- The Washington Times - Saturday, September 17, 2005

In the wake of the Katrina catastrophe, the Federal Reserve has been urged to take “a compassionate pause” from its 15-month campaign of gradually raising the federal-funds rate, the central bank’s benchmark interest rate that banks charge each other for overnight loans. Two important post-Katrina developments strongly argue against such restraint.

The first development comprises the inflation data released by the Labor Department last week. After rising 1 percent in July, producer prices for finished goods increased 0.6 percent in August. Over the past 12 months, the producer price index has increased 5.1 percent. That represents the strongest year-over-year rise in 15 years. Equally worrisome were consumer prices, which increased half a percent in August after rising by half a percent in July. Consumer prices have now increased by 3.6 percent over the past 12 months.

Various indexes can be used as proxies for the economy’s inflation rate. If the CPI’s year-over-year change is employed as a reasonable measure of inflation, then the fed-funds rate is negative. After being hiked by a quarter of a percentage point at each of the Fed’s last 10 monetary-policy meetings beginning in June 2004, the nominal fed-funds rate today is 3.5 percent, which is less than the 3.6 percent increase in consumer prices over the past year. Thus, the real (i.e.,inflation-adjusted) fed-funds rate is negative.

Given that the U.S. economy has grown by an average of 4.1 percent a year over the last two years, a negative federal-funds rate is hardly appropriate at this stage of the business cycle. Moreover, with energy-induced price inflation still intensifying, the Fed risks falling behind the curve if it takes “a compassionate pause.” Should consumer prices jump another half percent or more in September, as many economists believe they will, then three-month annualized inflation for July-September would exceed 6 percent.

The second post-Katrina development arguing against a pause was the fiscal-policy blank check that President Bush effectively signed Thursday night with his open-ended commitment to Katrina-related spending. Unfortunately, the federal money spigot is now wide open; and the price of oil is one conceivable crisis away from hitting triple digits. The Fed needs to continue raising its benchmark rate.

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