- The Washington Times - Saturday, August 6, 2005

Considering the solid, growth-sustaining economic reports from the past 10 days, Federal Reserve Chairman Alan Greenspan and his colleagues will certainly continue proceeding at their “measured” pace by raising short-term interest rates another quarter-percentage point at their Tuesday policy meeting. To that end, in fact, the normally opaque Mr. Greenspan, who celebrated his 18th anniversary as Fed chairman last Wednesday, had earlier uttered one of the most definitive statements he has ever made about the future path of interest rates.

Testifying last month before the House and Senate banking committees, Mr. Greenspan categorically declared that achieving the “sustained economic growth and contained inflation pressures” projected in the Fed’s latest forecast “will require the Federal Reserve to continue to remove monetary accommodation.” In other words, the Fed-controlled rate that banks charge one another for overnight loans will continue to rise.

Following the anticipated quarter-point increase Tuesday, the fed-funds rate will stand at a still relatively modest 3.5 percent. That is 2.5 percentage points higher than the extraordinarily low 1 percent fed-funds rate that prevailed for a year before the Fed began raising it early last summer. That cumulative increase, enthusiastically supported by this page, will reflect 10 consecutive quarter-point hikes, which the Fed has implemented in an systematic, clearly telegraphed policy over its past 10 regularly scheduled meetings.

The Fed has been gradually moving toward a more neutral stance from an extremely expansionary monetary policy, which was necessary to jump-start a lackluster economy following the 2001 recession and to ward off potentially debilitating deflationary forces. Taking note of current economic circumstances and the inflation-adjusted neutral federal-funds rate, which most economists estimate to be near 3 percent, a safe bet is that the Fed will not stop raising short-term rates until the nominal fed-funds rate exceeds 4 percent. Mr. Greenspan’s favorite gauge of inflationary pressures is the core personal consumption expenditures (PCE) price index, which excludes the volatile food and energy sectors. The Fed’s latest forecast projects that the core PCE price index will rise between 1.75 percent and 2 percent for both 2005 and 2006. At that inflationary level, a nominal federal-funds rate of 4.75 percent would generate the historically neutral real fed-funds rate near 3 percent.

Of course, all business cycles are different. And note well that the “core” PCE price index excludes energy prices, which have precipitated major bouts of inflation (and subsequent recessions) in the past. In that regard, it must be noted that the price of benchmark West Texas Intermediate crude oil surpassed $62 a barrel recently, a nominal record that reflected more than a 40 percent increase over the past year. So far, this huge rise in oil prices has barely reflected itself in the overall consumer price index and the overall PCE price index, which have increased by only 2.5 percent and 2.2 percent, respectively, over the latest 12 months. However, should that trend change or if oil prices continue to skyrocket, then inflationary pressures could intensify, forcing the Fed to react accordingly.

No doubt Mr. Greenspan and his colleagues will remain vigilant. At the moment, however, the prospects for the U.S. economy through next year appear to be quite favorable. The economy expanded at an annual rate of 3.4 percent last quarter. Because an inventory drawdown chopped more than 2 percentage points off last quarter’s still-impressive growth rate, rebuilding those depleted inventories will generate additional growth in the near term.

Nothing on the horizon suggests that the U.S. economy cannot achieve the Fed’s 2005-06 forecast, which projects low inflation, 3.5 percent annual growth and a steady 5 percent unemployment rate. But we do agree with the Fed: Realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation.

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