- The Washington Times - Monday, August 7, 2006

The Federal Reserve has raised short-term interest rates by a quarter-percentage point at each of its last 17 meetings, lifting the rate that banks charge one another for overnight loans from a four-decade low of 1 percent in June 2004 to 5.25 percent today. Now the Fed’s policy-making committee, which convenes today, faces its biggest dilemma in more than two years.

On the one hand, the annualized growth rate of the economy sharply decelerated during the second quarter, tumbling from 5.6 percent in the first quarter to 2.5 percent in the second. Meanwhile, the economy over the past four months generated significantly fewer jobs than it did over the same four-month period last year, when nonfarm payroll growth was 65 percent higher. Indeed, the unemployment rate ticked up from 4.6 percent in June to 4.8 percent in July. On the other hand, several inflation gauges are sounding the alarm that prices are not only rising, but they are doing so at an accelerating rate.

With growth slowing and inflation rising, what is a central bank to do? Compounding the Fed’s dilemma is the fact that monetary-policy actions do not fully impact the economy until after what Milton Friedman has so eloquently described as “long and variable lags.” That means that the last six or so quarter-point interest-rate increases (cumulatively 1.5 percentage points) are still working their way through the economy, exerting a decelerating effect on its growth rate. If that weren’t enough, the Fed’s new chairman, Ben Bernanke, will be overseeing only his fourth regularly scheduled policy meeting at the very moment when the Fed’s inflation-fighting credibility is being tested in a way that it has not been challenged in more than 15 years.

Considering all these circumstances, the Fed should react to the disturbing inflation signals by continuing to raise short-term interest rates by another quarter point. These disturbing signals include: (1) the recent upward revision (from 3.2 percent to 3.5 percent for 2005) in the price index for gross domestic purchases, which subsequently increased at a 4 percent annual rate during the second quarter; (2) the 4.3 percent increase over the latest 12 months (and an annualized 5.1 percent increase over the last three months) in the consumer price index (CPI), which increased by only 2.5 percent over the previous 12 months; (3) the 2.6 percent increase over the latest 12 months (and an annualized 3.6 percent increase over the last three months) in the core (excluding food and energy) CPI, which rose by only 2 percent over the previous 12-month period; and (4) a 2.4 percent increase over the latest 12 months (and an alarming annualized 3 percent increase over the last four months) in the core personal consumption expenditure price index.

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