April 21, 2004
OK, I was wrong in my last column. That 0.4 percent gain in the consumer price index other than food and energy was the termite that requires some interest rate action. Patience in maintaining subsidized interest rates no longer is appropriate when inflation already is intensifying.
I know I received e-mails complaining that interest rates should not rise. (Apparently, all those CD holders who complained just the opposite no longer can afford a newspaper to read this debate.)
I do not want higher interest rates. Any increase in rates will slow the growth of the economy.
But the correct policy goal is maximum sustainable economic growth over the longest possible period of time. That goal cannot be achieved if inflation is accelerating.
The correct time to remove a subsidy is when the economy is growing faster than its sustainable growth path, not after it already has slowed after exhausting all the benefits from past economic policy.
I agree that I must explain several issues. First, is there a subsidy or is the market merely dictating interest rates that would prevail if the Federal Reserve did not exist. Second, is the economy growing faster than sustainable growth. Third, is inflation accelerating.
I will answer the easiest first.
In the second half of last year, GDP grew at an annual rate of 6 percent. Even with the March drop in industrial output (mostly because of car assemblies and electricity generation as a result of a mild March), I and most of the forecasting fraternity are projecting economic growth in excess of 5 percent.
Unemployment is slowly falling and even unemployment claims are near their lowest levels in four years. These gains clearly are faster than sustainable growth.
Now the second easiest issue: are current interest rates those that would prevail without Federal Reserve intervention.
We know the interest rate gap between overnight money, 1 percent, and ten year money, almost 4.4 percent, is one of the widest in history. On average, that gap historically is only slightly over 1 percent.
The Federal Reserve works in the overnight market. They cannot always control that rate, as financial historians know from Federal Reserve difficulties during and shortly after World War II. However, there is no evidence that the Federal Reserve is struggling to maintain a 1 percent rate now. Indeed, virtually everyone believes that if the Federal Reserve decides not to engage in bond buying or selling until the Federal Funds rate reaches 1.5 percent, the markets will register 1.5 percent yields almost instantly.
The size of the gap between what the Federal Reserve can control, the overnight market, and what they cannot control, the long term bond rate, suggests that the overnight market is unusually low for current economic conditions. There are other ways to get at the same results, but most analysts believe a subsidy of 2-3 percentage points explains the unusually large discrepancy between short and long term rates.
Now the hard question. Is inflation accelerating?
As late as January, the price gains excluding food and energy were only up 1.1 percent from the previous year. That was no higher than the previous Septemberís gain from a year before. This was price stability.
However, in only 3 months, the CPI has increased almost 0.9 percent. Some special pricing, such as springtime pricing of fashions and strong seasonal shifts in lodging rates, clearly added to the totals. But we must remember that we are excluding food and energy. Both sectorís prices have been booming for more than a year.
My leading inflation indicators turned positive last summer and remain so. But the intensity of their surge is slowing. On balance, I would say that inflation is accelerating, though it is not yet becoming embedded in labor contracts, machinery costs, and many other cost items.
If I were head of the Fed, I would prepare the markets for rising interest rates at the next meeting (or maybe even in Congressional testimony) and then raise my overnight targets by half a point at the following meeting. I would then continue at half point increases every quarter either until the economy slowed too sharply or the subsidy is gone.
I would do this not because I want interest rates to rise but because removing the interest rate subsidy is necessary to approach the correct policy goal. As any good parent knows, too much of a good thing can be bad.