Not Another Tax Cut

The consensus was that they'd do it, and they did it. The Federal Reserve raised short-term interest rates again, the 11th consecutive rate increase, from a measly 1 percent in June of 2004 to 3.75 percent on September 20.

Technically, the rate in question is the interest rate that banks charge one another on overnight loans, but its impact is much more widely felt (see this graphic for how it works). In general, this rate-increasing campaign by the Fed represents an effort to be “less accommodative,” that is, to raise the cost of borrowing as the economy picks up speed. In Fed economists' own words, they're trying to “maintain price stability” by heading off any inflationary pressures that they fear may be building.

Given that this so-called removal of monetary stimulus has been going on for more than a year now, what's so interesting about the recent decision to proceed with business as usual? The answer is that this is the first Fed interest-rate move in the post-Hurricane Katrina world, and the way it interacts with misguided plans for future tax cuts is worth noting.

There were even a few analysts who thought the Fed might pause due to the economic disruptions caused by the hurricane. After all, the Congressional Budget Office estimates that the damage could cost 400,000 jobs and shave as much as a percentage point off economic growth over the rest of 2005. Other Katrina-related factors tilting against the increase were the recent big dip in consumer confidence and the probable decline in spending resulting from the hurricane and its joint impact on energy costs and family budgets.

But there were more factors leaning the other way. First, these central bankers are not in the business of surprising the markets, and without a lot more evidence, they didn't want to appear too worried. Recent comments from Fed members suggest that they're in reassurance mode, signaling that Katrina hasn't thrown the recovery off course (see statements to this effect in the Fed's press release).

Then there's the fiscal stimulus from the massive federally funded program to rebuild the affected areas. This amount is already at $62 billion and surely going higher -- the word on the street is that the bill could come to $200 billion. The members of the interest-rate committee might well be factoring this spending into their thinking. If the damage caused by the hurricane shaves a point off growth, this spending could easily put that point back (though spread over a longer period), so from the Fed's perspective, you're back where you started.

Extrapolating slightly, there's a lesson here regarding an upcoming policy fight -- at least I hope it's a fight -- in the halls of Congress.

One positive side effect of Katrina is that yet another round of tax cuts for the rich and spending cuts for the poor are temporarily on hold. Congress was all set to come back from its August recess and cut $70 billion in capital gains and dividend taxes, as well as $35 billion in spending from Medicaid, food stamps, child care, school training, and other such programs.

Katrina blew that agenda off the table. But once the images from the hurricane leave the front pages, it will be back. There are a million good reasons for no further tax cuts, but in the context of the Fed's action today, here's another one: We should be careful to avoid a situation in which fiscal and monetary policies are pulling in opposite directions.

Although it remains a highly unbalanced recovery, with growth flowing mostly to those at the top of the income scale (another reason not to pass more regressive tax cuts), the economy is expanding at a rate that the Fed's members clearly feel is just fine with them. Like I said, they're worried about overheating. It's possible that further tax cuts added to the Katrina spending could lead to a level of fiscal stimulus beyond the Fed's comfort level, . This in turn could lead them to accelerate their interest-rate-increasing campaign.

Many economists worry that the huge budget deficits that come out of this reckless pattern of revenue cutting will also lead to higher interest rates. And if our foreign creditors even think about pulling the plug on the billions they're lending us, interest rates will also have to shoot up to entice them to keep financing our international debt.

So here's the message for Congress and the administration: In the interest of interest rates, go ahead and spend what it takes to rebuild the Gulf Coast -- and stay the heck out of the tax-cut business.

Jared Bernstein is a senior economist at the Economic Policy Institute, a nonprofit, nonpartisan think tank in Washington, D.C.

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