Comment in the FT by Professor Stephen Cecchetti
Published in the Financial Times on March 21, 2005
Professor at the Brandeis International Business School
What has been true for seven consecutive policy meetings is true now. The Federal Open Market Committee will raise its target interest rate by one-quarter of one percentage point in its Tuesday meeting, bringing the federal funds rate to 2.75 per cent.
Improved communication - including speedier publication of the committee's deliberations - has brought us to the point where monetary policy is predictable a few days in advance. The real question, however, is not about today but about what will happen over the next year. How many more interest rate increases are coming? How high should the FOMC go, and how fast should it go to get there?
My conclusion is that the US federal funds rate target needs to rise to at least 4 per cent, and the faster it gets there, the better. As 50-basis point increases are rare, this means at least six more 25-point increases. Then, American monetary policy will be "neutral".
The neutral policy rate is the sum of the neutral real interest rate and the inflation objective of the monetary policymakers. The first part, the neutral real interest rate, is commonly thought to be in the range of 2-2.5 per cent. This is the rate consistent with the US economy operating at its sustainable, full employment level.
Even though the FOMC recently decided to forgo publicly announcing one, we can infer its long-term inflation objective from official speeches and publications. Taken as a whole, these suggest a number of about 1.5 to 2.5 per cent, as measured by the conventional consumer price index.
Adding the neutral real rate to the long-run inflation objective yields approximately 4 per cent. That is the minimum for the neutral policy rate today. The experience of the second half of the 1990s reinforces the view that neutral is at least 4 per cent. Back then, with inflation averaging slightly above 2 per cent on an annual basis and economic growth at about 4 per cent, the policy rate stayed at a level close to 5 per cent. That was neutral at the time. Growth and inflation may both be slightly lower today, suggesting a neutral federal funds rate not much below 5 per cent.
The FOMC cannot afford to take its time in getting to neutral. The consequences of three years of extremely accommodative monetary policy are now starting to show. The dollar has fallen 15 per cent on a trade-weighted basis, and business confidence is finally rising. As a result, economic slack is declining at the same time as inflation is increasing. The economy is growing fast enough to produce more than 200,000 new jobs per month, well in excess of the 140,000 needed to keep up with population growth. The labour market shows signs of tightening. On the inflation front, after falling consistently for two and a half years, goods prices (excluding food and energy) are rising at an annual rate exceeding 3 per cent. With service prices rising at a rate of 2.5 per cent, this means the inflation trend is nearly 2.75 per cent.
These very rough numbers imply significant risks if policymakers move too slowly. As a rule-of-thumb, an interest rate increase will start to dampen inflation 18 months later. That means we can expect inflation to continue to rise for at least one and a half years after policy reaches neutral. At the current pace, inflation could easily rise not only for the remainder of this year, but for much of 2006 also.
Assuming that CPI inflation in excess of 3 per cent is outside anyone's comfort zone, the FOMC would be forced to raise interest rates well above neutral in an effort to bring it down. Hopefully, the resulting slowdown in growth would be modest, but these things are difficult enough to calibrate when there could be a full-blown recession.
This conclusion makes clear why many people are confused about the fact that 10-year US Treasury note yields remain in the neighbourhood of 4.5 per cent. Experience of the past 50 years tells us that the 10-year rate is normally at least 125 basis points above the policy rate. With the federal funds target headed to at least 4 per cent with the year, long-term bonds should be yielding well over 5 per cent. And if I am right about the risks to inflation, rates will go even higher, contributing to a general economic slowdown.
The job of the FOMC is to manage these risks. The first step should be to use its improved communication structure - including the recent decision to expedite publication of the committee's minutes - to signal concern, emphasising that interest rates must continue to rise. Over the next few months, the challenge of controlling inflation requires that policymakers implement the promised increases - possibly even exceeding the current customary practice of raising in incremental quarter-point steps.
Without such decisive action there is a very real possibility that when Alan Greenspan retires as chairman early next year, he will leave his successor with inflation at levels we have not seen for a decade. No one wants that.
Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.
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