- The Washington Times - Tuesday, September 13, 2005

Recently, U.S. lawmakers on both sides of the aisle, including members of the Senate Banking Committee, have spoken in favor of the Federal Open Market Committee (FOMC) holding the line on interest rates at its Sept. 20 meeting.

Political pressure is something Federal Reserve Chairman Alan Greenspan and his colleagues don’t need right now as they labor to weigh rising inflation risks against an expected economic slowing due to Hurricane Katrina. In times like these, one appreciates the need for an independent Fed.

If the FOMC decides next Tuesday to raise the Federal Funds target rate another quarter point, it will not be because its members are downplaying or are insensitive to the human misery and destruction created by Katrina. Rather it will reflect the committee’s considered judgment of what’s best for the national economy given the tools at the Fed’s disposal.

Monetary policy is broad in scope, impacting the overall economy and operates with a lag. As such, it is ill-suited to deal with sudden and temporary regional disasters. In these cases, fiscal policy is the preferred tool, as even now federal monies pour into the Gulf Coast area and aid the needy and homeless dispersed throughout the country.

Gulf area oil and natural gas facilities gradually are coming back on line, businesses are finding creative ways to deal with transportation and shipping problems, and energy prices may have already seen their short-term highs. The industrial outlook is brightening though uncertainties continue, such as the time it will take for fully restoring coastal energy infrastructure.

Nationally, the pre-Katrina economy was strong, and forecasts were rosy. Looking forward, the macroeffects of the storm will probably shave a half percentage point or slightly more off the economy’s third-quarter annual growth rate, and probably less off fourth-quarter growth. Job growth may be cut by as much as half for a few months, but employment and output should bounce back toward the end of the year as coastal rebuilding picks up. To some extent, consumption will be held up by federal payments to displaced people.

Even after allowing for the storm-caused shortfall in economic growth, including some drag on consumption due to higher energy prices and some possible cooling in the housing market, there should still be enough punch left in the economy for it to continue moving forward in the next two quarters at a diminished but respectable rate.

Prior to Katrina, inflationary forces were building in the economy. The minutes of the August FOMC meeting, summarizing participants’ views, state that “higher energy prices and reduced resource slack were seen as pointing to elevated inflation pressures.” In addition, labor costs per unit of output were steadily building. Unit labor costs in the nonfarm business sector jumped 4.2 percent in the second quarter over last year, the fourth increase in a row and the largest since before the 2001 recession.

Slack in the economy continued dwindling, with unemployment falling to 4.9 percent last month even as the Fed staff raised its projection of economic growth for the remainder of 2005 and forecast the output gap (between actual and potential output) “to be essentially closed by the end of this year.”

By driving up already high energy prices and disrupting supply chains, Katrina has increased inflationary pressures. Some higher energy costs are filtering through the economy, particularly in transportation and other high-energy-using industries. Consequently, core producer and consumer prices are likely to rise faster in the months ahead.

There is a danger consumers and businesses will perceive rising prices as more than transitory and this will unleash inflation expectations, which could become self-fulfilling. The Fed would then have to face the uncomfortable decision of greater tightening, thereby threatening the economic expansion. The elevated prices of far-dated oil futures suggest high oil prices will be with us for some time.

The FOMC has steadily raised the federal funds target rate 10 times by a quarter point, to 31/2 percent currently, since June 2004. Based on recent remarks by Fed officials, the odds favor the committee notching up short-term rates another quarter-point on next Tuesday and again at the November and December meetings. That makes sense. Many economists, I among them, believe the Fed is still behind the curve, playing catch-up and that the federal funds rate is still too low given the state of the economy.

But even if short-term interest rates were in equilibrium with the economy, the outlook beyond the next quarter or two justifies at least near-term continued, gradual tightening.

Whatever the FOMC decides, lawmakers should respect the Fed’s independence and stop putting ill-advised political pressure on Alan Greenspan and company.

Alfred Tella is former Georgetown University research professor of economics.

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