- The Washington Times - Wednesday, June 16, 2004

When Federal Reserve Chairman Alan Greenspan declared in a June 8 speech that the Fed was “prepared to do what is required to fulfill our obligation to achieve the maintenance of price stability,” he signaled that the Fed’s “measured” pace for raising short-term interest rates might begin with a larger incremental change than initially expected. Rather than raise the Fed’s targeted federal funds rate by the expected 25 basis points (one-quarter of a percentage point), he appeared to suggest, that the Fed instead might increase it by 50 basis points. However, in his testimony Tuesday before the Senate Banking Committee, Mr. Greenspan implied that the Fed would likely be raising the federal funds rate by only 25 basis points when it meets at the end of June.

Frankly, under rapidly changing circumstances, an increase of 50 basis points seems to be the more prudent policy. Those circumstances include the steady accumulation of evidence since the beginning of the year strongly suggesting that the buildup of inflationary pressures has exceeded year-end expectations. It is worth recalling that six months ago, for good reason, the major threat was deflation.

But much within the U.S. economic landscape has changed since December. First, the economic recovery has demonstrated its underlying robustness in that total output has expanded by 5 percent during the past four quarters. With nearly 1 million jobs created during the past three months, the labor market has shaken off its doldrums. Meanwhile, long-term interest rates, which, unlike the Fed-controlled short-term rates, are determined in the financial markets, have increased by more than 1 percentage point since March. On the day after Mr. Greenspan’s testimony, the Fed reported that industrial production increased by 1.1 percent in May, its strongest monthly gain since 1998; industrial output has now expanded by a strong 6.3 percent over the past 12 months.

With the welcome acceleration of economic activity, however, has come a disconcerting acceleration of inflation. The celebration of the defeat of deflation has been cut short by an unanticipated and unwelcome emergence of intensifying inflationary pressures. Throughout 2003, for example, consumer prices increased by less than 2 percent. The annualized rate of consumer price inflation for the first five months of 2004 now exceeds 5 percent. Over the same periods, the core consumer price index, which excludes the volatile food and energy sectors, has nearly tripled, rising from 1.1 percent during last year to an annualized rate of 2.9 percent for the first five months of 2004. Unit labor costs, which had declined by 4.3 percent over two years, have now increased during the past two quarters.

For nearly a year now, the nominal federal funds rate has remained at 1 percent, a 46-year low. The recent jump in inflation, however, means that the real (i.e., inflation-adjusted) Fed funds rate has actually declined into negative territory. A negative federal funds rate means that monetary policy has become even more accommodative than the Fed intended. In the wake of these recent developments, raising the federal funds rate to 1.5 percent would be the prudent course of action.

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