- The Washington Times - Monday, September 20, 2004

After driving down nominal short-term interest rates to their lowest levels in more than four decades, the Federal Reserve Board spent months laying the groundwork and preparing the markets for a rise in short-term interest rates that would proceed at a “measured” pace. The increases began in June and continued in August, when the Fed raised the overnight federal-funds rate by a quarter-percentage point at each of those meetings. Even after increasing the nominal federal-funds rate from 1 percent to 1.5 percent, however, the Fed is confronted with a situation in which the inflation-adjusted federal-funds rate is lower today than it was in December. That situation means that the Fed almost certainly will continue following its measured pace by increasing the rate today by another quarter-percentage point.

There is a simple reason why the real federal-funds rate is lower today than it was late last year: The inflation rate has risen faster than the fed-funds rate. This is true, moreover, despite the fact that overall inflationary pressures, which rapidly accelerated earlier this year, have significantly abated during July and August, when the consumer price index remained essentially unchanged.

In December, the economy confronted disinflationary pressures (prices were rising ever more slowly), which threatened to evolve into outright deflation (a potentially debilitating situation in which the general price level would actually decline). While the Fed has raised the nominal federal-funds rate to 1.5 percent, the rate of consumer price inflation for the 12 months ending in August has increased to 2.7 percent. The real federal-funds rate has thus fallen from a negative 0.9 percent in December to a negative 1.2 percent today. The effective result has been that monetary policy has become even more stimulative despite the fact that the Fed has been raising its targeted interest rate.

Given the economically traumatic circumstances that followed September 11 and the subsequent threat of deflation, the Fed was right to maintain the exceedingly strong monetary stimulus for the prolonged period that it did. However, in an environment where fiscal policy will remain quite expansionary for the foreseeable future, there is no apparent need for the Fed to permit real short-term interest rates to continue to decline into ever-deeper negative territory.

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