- The Washington Times - Saturday, April 2, 2005

As expected, the Federal Reserve’s monetary-policy committee increased its short-term target interest rate by another quarter-percentage point at its meeting last week. The Fed raised the so-called federal funds rate, which is the interest rate that banks charge each other for overnight loans, to 2.75 percent. Before the Fed began removing monetary stimulus from the economy last June, it had slashed the fed-funds rate from 6.5 percent at the beginning of 2001 to a 58-year low of 1 percent in June 2003. For the next year, the overnight rate remained 1 percent, as the Fed aggressively fought off deflationary forces, which threatened to debilitate the U.S. economy.

Going into its regularly scheduled March 22 policy meeting, which takes place eight times a year, the once-secret Fed knew that all eyes would be focusing on the policy statement that the central bank releases after each meeting. The Fed did not disappoint. To be sure, Fed Chairman Alan Greenspan and his colleagues defied widely held expectations by declaring for the seventh time since last June, when they began tightening the money spigot, that “policy accommodation can be removed at a pace that is likely to be measured.” But for the first time since November 2000, the Fed issued an explicit warning about inflation, noting that pressures on inflation have picked up in recent months. Having described the pace of output growth as “moderate” following its three previous meetings, the Fed switched gears in March and said output was growing “at a solid pace despite the rise in energy prices.” Hinting that future interest-rate increases could be ratcheted upward to half a percentage point, the Fed declared that “appropriate monetary-policy action” would be deployed toward “the attainment of both sustainable growth and price stability.”

Acknowledging the obvious, the Fed said that, even after its latest rate increase, “the stance of monetary policy remains accommodative,” i.e., stimulative. That is so because even though short-term rates have increased 1.75 percentage points over the past nine months, the rate of inflation has risen as well. For example, on a year-over-year basis, the core consumer price index, which excludes the volatile energy and food sectors, has increased from 1.1 percent at the beginning of last year (when the fed-funds rate was firmly ensconced at 1 percent) to 2.4 percent in February (its highest level since August 2002). As the nominal fed-funds rate has increased by 1.75 percentage points since last year, the core rate of inflation has risen by 1.3 percentage points. In other words, the real rate has risen less than half a point. Thus, the inflation-adjusted real short-term interest rate has increased by a much smaller amount than the nominal interest rate.

Now that the Fed has officially recognized that “pressures on inflation have picked up in recent months,” the “solid pace” of growth in output may soon require Mr. Greenspan and his colleagues to pursue an “appropriate monetary-policy action” that raises the incremental increase in their target rate to half a percentage point.

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