Washington, DC, May 21--An unexpected quickening in the pace of price increases in the past two months is challenging the Federal Reserve's plan to raise short-term interest rates only slowly from today's 46-year lows.
The recent shift in prices is at odds with Fed officials' forecast that the combination of unemployment, unused industrial capacity and rapid growth in productivity would keep inflation very low for another year or two.
Fed officials, though not ready to abandon the forecast, acknowledge that their primary concern has shifted in the past few months from sluggish job growth to rising prices. If inflation moves higher in coming months, they are likely to re-examine their public assessment, made earlier this month, that rates will rise "at a pace that is likely to be measured."
"The flareup in inflation in the first quarter is a matter for concern," Fed Governor Ben Bernanke said yesterday in a speech in Seattle. "The inflation data bear close watching."
He warned that the Fed's reference to "measured" rate increases was "not an unconditional commitment," but rather a forecast that depends on "the ongoing recovery in the labor market and developments on the inflation front."
Mr. Bernanke, who was among the Fed officials most concerned last year about the prospect of deflation, said he still expects the Fed to be able to move gradually. He said that's because inflation should be restrained by the gap between the economy's actual output and what it could produce at full employment. That gap moderates workers' ability to get wage increases and businesses' ability to raise prices. He also cited other inflation-restraining factors: brisk growth in productivity, or output per hour, which allows businesses to raise wages without raising prices; and an apparent end to the dollar's decline and to the rise in commodity prices -- except, of course, for oil. Inflation, excluding volatile food and energy prices, is "likely to remain in the zone of price stability during the remainder of 2004 and 2005."
The Fed is almost certain to raise its target for the federal-funds rate, charged on overnight loans between banks, from 1% at its late June meeting. Markets are assuming the rate will then rise rapidly to about 2% by the end of the year. A month or so ago Fed officials would have considered that too fast, but have indicated in recent days they are happy with market expectations. That's important because they don't want to surprise bond markets, as that could catch some big investors unawares and trigger unwelcome turmoil, as it did in 1994.
To avoid such surprises, the Fed has crafted the statements it issues after each of its policy meetings to signal its changing intentions. Chairman Alan Greenspan has done the same in his public remarks. Mr. Bernanke yesterday noted that thanks to the clarity of the Fed's communications, long-term interest rates have risen sharply in recent weeks on the assumption the Fed would raise rates. That, he noted, helps the Fed do its job by damping interest-sensitive spending as long as the Fed actually raises rates, as markets expect.
Some private analysts are questioning how long the Fed can say it will be "measured." "Odds of the Fed moving from a measured pace of tightening to a more-aggressive pace by late this year or early next are rising," Peter Hooper, chief U.S. economist at Deutsche Bank, warned in a recent report; he predicted that the federal-funds rate would hit 2% by the end of this year and 4% by the end of 2005.
Although many economists place great weight on the output gap -- the difference between the economy's actual production and what it could produce if all available workers were employed -- Mr. Greenspan doesn't. Instead, he takes his inflation signals from labor costs -- specifically, hourly wages adjusted for changes in productivity, or unit labor costs.
