, and materials from other firms with higher prices. Costs rise for all businesses, and in most industries firms will try to pass higher costs to consumers in higher prices. That’s inflation.

The Federal Reserve is the sworn enemy of inflation. When they see it as a threat, they act to cut the ability of people, businesses and governments to increase their purchases. They do this using the only tool they’ve got, interest rates. The Fed raises interest rates. Home buyers think again when they see their potential mortgage payments rise. Businesses think again when the cost of borrowing for new equipment rises. Even governments may post-pone capital projects, not wanting to pay extra interest. The growth in purchases slacks off, with luck to the rate that the economy can grow.

There is No Inflation

The inflation rate over the past year was 3.6%, the highest rate since 1991. Did the economy finally suffer the costs of rapid growth and low unemployment? No. Oil prices increased, and with it the Consumer Price Index. Taking the energy and food sectors out of the inflation rate gives a better measure of the overall trend in prices. This “core” rate of inflation increased from 2.1% in July 1999 to 2.4% in July 2000. Inflation remains low.

Perhaps the most mysterious eco-nomic event of the past decade is how an economy at full capacity can grow so fast without increasing inflation. Answers come in two flavors: productivity growth and increased competition.

Until the mid-1990s, most economists thought the full-capacity growth rate was around 2.5%, not 3.5%. It had been something like that lower figure for about twenty years. In the second half of the decade, though, productivity started to grow faster. Maybe information technology reached some sort of “taking off point.” Maybe the boom in investment in plant and equipment so increased the capital stock that each worker had more and better tools to work with. That’s what the Fed means when they say, “rapid advances in productivity have been raising that potential growth rate.”

Each worker produces more out-put. When workers and suppliers must be bid away from other firms at higher costs, firms can cover those costs with sales of more output. There is less need to pass along cost increases in higher prices. There is less inflation.

Another reason that price increases have been less than expected is because of increased global competition. Imports as a share of inflation-adjusted GDP grew from 9% in 1989 to 15% in 1999. Businesses fear raising prices lest they lose market share to the competition. Instead, they look for even more cost savings and productivity improvements, or cut their profit margins.

Will the Economy Slow Down?

Productivity is rising, competition is fierce, and inflation is mild. In 1999-2000, the Fed decided that the better part of valor required interest rate hikes, to slow the economy down. Now they see it happening. What is the evidence?

Consumers increased their spending faster than their incomes during the past year, so much so that saving turned negative. Households in total are withdrawing funds from savings to support their purchases. In the second quarter, though, consumer spending slowed to just 3%, after a 7.6% rise in the first quarter. Higher interest rates should discourage purchases of durable goods, and perhaps slower growth in stock market values will make consumers feel less wealthy.

Housing construction really did slow down over the past year, growing only one percent above inflation. This will continue, as shown by the declining number of building permits issued to construction firms. Higher mortgage rates are probably the rea-son. Business investment in equipment and buildings did not slow, and shows no sign of doing so. Eventually, though, higher interest rates must affect these investment decisions, too. There also are signs that the investment sector is pressing against capacity limits. Firms may buy fewer trucks because they can’t find drivers. Fewer buildings may be built because of a shortage of materials.

Exports of all goods and services grew faster over the past year than in the previous two, mostly because of the recovery in Asia. Imports grew even faster, which probably helped hold down inflation in the United States.

The Federal government ran an enormous surplus, about $230 billion in fiscal 2000. This is exactly what the economy needed. Big surpluses mean that income is taxed away and not spent, which reduces the amount people and firms can try to spend on the economy’s limited output. Our divided, stalemated government is partly responsible. In the current cli-mate, perhaps this is a blessing.

Outlook

Probably the economy will slow down. Consumers show some signs of cooling it. Higher interest rates, low savings and slower growing stock values may discourage them. Housing construction has already slowed; other investment likely will respond to higher interest rates too. Import growth will continue to exceed export growth. Even if the election ends divided government, big tax cuts or spending increases won’t affect the economy before next summer. Expect GDP to grow 3.5%above inflation. That’s the rate the economy can grow from labor, capital and productivity increases. Slower growth and smaller changes in oil prices should let inflation drop to 3%over the next year, and the economy will still grow enough to keep the unemployment rate down at 4%.

Let’s take the Fed at their word. They see a slow down – their mission is accomplished. They may also want to appear neutral during the coming election season. For most of the rest of this year, and the first part of the next, then, expect no changes in interest rates from the Fed. If the economy doesn’t slow down, though, they will surely act to raise rates. So we hedge, a little. By this time next year, put the short and long term rates a bit higher than they’ve been, the 3-month Treasury rate at 6.2%, the 30-year Treasury rate at 6.4%.