- The Washington Times - Wednesday, April 30, 2008


After slashing the overnight interbank lending rate by 3 percentage points since mid-September, the Federal Reserve should pause today when its policy committee meets to decide whether to cut its target short-term interest rate further. As the Fed proactively confronted potentially catastrophic crises in the credit and financial markets in the midst of a significant slowdown in the U.S. economy, Fed Chairman Ben Bernanke has already demonstrated how agile, innovative and aggressive the central bank can be under his leadership. Now is the time for restraint.

Today the Fed should send the markets a signal that the its hard-earned inflation-fighting credentials remain intact. Maintaining the overnight federal-funds rate at 2.25 percent, which is already 1.75 percentage points below the 12-month consumer-price inflation rate of 4 percent, would help to convey that important message.

Since Mr. Bernanke replaced Alan Greenspan as Fed chairman 27 months ago, Fed-watchers have been repeatedly reminded how appropriately obsessed he is over the issue of maintaining inflation expectations in a “well-anchored” position. Once that anchor begins to loosen, history has shown that it often can be re-instated only at the great cost of lost income and high unemployment.

The Fed statutorily has three primary goals: maximum employment, stable prices and moderate long-term interest rates. In the past, the failure to maintain stable prices (in large part by keeping inflation expectations “well-anchored”) has resulted in the failure to achieve the other two goals. With gasoline prices racing toward $4 per gallon and milk prices already topping that level and the general consumer price level now consistently rising at an annual rate of 4 percent or more (which is 60 percent faster than the 2.5 percent average inflation rate during the 2001-2006 period), the Fed is in danger of losing control of inflation expectations. Indeed, in its press release issued after its three-quarter-point cut in March, the Fed warned that “some indicators of inflation expectations have risen.” In fact, Harvard economist Martin Feldstein recently cited surveys revealing that “households are expecting a 4.8 percent rise [in consumer price inflation] in the coming year.”

Once low, stable inflation expectations become unanchored, their impact on long-term interest rates can be devastating. If housing prices and home sales are in free fall today with 30-year fixed-rate mortgages hovering around 6 percent, imagine how truly catastrophic the economic situation and the housing and home-equity situations would become if inflation-induced long-term interest rates approached 7.5 percent or higher.

The effects of monetary policy occur after long and variable lags. Much monetary stimulus remains in the pipeline, and more than $150 billion in fiscal stimulus is now being released. Since the markets expect the Fed to lower its target rate by only a quarter-point today, it is fair to say that the anti-inflation credibility the Fed would regain through restraint would exceed any stimulative benefit from an additional quarter-point cut.

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