With a nominal rate of 3.75 percent and inflaton at 2 percent, The real federal funds rate is just under 2 percent. During the 1970s the real federal funds rate averaged under 2 percent and the result was high and rising inflation. During the 1980s the real federal funds rate averaged over 4 percent and the result was falling inflation. Two periods of low and stable iflation, the (early) 1960s and (mid) 1990s were accompanied by a real federal funds rate in the neighborhood of 2-4 percent. So one guess is that ultimately, an appropriate level for the real federal funds rate is between, say, 3 and 4 percent; with an inflation rate of 2 percent, that implies a nominal rate of 5 to 6 percent. If the Fed continues to raise the federal funds rate by a quarter of a percent at every meeting, this would mean rate increases every meeting until the end of 2006.
But history may in fact be a poor predictor of the economy’s “neutral” rate of interest. Financial market innovations, stable inflation expectations, the strengthening of the dollar’s role as an international reserve currency, and other factors may mean that the neutral rate of interest is lower than it was a decade ago. At any rate, the bond market has been in no hurry lately to push long-term interest rates up, despite several factors that might be expected to be increasing the neutral rate, including prospective federal budget deficits and the possibility of a large depreciation of the dollar. Given uncertainty over the appropriate ultimate target for the federal funds rate, the best strategy for the Fed to follow is to feel its way along, raising rates at a “measured pace” while keeping watch for signs of an economic slowdown or rising inflation.
This is precisely what the Fed has been doing. But recent statements by Fed officials suggest that the rise in oil prices since Hurricanes Katrina and Rita, and before, has generated alarm at the Fed, and could cause them to raise interest rates much more aggressively in the months to come. If the Fed were to follow this path, I think it would be making two serious mistakes. First, it would be misreading the lessons of history, particularly that of the 1970s. The Fed seems to hold to the belief that inflation is a force that once unleashed takes on a momentum of its own and is very costly to stop. The lessons of the 1970s, the Fed believes, is that the Fed erred by waiting until inflation had “reared its ugly head” before it raised rates. Once inflation was unleashed, bringing it back down was too costly for the Fed to contemplate. As a result, the Fed has since the 1980s pursued a policy of making pre-emptive attacks on inflation in response to what Marvin Goodfriend calls “inflation scares.” Today, as in for example 1994, the Fed stands ready to raise rates at the first sign that inflation will rise in the future; it is not content to wait to see evidence of inflation in, say, the core PCE inflation rate. The evidence shows, however, that the true error made by the Federal Reserve was manifestly ignoring clear signs of actual, ongoing, accelerating inflation. The experience of 1977-79, which I analyzed in a previous post (scroll to the bottom), is an almost comic illustration. During this period, the Fed repeatedly called attention to unacceptably high (real, actual) inflation, warned of its harmful consequences, and then did absolutely nothing about it.
Even if it was true in the 1970s that inflation quickly built momentum once it came unleashed, the theory of rational expectations teaches us that this was true only because the public understood, based on the Fed’s past behavior, that the Fed would accommodate any increase in inflation rather than fight it by raising interest rates. For the last 25 years, however, the Fed has acted quickly to reduce inflation the moment it appears (and often before); surely in this environment if inflation were to rise by a percentage point or so the public would anticipate that the Fed would respond aggressively, and that belief by itself would go a long way towards preventing the inflation from taking on a life of its own.
The second mistake follows from the first. The preemptive attack strategy made perfect sense when the Fed was trying to build its credibility as an inflation fighter. As long as the public questioned the Fed’s commitment to fighting inflation, the Fed could reasonably argue that it was less costly to raise interest rates at the first signs of inflation; and the very act of taking a tough stand would bolster the Fed’s credibility. The Fed’s heroic efforts in fighting inflation over the last two-plus decades, however, has earned the Fed a level of credibility unprecedented in its – perhaps any central bank’s – history. If the inflation rate rose from two percent to three or four percent, it is inconceivable that the public would assume the Fed would fail to act. The Fed therefore, I believe, has the luxury – hard-earned over the last 25 years – of waiting to see whether inflation is actually occurring before it strikes. Core PCE inflation was 2.4 percent in the first quarter of 2005, about half a percentage point above inflation over 2004; but in the second quarter it is back to 1.7 percent, below where it was in 2004. Why panic? The Fed should take advantage of the credibility it has earned, and hold off on a preemptive strike. To paraphrase George Bush, the Fed has built up some capital, and now is precisely the time to spend it. If the Fed’s credibility does not allow it this flexibility, one must question whether the sacrifices made to accumulate it over the last 25 years were worth it.
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