Academic journal article ABA Banking Journal

Why Not Stop at 4.5%?

Academic journal article ABA Banking Journal

Why Not Stop at 4.5%?

Article excerpt

WE EXPECT THE FED TO PAUSE in its interest rate hikes at 4.5% early this year. Economic growth began to slow significantly in the fourth quarter of last year, and inflation will be moderating. Under these conditions--and recognizing that recent Fed interest rate increases have not yet had their major impact--why would the Federal Open Market Committee want to push the funds rate higher than 4.5%?

Moreover, although outgoing Fed Chairman Alan Greenspan had little practical use for the concept of a "neutral" fed funds rate, there is some evidence that incoming Fed Chairman Ben Bernanke does. And the circumstantial evidence is that he would view a 4.5% funds rate as neutral, if not restrictive.

Real GDP growth was at a 4.3% annual rate in the third quarter of last year. However, a lot of that strength occurred in July and petered out thereafter. Real consumer expenditures fell in both August and September and increased by only 0.1% in October. With consumption accounting for about 70% of GDP, it is the closest thing to a slam dunk in economic forecasting that real GDP growth in the fourth quarter will fall well short of third-quarter growth. We see GDP growth moderating to 3.0% in 2006, implying a rise in the unemployment rate.

We also think inflation is more likely to trend lower this year. The spike in energy prices was the primary contributor to recent acceleration in consumer inflation. Moreover, core consumer inflation peaked in November 2004 and has been trending lower ever since. Also, energy prices have been stabilizing, at the least, and labor costs are behaving benignly and aggregate demand is in the process of moderating. …

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