A 'Soft Landing' Sequel?

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The decision Tuesday by the Federal Reserve's rate setting board to hold interest rates steady is a sign Chairman Alan Greenspan may have engineered another "soft landing" for America's booming economy.

CBS News Business Correspondent Anthony Mason reports recent evidence of a slowing economy may have convinced the Fed to keep the federal funds overnight bank lending rate at 6.5 percent, the highest in nearly a decade, and the result of six rate increases between June 1999 and June 2000.

While unemployment held steady in July, new-home building dropped and payrolls shrunk. Plus, productivity—the amount each worker produces—has increased, meaning companies can produce more without hiring new workers, dampening inflation.

"Productivity growth is just awesome," said Bruce Steinberg, an analyst at Merrill Lynch, "and ultimately that is the source of all the good things we're seeing in our economy."

And the effects of those six rate increases are still rippling through the economy.

Because of higher mortgage rates, the National Association of Realtors predicts existing home sales will fall 7.7 percent this year and new home sales will be down 5.3 percent.

"No question about it, the interest rate hikes of the Fed have weakened the housing market," said David Lereah, chief economist at the realtors association. "What we are seeing is that the slowdown in home buying is making homebuilders more cautious. They're thinking twice before they dig holes in the ground."

If the economy has indeed slowed down, it would mark another first for the Fed.

In 1994, Greenspan used interest rate hikes to keep the expansion on course and engineer a so-called "soft landing."

What is inflation?
Inflation is a rise in the general price level—in other words, the price of all goods and services.

The government measures inflation with the Consumer Price Index, which is a measure of the cost of a basket of goods that an average American might buy.

The causes of inflation are often mysterious.

Sometimes prices of goods go up because of higher demand and wages follow; other times, wages go up first and business owners raise prices to cover the higher wages.

Inflation can have wide-ranging effects.

First, it makes business decisions and investments uncertain. If prices are changing, it's tricky for two firms to enter into a long-term contract. It' also difficult for people to plan for retirement, because they can’t be sure how much their money will buy.

Inflation hurts people on fixed-incomes because it means they can buy less. It tends to discourage saving and investment because when inflation hits, people rush to buy things before prices go up further.

Inflation also tends to benefit people who owe money and hurt people who lend it. As prices rise over the life of a loan, the money lent out loses value.

(Source: Federal Reserve Bank of Boston)size>
If the latest round of rate increases has produced another soft landing, it would mark the first time the central bank has succeeded in slowing but not stopping a boom twice during the same expansion. Usually, inflation or excessive interest rate hikes would have killed a boom by now.

The central bank's decision came after a closed-door meeting of the Federal Open Market Committee—the officials, including Greenspan, who set interest rate policy.

In a statement explaining its decision, the Fed said recent economic 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 produce."

However, in its bias statement, the part of their announcement that provides an economic outlook, the FMOC said, "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future."

"The Committee remains concerned about the risk of a continuing gap between the growth of demand and potential supply at a time when the utilization of the pool of available workers remains at an unusually high level," the statement said.

The Fed has three more rate-setting meetings this year, in October, November and December.

The Oct. 3 meeting would bring it perilously close to the November presidential election and risk charges of being drawn into politics, although Fed officials deny politics play any role in their decisions.

Stocks saw steady action following the meeting, with the Dow closing up 0.5 percent and the Nasdaq composite index eking out a gain of 5.06 points.

A booming economy creates inflation when consumer demand exceeds the supply of products and companies have to hire new workers to keep up with demand. As the pool of available workers shrinks, wages go up. This in turn pushes prices up.

When prices go up, it becomes harder for businesses to make long-term decisions and it can cause hardships for people with fixed incomes.

Raising interest rates slows this process by making it more expensive to borrow money for investing or buying.

But higher rates have other consequences, lik making it harder for a lower-income family to buy a house, and increasing the credit crunch felt buy people carrying balances on their charge cards.



  • CBSNews.com staff CBSNews.com staff

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