Why the Fed Can Go Easy


By Christopher Farrell The consumer price index in May rose at its fastest pace in three years. For the first five months of the year, the CPI is up at a 5.1% annual rate, sharply higher than the 1.9% increase for all of last year. Yet Federal Reserve Board Chairman Alan Greenspan seemed to take the news calmly during his testimony before Congress on June 15 -- and with good reason.

Despite the ominous headlines, the inflation outlook is mixed. Prices are dramatically higher for many visible items, such as shoes, energy, newspapers, restaurants, pet food, and drugs. Wall Streeters may fear the worst since so many items in the high-end consumption basket are climbing, such as dry cleaning, club memberships, private flying lessons, trust services, and theater.

Yet it's remarkable how many prices in significant parts of the economy are falling. For instance, year-over-year, they're lower for such items as new cars, kitchen appliances, computers, furniture, photographic equipment, and toys. Taken altogether, the core inflation measures -- inflation minus volatile food and energy -- remain relatively tame.

MOVING TARGET. Of course, no one doubts that the era of low interest rates is over. Every member of the Federal Reserve Board has said so publicly and often, including Greenspan, most recently is in his latest testimony before Congress. The central bankers remain convinced that they can raise the benchmark Fed funds rate gradually from its current level of 1%, although the governors say they're prepared to act more precipitously if necessary. But it's doubtful that the Fed will need to take draconian steps.

For one thing, the financial markets have already appreciably tightened. The 10-year Treasury yield has risen by 140 basis points since last June's low and by 100 basis points since January. By contrast, the 10-year yield was only 40 basis points above the cyclical trough on average at the onset of tightening during the previous four Fed cycles, calculates Haseeb Ahmad, economist at Economy.com. The equity markets have also moved sideways despite strong evidence of a healthy economy and robust earnings.

For another, the real Fed funds rate -- the Fed funds rate adjusted for inflation -- has averaged 1.9% over the past 45 years. The Fed has never stated its official inflation target, but most Wall Street economists place it between a 1.5% and 2% annual increase in the CPI. If that's the case, it's reasonable to assume that the central bank will push its benchmark interest rate -- currently at 1% -- to the 3.5 to 4% range.

DIFFERENT MEASURES. The Fed funds rate could be lower, however. Another way to look at it: The period from 1950-65 shares a number of economic characteristics with today. Inflation was low and stable, productivity was strong, and the swings in economic activity mild. The real Fed funds rate averaged 1.1%, but after adjusting for the business cycle, a better figure to use is 0.6%, says David Rosenberg, chief North American economist at Merrill Lynch. Using that measure, the Fed could then raise rates as little as 2.5%.

It all comes down to the outlook for inflation. With China slowing down, international competition for goods and services fierce, labor costs under control, productivity high, and technological developments continuing to lower the cost of doing business, it's hard to see a sustained rise in the price level. The Fed will tighten, but not by much. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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