- The Washington Times - Thursday, June 15, 2006

In recent weeks, there’s been an awful lot of whining from Wall Street about Federal Reserve Chairman Ben Bernanke. Having reaped rewards from the bull market in recent years, Wall Street investment bankers and their customers apparently now view outsized annual gains as a birthright. Few of them seem to appreciate, much less understand, the fact that the tremendous bull market of recent years may have had something to do with the extraordinary liquidity the Fed has been injecting throughout the economy.

Until soaring petroleum demand began to approach relatively fixed supply, sending oil prices upward, rising U.S. productivity and the forces of globalization effectively contained consumer-price inflation — so much so, in fact, that deflation became a real threat. As a result, much of the Fed’s liquidity made its way into asset prices, helping to send the stock market soaring.

How much liquidity did the Fed inject? Over a 20-month period (November 2002 through June 2004), the Fed’s target interest rate averaged a minuscule 1.1 percent. Over the next 18 months, from late June 2004 through December 2005, as the Fed raised the fed-funds rate from 1 percent to 4.25 percent, the target interest rate nonetheless averaged less than 2.75 percent, still extremely low by historical standards. Not coincidentally, the stock market continued to soar. The monthly average of the Standard & Poor’s 500-stock index increased by more than 50 percent between February 2003 (838) and December 2005 (1,262), reflecting a compound annual growth rate in excess of 15 percent.

By the end of last year, notwithstanding 13 quarter-point increases by the Fed, monetary policy still remained accommodative and expansionary. Although the fed-funds rate stood at 4.25 percent at year-end, petroleum-induced consumer-price inflation during 2005 was 3.4 percent. The difference, 0.85 percent, represents the real (i.e., inflation-adjusted) interest rate. Who could rationally argue that a real federal-funds rate of 0.85 percent was too restrictive?

What has happened so far in 2006? The Fed has raised the fed-funds rate three times, bringing it to 5 percent today. Meanwhile, consumer-price inflation has accelerated. During the first five months of 2006, the Labor Department reported Wednesday, consumer prices have increased at an annual rate of 5.2 percent. Thus, consumer-price inflation has increased this year much faster than the fed-funds rate. As a result, the real fed-funds rate has declined. In fact, it has turned negative.

With a current nominal fed-funds rate of 5 percent and annualized consumer-price inflation running at 5.2 percent this year, the real fed-funds rate is a negative 0.2 percent today. By what standard is a negative fed-funds rate indicative of a Bernanke-led Federal Reserve that has become too restrictive?

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