Business: Inflation and interest rates

By Jeffrey Lipsey

I am sure you have heard it many times recently, but the Federal Reserve is raising interest rates again and will not stop there. After being at a 46-year low in June of 2004 at 1 percent, Alan Greenspan has raised interest rates 12 consecutive times until the current level at 4 percent.

Usually coupled with this piece of information are the increasing fears of inflation. According to investopedia.com, inflation is the sustained increase in the level of prices for goods and services and is measured in terms of annual percentage increases. This means that as inflation increases, the amount of products you could buy decreases for the same amount of spent.

To determine the affects of inflation, it is best to find out what causes. Two theories are generally accepted among economists about the cause of inflation: demand-pull and cost-push inflation. In demand-pull, the demand is growing at a higher rate than supply, and thus prices increase. In cost-push, increasing costs lead to increasing prices to maintain the same level of profitability. When inflation is expected, however, it is easier to cope with when employers provide contracts with an annual cost of living included.

However, other people aren’t as fortunate. The elderly who live off of fixed incomes would be the most affected inflation. The amount they get in comparison decreases and thus their standard of living decreases as well. Most people are worried about inflation but don’t realize their wages increase with it as well. Generally, you should only worry about inflation when it increases more than your wages.

Interest rates are used by the Fed as a way to stabilize inflation to reasonable and controllable levels. The Fed decreases the rate as a way to increase consumer spending and liquidate the market, and will increase the rates when they want to achieve the opposite result. By increasing the interest rates, the Fed increases the cost of borrowing and consequentially decrease the purchasing demand for consumers. A decrease in demand leads to a drop in price and we are in equilibrium again.

In January, however, we will have a new Federal Reserve Chairman, as Greenspan is leaving after 18 years. During the final two months of his tenure, he will probably continue to raise rates another half point and his successor, Ben Bernanke, will probably continue the trend, according to the Wall Street Journal.

In my opinion, I believe the real estate industry will be among the most affected. As I mentioned earlier, a rise in interest rates decreases the demand by consumers. Thus, this decrease in demand will lower house prices that have been driven skyward the last few years during the real estate boom. But we will not see the affects of the interest rate increases yet, as it usually takes up to two years for any noticeable results.

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Jeffrey Lipsey is a senior in Business. His column appears on Thursdays. He can be reached at [email protected]