- The Washington Times - Tuesday, October 24, 2006

The Federal Reserve’s monetary-policy committee meets today amid concerns that the economy’s core inflation rate is rising while economic activity is slowing. The Fed hasn’t raised the federal-funds rate since late June, when the Fed increased it by a quarter-percentage point to 5.25 percent. That represented the 17th consecutive quarter-point increase over two years.

When the Fed convened in late June, the funds rate stood at 5 percent; and the 12-month consumer-price inflation rate (through May) was 4.2 percent. That meant that the real (i.e., inflation-adjusted) funds rate was 0.8 percent, which was quite low for that stage of the business cycle. Real gross domestic product had increased by 3.7 percent over the latest four quarters, including an annualized rate of 5.6 percent during the first quarter. Meanwhile, the core consumer inflation rate, which excludes the volatile food and energy sectors and is widely viewed as providing a good gauge of the economy’s underlying inflationary pressures, had risen by 2.4 percent over the 12 months ending in May. The Fed’s “comfort zone” for core inflation is between 1 percent and 2 percent.

By September, the 12-month rise in the CPI had sharply decelerated to 2.1 percent. This occurred for two reasons. First, energy prices plunged by more than 7 percent in September, causing the overall CPI to decline by 0.5 percent for the month. Second, the latest 12-month period now excludes September 2005, when energy prices soared in the wake of Hurricane Katrina. Because the Fed has held the funds rate steady and because the overall inflation rate has declined to 2.1 percent, the real funds rate has now moved above 3 percent, a level it had not reached since late 2000. Meanwhile, businesses have succeeded in passing through higher costs (from earlier energy hikes) into non-energy prices. This has significantly increased the core inflation rate, which reached 2.9 percent in September, nearly a full point above the Fed’s “comfort level.”

Earlier, economic growth sharply decelerated to an annual rate of 2.6 percent for the second quarter and will likely decelerate further when the “advance” estimate for third-quarter GDP is released Friday. For now, the Fed is expected to maintain its target interest rate at 5.25 percent, hoping that the continuing slide in energy prices exerts downward momentum on the economy’s underlying (core) inflationary pressures.

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