- The Washington Times - Monday, May 17, 2004

Last week’s reports on inflationary trends at both the producer and consumer levels left little doubt that price increases have reached an accelerating phase that will almost certainly require the attention of the Federal Reserve at the next scheduled meeting of its monetary-policy committee in late June.

The Fed recently announced its intention to raise short-term interest rates at a “measured” pace. Most analysts have interpreted this to mean upward adjustments in increments of a quarter-of-a-percentage-point (i.e., 25 basis points). If that proves to be the case — and if the current economic growth rate and inflationary trends continue — then the Fed will likely have to raise its targeted interest rate, the overnight federal funds rate, by a quarter point at each of its five remaining Federal Open Market Committee meetings this year, including the three that precede the November elections. While the Fed traditionally prefers not to raise interest rates in the heat of a presidential campaign, experience dictates that the Fed cannot afford to permit inflationary momentum to race ahead of its policy actions.

That said, there is a caveat that cannot be overemphasized: Any action undertaken by the Fed at a “measured” pace will not have the effect of reversing monetary policy from its current accommodative status. The Fed is not talking about slamming on the monetary brakes. Even if the Fed raises its target rate by 25 basis points during each of the three meetings preceding the Nov. 2 election, the overnight rate, which has been at a 46-year low of 1 percent since it was last reduced in June, will remain below 2 percent. By any standard, historical or contemporary, such a policy must be judged objectively to be accommodative. Moreover, it further needs to be noted that the federal funds rate has been below 2 percent since December 2001. That means that the Fed has been aggressively accommodative for two-and-a half-years.

Adjusting the targeted overnight rate for inflation is the best standard to judge whether the Fed is tightening monetary policy. The real (i.e., inflation-adjusted) fed funds rate is what matters. During 2003, when the fed funds rate averaged 1.125 percent, consumer prices increased by 1.9 percent. That means the real rate was actually negative, as the Fed intended it to be in an effort to first jump-start and then sustain an economic growth rate sufficient to generate job growth. For the first four months of 2004, the Labor Department reported last week that consumer prices have increased at a seasonally adjusted annual rate of 4.4 percent, more than double the inflation pace of 2003. Prices at the producer level have been rising this year at a 6 percent annual pace, compared to 4 percent during 2003. Meanwhile, the economy has been growing at a 5.5 percent annual rate since mid-2003, and growth for the balance of 2004 is projected to be about 5 percent. Under these circumstances, the Fed’s “measured” policy actions seem appropriate.

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