- The Washington Times - Monday, May 2, 2005

What a difference six weeks makes. On Mar. 22, when Federal Reserve Chairman Alan Greenspan convened the last meeting of his monetary-policy committee, the U.S. economy’s growth rate seemed to have become so robust that the Fed changed its description of it from “moderate” — the word it used to characterize the pace of economic activity following its three previous meetings — to “solid.” And why not? Gross domestic product (GDP) had increased 4.4 percent in 2004, and February nonfarm payrolls had expanded by 262,000 jobs.

According to the minutes of the Fed’s March 22 meeting, the data available at the time indicated that consumer spending “appeared to be on track to post another strong advance in the first quarter of the year.” Excluding motor vehicles, business spending on equipment and software, which had been expanding at a rapid pace during each of the seven previous quarters, “appeared to be growing briskly in the first quarter,” the minutes further reported. In announcing that the Fed had raised its short-term target interest rate by a quarter-percentage point for the seventh time since June 2004, the Fed’s statement following its March 22 meeting warned that “pressures on inflation have picked up in recent months and pricing power is more evident.”

As it turned out, the Fed was right about the intensification of inflationary pressures but wrong about the pace of economic activity. Based on data released since the March 22 meeting, it now appears that the economy entered a soft patch in March. The Labor Department reported early last month that nonfarm payrolls increased by only 110,000 jobs in March. Last Wednesday the Commerce Department reported that orders for non-defense capital goods (excluding aircraft) — a crucial barometer of investment spending — had fallen 4.7 percent in March after declining 2.5 percent in February. On Thursday, Commerce reported that U.S. GDP grew by a disappointing annual rate of 3.1 percent during the first quarter. Overall consumer spending decelerated, as the consumption of long-lasting durable goods stagnated. Meanwhile, business spending on equipment and software crawled forward at a disappointing 4.7 percent annual rate.

The economic slowdown makes the Fed’s job much more difficult as the central bank’s monetary-policy committee meets today to determine what to do about short-term interest rates. The big problem is that while the pace of economic activity has significantly moderated, inflationary pressures have unquestionably intensified. The first-quarter GDP report, for example, revealed that the GDP price index has now increased from an annual rate of 1.4 percent during last year’s third quarter to 2.3 percent during 2004’s fourth period to 3.3 percent during the first quarter of 2005. The monthly change in the consumer price index (CPI), meanwhile, has accelerated this year, increasing by 0.1 percent in January, 0.4 percent in February and a surprising 0.6 percent in March. Even the core CPI, which excludes food and energy prices, has accelerated in 2005, increasing by 0.4 percent in March alone. It was the largest monthly increase in two and a half years. For the first quarter, the overall CPI increased at an annual rate of 4.3 percent, while the core-CPI rose at a 3.3 percent annual clip. By way of contrast, during 2003 and 2004 the core-CPI increased by 1.1 percent and 2.2 percent, respectively.

In June, with a self-sustaining economic expansion finally firmly established, the Fed began raising nominal short-term interest rates in a determined effort to remove the extraordinary monetary stimulus that was necessary to beat back the forces of deflation, which threatened the economy following the 2001 recession. Since early last year, soaring energy prices have underpinned the increasing inflationary pressures, which, as numerous core price indexes clearly indicate, now threaten to become entrenched throughout the economy. Even in the midst of the current, unexpected soft patch, the Fed must continue battling these pressures by raising the short-term interest rates it controls. In doing so, the Fed will retain its hard-earned credibility throughout the financial markets that the fight against inflation will be won, just as Mr. Greenspan and his colleagues emerged victorious in the battle against deflation.

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