- The Washington Times - Sunday, January 23, 2005

The Department of Labor reported last week that the overall annual rate of consumer price inflation increased by nearly 75 percent during 2004, rising from 1.9 percent in 2003 to 3.3 percent. Excluding the volatile food and energy sectors, the core consumer price index doubled during 2004, increasing from 1.1 percent in 2003 to 2.2 percent last year.

Not long ago, there was good reason for U.S. policy-makers to be worried about deflation, which represents a decline in the general level of prices. Just as a large increase in inflation can badly damage an economy, so too can a bout of deflation, which has the effect of raising the burden of debt. U.S. policymakers have witnessed the compounding, debilitating effects that Japan’s economy continues to experience as a result of the deflationary trend that followed the collapse of its stock and real-estate markets 15 years ago. The Federal Reserve was right to be concerned in 2002, 2003 and early 2004 as America’s cascading inflation rate threatened to evolve into outright deflation. The Fed pursued an extremely stimulative monetary policy. It slashed short-term interest rates to their lowest levels in nearly half a century; then the central bank maintained those rates at that level for an unprecedented period of time.

This policy helped to jump-start a lackadaisical economic recovery. Thus, the U.S. economy, which was growing at an annual rate of less than 1.5 percent (from October 2002 through March 2003), has expanded at an annual rate of 4.5 percent during the subsequent seven quarters. Also, the Fed’s stimulative monetary policy provided so much liquidity that some of it spilled over into consumer-price inflation, overwhelming the deflationary pressures.

Since the middle of last year, the Fed’s policy-making committee has raised the federal-funds rate — the interest rate banks charge one another for overnight loans — in quarter-point increments at each of its regularly scheduled meetings, which occur eight times a year. The effect of this policy, which the Fed describes as “measured,” has been to increase the fed-funds rate from 1 percent to 2.25 percent since last June.

Roughly speaking, because the 2004 increase (1.4 percentage points) in the overall rate of consumer-price inflation actually exceeds the Fed’s 1.25 percentage-point increase in the fed-funds rate, the real (i.e., inflation-adjusted) overnight interest rate has effectively declined. Another way to look at monetary policy is to observe that the overnight rate of 2.25 percent is now a little more than 1 percentage point below the latest year-over-year (December-over-December.) consumer inflation rate of 3.3 percent. This implies a negative real interest rate, which confirms that monetary policy is still extremely stimulative. Indeed, the Fed regularly makes this point in its policy statements announcing another quarter-point increase in its target interest rate. If the economy continues to expand at a 4-percent annual pace, the Fed will almost certainly continue to raise nominal short-term interest rates, as it should.



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