- The Washington Times - Monday, January 29, 2007

After keeping its target short-term interest rate below 2 percent from late 2001 to mid-2004, the Federal Reserve steadily ratcheted the key rate upward over the next two years. By the middle of last year, the federal funds rate, which banks charge each other for overnight loans, stood at 5.25 percent. From a standing start of 1 percent in June 2004, the Fed increased its target rate by a quarter-percentage-point at each of 17 consecutive central bank monetary-policy meetings.

Since last June the Fed has taken a breather while observing the results of its handiwork. The Fed appears unlikely to change its target rate at its annual two-day meeting that begins today. Interestingly, since June 2004, when the Fed began raising short-term rates, long-term interest rates, which are set by the bond market, have barely moved. The 10-year rate averaged 4.73 percent in June 2004 and closed at 4.87 percent on Friday.

After increasing by an annual average of less than 2 percent during 2001, 2002 and 2003, consumer-price inflation accelerated to 3.3 percent during 2004 and 3.4 percent during 2005. Last year, consumer prices increased by 2.5 percent. After several years (2002, 2003, 2004 and much of 2005), when inflation-adjusted short-term interest rates were negative, the Fed last year finally achieved a real short-term rate (2.75 percent presently) that is near its equilibrium level. At that level, monetary policy is neither stimulative nor contractionary. In response to the increase in real short-term interest rates, the annualized growth rate of the economy decelerated from an average of 3.8 percent during the three years ending last March to 2.3 percent during the second and third quarters. The Fed will learn tomorrow morning how the economy fared during the fourth quarter. The consensus projection among economists is 3 percent, indicating that the Fed may well be on the path toward its desired “soft landing.”

The deceleration of overall inflation was good news. However, the Fed understandably remains concerned about the change in so-called “core” consumer prices, which exclude the volatile energy and food sectors. Fed Chairman Ben Bernanke, who will be celebrating his first-year anniversary this week as the central bank’s helmsman, possesses a well-advertised “comfort level” between 1 percent to 2 percent for core inflation. Core consumer prices, measured by the consumer price index, increased by 2.6 percent last year, the fastest increase during any year since 2001. Over the 12-month period ending in November, the Commerce Department’s core personal consumption expenditure price index increased by 2.2 percent, having declined from a 12-month rate of 2.4 percent that prevailed at the end of the three previous months. After worrisome monthly increases of 0.3 percent (August) and 0.2 percent (September and October), the core PCE index remained unchanged in November.

For now, the Fed would be wise to keep policy unchanged by maintaining its target rate at its present level.

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