- The Washington Times - Monday, March 27, 2006

This afternoon, the Federal Reserve’s monetary-policy committee will announce its first decision on short-term interest rates since Ben Bernanke succeeded Alan Greenspan as Fed chairman on Feb. 1. In the wake of Mr. Bernanke’s repeated pledge of “continuity,” the Fed will almost certainly raise its target interest rate by another quarter percentage point. At the same time, Mr. Bernanke will be able to begin establishing his bona fides as an inflation hawk.

Raising short-term interest rates by a quarter point is the correct policy action in today’s environment, which reflects a briskly expanding economy (most forecasters expect gross domestic product to grow at an annual rate of 5 percent during the current quarter); a low unemployment rate (4.8 percent); strong nonfarm payroll expansion (monthly employment growth has averaged 228,000 jobs during the November-February period); sky-high profits (inflation-adjusted net profits in 2005 were about 75 percent above 1999 net profits); and continuing, albeit somewhat-alleviated, concerns about both the economy’s underlying inflationary pressures and the inflation expectations of consumers and businessmen.

At 14 consecutive policy meetings, beginning in June 2004, the Fed raised the interest rate that banks charge each other for overnight loans by a quarter point. Over that period, the fed-funds rate increased from an extremely accommodating 1 percent, which was appropriate to beat back the potentially debilitating forces of deflation, to 4.5 percent, which most observes consider to be approaching the so-called “neutral” level. A “neutral” fed-funds rate is one that neither stimulates economic activity nor restricts it. Under current circumstances, a “neutral” fed-funds rate is probably closer to 5 percent than 4.5 percent.

On Jan. 31, when the Fed last raised the federal-funds rate, the central bank’s press release announced that “some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.” In conjunction with Mr. Bernanke’s commitment to continuity, futures markets have interpreted that statement to mean that the Bernanke-led Fed will likely raise the overnight interest rate today and at its May meeting. Whether the Fed then pauses should be determined by economic data available at the time.

Recent inflation data indicate that the Fed’s approach since mid-2004 has, so far, succeeded in its crucial task of preventing the inflationary impact of soaring energy prices from excessively affecting other sectors of the economy. The 12-month change in the Fed’s preferred inflation gauge — the personal-consumption-expenditure (PCE) core price index, which excludes the volatile food and energy sectors — has receded from 2 percent in August and September to 1.8 percent in January. That’s the lowest year-over-year level for the PCE core index since March 2004. The 2 percent level is regarded as the upper limit of the Fed’s comfort range. And if Mr. Bernanke doesn’t feel comfortable, neither will markets.

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