- The Washington Times - Thursday, August 17, 2006

The day before the Federal Reserve’s policy-making committee convened earlier this month to decide whether to raise short-term interest rates, Harvard economist Martin Feldstein offered a bit of historical perspective. At issue was whether the Fed should increase the federal-funds rate (the interest rate banks charge each other for overnight loans) by a quarter point from 5.25 percent to 5.5 percent. Writing in the Wall Street Journal, Mr. Feldstein, who served as chairman of the Council of Economic Advisers during the first term of the Reagan administration (when the federal-funds interest rate reached 20 percent), observed: “In assessing the current interest rate decision, [Fed policymakers] should recall that during the Volcker and Greenspan years the Fed pushed the fed-funds rate to 8 percent above the concurrent rate of CPI [consumer price index] inflation in the early 1980s, to 4 percent in 1989 and to almost 3 percent in 2000. That measure of the real [i.e., inflation-adjusted] fed-funds rate is now less than 1 percent.”

As readers of this page know, Mr. Feldstein was making the very point The Washington Times editorial page had been making for months. It is the real fed-funds rate that matters, not the nominal rate. When combined with a 12-month CPI inflation rate of 4.3 percent through June, a fed-funds nominal rate of 5.25 percent generated a real fed-funds rate of 0.95 percent, a level that could hardly be considered excessive when judged by historical standards.

As it happened, the Fed’s policy committee voted earlier this month to keep its target interest rate at 5.25 percent, though the vote was not unanimous. (It was the first time since Ben Bernanke replaced Alan Greenspan as Fed chairman on Feb. 1 that a policy vote on interest rates had not been unanimous.) In the press release explaining its decision to pause after the Fed had raised the fed-funds rate by a quarter point at each of its 17 previous policy meetings, the Fed did repeat its warning that “some inflation risks remain.” The Fed explained that “high levels of resource utilization and [high levels] of the prices of energy and other commodities have the potential to sustain inflation pressures.” However, noting that inflation expectations remained contained and that previous interest-rate hikes had not fully worked themselves through the monetary-policy pipeline, the Fed predicted that these “inflation pressures seem likely to moderate over time.”

This week the Labor Department released CPI information for July. The 12-month inflation rate through July was 4.1 percent. That means the real fed-funds rate is now 1.15 percent, marginally exceeding the 1 percent level but still remaining quite low by historical standards.

Let’s examine the evolving real fed-funds rate from a different angle. When comparing the pace of inflation so far in 2006 (over the first seven months, the annualized CPI rate is 4.8 percent) with the inflation rate for all of 2005 (3.4 percent), policymakers can only conclude that inflation has actually accelerated this year. Thus, annualized inflation in 2006 is 1.4 percentage points higher than the 2005 inflation rate, but the Fed has raised the fed-funds rate by only 1 percentage point this year (from 4.25 percent to 5.25 percent). From this reasonable perspective, the Fed seems to be losing ground.

If the Fed is not to lose a big chunk of the credibility it has painfully earned over the last 25 years, it had better win the huge bet it has just placed by projecting that “inflation pressures seem likely to moderate” in the absence of sustained interest-rate increases.

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