- The Washington Times - Tuesday, December 9, 2003

The substantial improvement of the economy and job market seen in the past month prompted the Federal Reserve yesterday to say that inflation is as likely to rise now as it is to fall, though the Fed expects to keep interest rates at 40-year lows for some time to come.

Despite the more upbeat assessment by the central bank, the possibility of an uptick in inflation spooked the financial markets and thwarted an effort on Wall Street to push the Dow Jones Industrial Average over 10,000. After crossing the millennial mark after the open of trading, the Dow fell and ended down 42 points at 9,923.

“Output is expanding briskly, and the labor market appears to be improving modestly,” the Fed’s rate-setting committee said in a statement, adding that it sees no immediate threat of inflation. “Increases in core consumer prices are muted and expected to remain low.”

But a subtle ploy by the Fed — withdrawing its previously stated concerns about the risk of deflation or “an unwanted fall in prices” that previously had led the central bank to cut interest rates — signaled to financial markets that the central bank has moved a step closer to raising interest rates, analysts said.

Rates shot up sharply in the bond market, with the yields on 10-year Treasury bonds jumping to 4.35 percent from 4.2 percent just before the Fed’s statement, ensuring that 30-year mortgage rates, which are linked to the Treasury bond, will rise in coming days. Despite the higher rates, the dollar declined on worries that rates will not rise fast enough to bring back foreign investors who have been burned by low returns on their U.S. investments.

Thanks to the considerable improvement in the economy seen since the summer, the Fed has begun the long process of “unwinding its aggressively accommodative stance,” said Joel Naroff, president of Naroff Economic Advisers. The Fed itself noted that the low level of rates it has maintained for several years is highly stimulative to the economy and should continue to promote growth for months to come.

The Fed also repeated its belief that “accommodation can be maintained for a considerable period.”

The central bank is not likely to raise rates until it sees more than the “modest” improvement it noted in the job market, Mr. Naroff said.

After years of job losses, job growth returned with an upsurge in economic growth to 8.2 percent this past summer. But the monthly gains have been less than the estimated 150,000 needed to accommodate a natural increase in job seekers each month caused by population growth and immigration.

Once a recovery is assured in the job market, Mr. Naroff expects the Fed to start moving rates back to more normal levels.

He predicted that will happen in May.

While inflation has remained quiescent since the 2001 recession, economists say both the Fed and the Bush administration have laid the groundwork for a pickup in prices once the economic recovery gathers steam.

Health care prices already have soared over 10 percent and may go even higher with the enactment of a new federal program to pay for seniors’ prescription drugs.

Meanwhile, extraordinarily low interest rates nurtured double-digit increases in house prices even in the midst of the recession, while the dollar’s steep fall of more than 25 percent against other major currencies has increased the prices on imported goods, from oil to gold and copper.

The higher prices will increasingly filter down to consumers, said Diane Swonk, chief economist with Bank One.

The government’s fall from substantial surplus into huge budget deficits near $500 billion, and the likelihood that those deficits will remain high for years to come, also will lead to higher inflation and interest rates in the years ahead, she said.

“Inflation will re-emerge as a threat, especially given the additional upward pressure on prices created by the deficit, easy monetary policy, and a weak dollar,” she said.

“Gains today could be at the expense of gains in the future.”

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