Monday, May 3, 2004

With long-simmering disinflationary pressures having significantly diminished in recent months as the economy’s robust expansion continued on track, the conduct of monetary policy will come under intense review today as the Federal Reserve’s policy-making committee meets to discuss future strategy. Look for a strong signal forecasting higher short-term interest rates in the near future.

Short-term rates, which the Fed can directly control by injecting and withdrawing the appropriate amounts of reserves throughout the banking system, have remained at a nearly 50-year low ever since the Fed reduced its overnight target rate last June to 1 percent, where it has remained for nearly a year. In the meantime, beginning with the third quarter last year, the U.S. economy has enjoyed its fastest annualized growth rate over nine months — 5.5 percent — since 1984.

During the past three years, core consumer price inflation, a favorite Fed inflation gauge that excludes the volatile food and energy sectors, ratcheted downward from 2.7 percent (2001) to 1.9 percent (2002) to 1.1 percent (2003). This worrisome trend threatened to force the economy into a potentially debilitating deflationary spiral. During the first quarter this year, however, core consumer prices have finally begun to rise at a pace that makes the Fed more comfortable. The goal now is to continue promoting conditions permitting robust expansion while preventing a breakout of inflationary pressures.

Few analysts expect the Fed to actually raise short-term rates today. Rather, the central bank, whose policies have become increasingly transparent since Alan Greenspan became chairman in 1987, is likely to signal the financial markets that the Fed’s targeted overnight rate will begin rising later this year, perhaps when it meets again in late June and almost certainly by August. Today, the Fed likely will declare a well-earned victory over deflation and report a return to a so-called “neutral” bias, stating that the risks are now balanced between a fall in inflation (disinflation) and a rise in inflation. The press release the Fed issues after its policy meetings probably will exclude its declaration following its January and March meetings that the Fed will remain “patient in removing its policy accommodation.”

The Fed’s last statement, issued after its March 16 meeting, declared that “core consumer prices are muted and expected to remain low.” Since then, however, there has been an unexpected, though welcome, advance in core consumer prices. For the three-month period ending in December, core consumer prices increased at an annual rate of 1 percent. For the three-month period ending in March, however, core consumer prices jumped at a 2.9 percent annual rate. In addition, core consumer prices over 12 months ending in March increased by 1.6 percent, or half a percentage point faster than the 12-month rate ending in December. Mr. Greenspan and his colleagues understand that as facts and trends change, so, too, must policy.

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