The United State’s Federal Reserve Bank has recently indicated that it will raise interest rates for the first time since December 2008. However, with the continued sluggishness of the economy and price inflation at .2%, the decision could well be deferred. In trying to understand how the interest rate, inflation and wages work together, it is necessary to understand each component of the economic puzzle separately.
Inflation is a rise in prices. The rise or fall (known as deflation) can be a result of a number of factors. At the most basic is the fundamental economic theorem of supply and demand. As the supply of a product is greater than the demand, then the price of that product should, at least in theory, fall in a free market. Similarly, when the demand increases, the supply is reduced and prices rise. A healthy amount of inflation (around 2% a year) is considered good for the economy as a whole as it allows producers to pay more in salaries, provide more benefits and expand facilities.
Wages paid to employees by businesses have been stagnant for the past several years, as there have been more employees than jobs (supply exceeding demand). This has acted to keep prices down since another factor in the economy is the availability of money. No matter how needed a product is, if people can’t afford it, then the producer will not make any profits, and the economy staggers. No profits mean no expansion, no raises and possibly layoffs.
Banks lend money for the expansion of manufacturing plants and other capital investments by companies. Interest is the amount that banks charge their customers for the use of this money. However, banks only have so much money to lend, and they in turn go to the Federal Reserve to borrow money. In order to encourage economic expansion, the Federal Reserve reduces the interest it charges to banks. As it becomes less expensive for banks to borrow from the Fed, then they are more likely to lend more money to their customers to expand. That rate as mentioned has remained virtually the same, near zero, since 2008.
When the Fed raises the rates as it has signalled it would do so later this year it will likely mean that some of the economic growth in certain industries will slow allowing for prices and the labor market to adjust. Job growth will slow which is consistent for limiting inflation.
One economist watching this debate unfold is Christian Broda. Broda earned a Masters and a Doctorate in Economics from MIT. Working as an analyst for the Federal Reserve Bank of New York, he studied international economic issues. Later Broda became a tenured professor of economics at the University of Chicago, edited several academic journals, and is currently the managing director of Duquesne Capital Management, a New York hedge fund.