The Fed's Inflated Expectations
With the sort of attention usually reserved for royal weddings, the Federal Open Market Committee of the Federal Reserve convenes today and tomorrow to determine whether or not to leave the current federal funds rate unchanged. In the course of their deliberations, which closely resemble an academic seminar, the Fed governors will take into account everything from the unexpectedly large increase in the April consumer price index to its benign follow-up in May to Japan's first-quarter growth. The probable result of all this activity: a rate hike of one-quarter of one percentage point.</br></br>Why so much attention to an event once known only to Fed watchers at investment banks? The reason has little to do with whether and by how much the Fed raises the rate, though this will of course have some bearing on the immediate direction of the markets. What really matters, however, is what the Fed's action suggests about its view of the future of inflation.</br></br>After decades in which mainstream economists held that the costs of inflation were negligible, and that an inflationary monetary policy could stimulate economic growth, it is now widely appreciated (thanks to the work of Milton Friedman, Robert Lucas, Martin Feldstein and others) that stable, low inflation is essential to longer expansions and stronger growth. Thus the intense speculation: Will tomorrow be the start of another "long march," a 300 basis point increase such as began in 1988 and 1994 to ward off inflation? Is the Fed going to reverse the 75 basis point decrease in interest rates in response to the last year's global turmoil and the prospect of deflation?</br></br>The change in forecasts of what the Fed will and should do has been rapid. As recently as late February, the Economist magazine ran a cover story worrying about the risk of global deflation; a few weeks later it hawkishly editorialized that the Fed was late in raising interest rates. Behind these large swings in opinion lie some unresolved questions about the economy, among them:</br></br>-- Why has inflation continued to decelerate? Is it due to a string of one-time favorable "shocks," such as low oil prices, a strong dollar, and a steeper than anticipated decline in computer prices? Has that string run out?