- The Washington Times - Thursday, December 15, 2005

On Tuesday the Federal Reserve’s Open Market Committee (FOMC) nudged up the federal funds interest rate to 41/4 percent, the 13th successive quarter-point rise in 18 months. How much further is the Fed likely to go?

Consistent with its present policy of openness, the FOMC usually drops hints about what it’s likely to do next. The wording of the committee’s latest policy statement suggested that the end of rate hikes is not far off, though it noted the potential for additional inflation pressures and said that “some further measured policy firming is likely to be needed.”

It seems clear that the FOMC will raise the federal funds rate another quarter of a point at its next meeting January 31. Beyond that date, when it will decide to stop raising rates is uncertain.

Monetary policy is art as well as science, and knowledgeable economists will disagree about what the “right” peak federal funds rate should be for 2006. Individual FOMC members who were in agreement about past rate hikes are now more likely to differ in their assessment of the best stopping point. For more than a year short-term interest rates have lagged economic growth, but now they have nearly caught up. How far they have yet to go becomes a matter of judgment.

The decision on when to halt interest rate increases will depend heavily on the strength of the economy, on price behavior and on Fed forecasts. Right now economic growth is robust, core inflation is contained, and the Fed and economists generally are predicting solid growth for 2006.

The range for a neutral (neither expansionary nor contractionary) peak federal funds rate in 2006 is probably 41/2 to 51/2 percent, and within that span, the likely Fed stopping point is probably between 43/4 and 51/4 percent. Given the economic outlook and the risks of inflation, it would not be surprising if the FOMC shoots for a 5-plus percent interest rate ceiling.

Supporting an upper-end peak funds rate is a statistic known as the sacrifice ratio. The ratio attempts to measure the short-term economic cost of reducing inflation, that is, the amount of employment or output that is lost, or has to be “sacrificed,” in order to reduce the inflation rate. The sacrifice ratio is also defined in terms of joblessness, measured by the amount of unemployment required to lower the inflation rate. Though some economists consider the ratio crude and of dubious reliability, it’s a statistic that the Fed calculates and looks at in deciding policy.

The ratio has an important message to tell, namely that it’s more costly to lower inflation today than in the past. That means it’s more important now than it used to be to prevent inflation from getting out of hand.

In remarks to the Economics Roundtable in 2003, Fed Chairman-designate Ben S. Bernanke talked about the sacrifice ratio, noting that it had risen over time, i.e., that the economic costs of lowering the inflation rate had increased. More recently, in a talk Sept. 29 of this year, Fed Gov. Donald L. Kohn presented data showing that the Board’s staff estimates of the unemployment sacrifice ratio had risen sharply since the mid-1980s. Concluded Mr. Kohn, “Imbalances between demand and potential supply would thus now be slow to show through convincingly to inflation, but when they do, they may be costly to correct.”

In other words, it’s harder for inflation to take hold today than in the past. But if it does take hold, the Fed would have to brake the economy and push up the unemployment rate to recession levels in order to bring down the inflation rate. It would be much less costly to the economy for the Fed to stay ahead of the game by gradually raising interest rates to the point where it’s confident that inflation will remain under control than to ramp up rates once inflation gets out of hand.

The credibility the Fed has built up over many years would be badly damaged by a period of accelerating inflation. Maintaining confidence in the Fed is important. When financial markets, investors and consumers believe the Fed is doing its job well, by their consequent actions they help bring about non-inflationary economic growth and give the Fed more elbow room to promote prosperity.

The “best” federal funds rate for next year’s economy lies in a zone of uncertainty. Considering the potential gains and losses, the Fed should and probably will risk overshooting rather than undershooting.

Alfred Tella is former Georgetown University research professor of economics.

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