- The Washington Times - Tuesday, February 1, 2005

The Federal Reserve’s policy-making committee is likely to conclude today — its first meeting in 2005 — by repeating the action it took during the last five meetings of 2004. Specifically, the Fed will almost certainly raise the nominal federal-funds rate (the interest rate banks charge each other for overnight loans) by a quarter-percentage point, lifting it from 2.25 percent to 2.5 percent. The Fed will also likely announce, as it has following each of its meetings since June, that “policy accommodation can be removed at a pace that is likely to be measured.”

“Policy accommodation” is Fedspeak for a stimulative monetary policy. Indeed, despite the fact that the Fed raised its target interest rate by 1.25 percentage points last year, monetary policy continues to remain extraordinarily stimulative, as it has been since late 2001. During that year, the Fed, responding first to a recession and then to the September 11 terrorist attacks, lowered the nominal fed-funds rate from 6.5 percent to 1.75 percent. By June 2003, as the recovery faltered and deflationary forces grew stronger, the Fed had reduced its nominal target rate to 1 percent. There it remained for a year, after which the Fed began raising it in quarter-point increments.

Nominal interest rates are the rates that consumers, corporations and governments pay for loans, whether the borrowing is from banks and other financial intermediaries or from issuing bonds. What matters to an economy, however, is not the nominal interest rate; rather, it is the inflation-adjusted real interest rate.

The real interest rate is the nominal rate minus the inflation rate, which can be measured by several different objective indexes and by others that subjectively project the expected rate of inflation. Some price indexes, called “core” measures of inflation, remove the volatile energy and food sectors. The point is this: While the Fed was raising its targeted nominal short-term interest rate last year, objectively measured inflation rates — the consumer price index (CPI), the core CPI, personal-consumption-expenditure price indexes and economy-wide GDP price indexes — also increased last year, relative to 2003. The CPI, for example, accelerated from a 1.9 percent increase in 2003 to 3.3 percent in 2004, while the core CPI jumped from 1.1 percent in 2003 to 2.2 percent last year.

Thus, the Fed’s recent tightening campaign has been significantly mitigated by accelerating inflation. Real short-term interest rates, which were negative or close to zero since late 2001, remain in the same range today despite the Fed’s action during the past seven months.

The Fed has declared that its goal is to return short-term interest rates to equilibrium levels, where they are neither stimulative nor contractionary. The equilibrium range of short-term interest rates for a neutral monetary policy can be quite large, ranging from 3.5 percent to 5.5 percent — or even higher, depending on inflationary trends. In any case, 2.5 percent is not very close to neutral, especially if inflation rates remain at their 2004 levels. With fiscal policy remaining extraordinarily stimulative at least through 2005, the Fed may soon decide that “[monetary] policy accommodation” should be removed at a pace that is somewhat faster than measured.

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