- The Washington Times - Wednesday, June 29, 2005

More than four decades ago, Supreme Court Justice Potter Stewart acknowledged in an opinion that obscenity was difficult to define. Nevertheless, Justice Stewart famously declared, “I know it when I see it.” Earlier this month, Federal Reserve Chairman Alan Greenspan testified before the Joint Economic Committee. Referring to the Fed’s target interest rate — the federal-funds rate, which is the interest rate banks charge each other for overnight loans — Sen. Robert Bennett asked Mr. Greenspan where he thought “the ideal overnight rate should be.” The ideal rate is the “neutral” fed-funds rate. At that level, the fed-funds rate is sufficient to control inflation, while neither hindering nor stimulating economic growth. In his very best rendition of Justice Stewart’s famous declaration, the Fed chairman replied that “it’s very difficult to know where that so-called neutral rate is. But we probably will know it when we are there.”

Suffice to say, the Fed has not yet arrived at its “neutral” destination. But it is getting closer. The Fed will almost certainly take one more step today when its policy-making committee is universally expected to raise the fed-funds rate another quarter-percentage point.

Increasing the target rate to 3.25 percent is the right move to make. Subsequent raises also seem to be in order. With the consumer price index having increased at an annual rate of 3.7 percent during the first five months of 2005, even a nominal fed-funds rate of 3.75 percent would reflect an inflation-adjusted target rate of zero. No way is zero the neutral rate.

Dating back to one year ago, today’s policy meeting will be the ninth consecutive one during which the Fed will have raised the overnight rate by a quarter of a point. When the Fed began to tighten monetary policy on June 30, 2004, the fed-funds rate stood at 1 percent, its lowest level since 1958. At 3.25 percent today, the target rate will have reached its highest level since September 2001, when the economy was in the midst of a recession and about to be attacked by terrorists. The recession ended in November 2001, but the recovery was initially so sluggish and potentially debilitating deflationary pressures had become so strong that the Fed continued lowering its target rate through June 2003, when it bottomed out at 1 percent.

The U.S. economic growth rate finally began to accelerate during the second quarter of 2003. Yesterday, in its “final” estimate of first-quarter gross domestic product (GDP), the Commerce Department reported that the economy expanded by a relatively robust 3.8 percent annual rate.

Following two upward revisions, that growth rate compares quite favorably to the 3.1 percent rate for the first quarter that Commerce initially reported two months earlier. Over the past eight quarters for which data are available, the economy has expanded by 9 percent, reflecting an average annual growth rate of 4.5 percent. By any standard, that is impressive. It is especially so considering that business investment has increased by 23 percent during the past two years, fueled by a 29 percent rise in business spending on equipment and software.

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