It will probably be six weeks before the Federal Reserve curtails its policy of cheap money, but a growing number of analysts worry that it may have already waited too long.
The pressure to raise rates has increased over the last month, after the federal government reported that job creation surged in April for the second month and prices rose markedly in both March and April.
Commodity prices have soared in the last year, with crude oil for delivery in June settling at US$41.38 a barrel on Friday, the highest since the contract was first traded. The prices of many industrial raw materials are at their highest levels since the late 1970s.
Wholesale food prices surged 1.4 percent last month, after a similar jump in March. The so-called core rate of retail inflation, excluding food and energy, has climbed at an annual pace well above 3 percent in the last three months.
"The Federal Reserve has been behind the curve," said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson, an investment firm in Chicago. "With GDP growth at a 20-year high, with inflation pressures rising, there is no justification for keeping rates this low. In my opinion, they should have started raising rates last year."
Fed officials have been hinting for months that they will have to increase interest rates, and all evidence suggests that they will begin the process with a quarter-point rise in short-term rates at their next policy meeting on June 28-June 29.
Senior Fed officials are quietly pleased that bond market investors have already anticipated rate increases by pushing up mortgage rates and yields on benchmark 10-year Treasury notes to the highest levels in nearly two years. Officials hope that the advance rise in long-term rates will cool the economy even before they take any action, making their job easier.
"Monetary conditions in the United States are already in the process of normalizing," remarked Ben Bernanke, a Federal Reserve governor, in a speech last month. As a result of the Fed's communications strategy, he continued, "market rates have generally responded continuously and in a stabilizing manner."
But analysts said the bond markets were affected more by evidence of rising employment and faster inflation than by the Fed's hints.
"I don't think you should give the Fed's communications much credit for the tightening in financial markets," said Lyle Gramley, a former Fed governor who is now a senior economic adviser at Schwab Soundview Capital Markets. "You should give credit to the markets for correctly interpreting the numbers that have been indicating that the economy is stronger than expected and that prices were increasing."
Federal Reserve officials and private economists all agree that short-term rates are too low to sustain much longer. At its current rate of 1 percent, the Federal funds rate on overnight loans is at it's the lowest level since 1958. The "real" interest rate, after accounting for inflation, is negligible at a time the economy is growing.
Jittery bond investors have been gearing up for higher rates for more than a year, but Alan Greenspan, the Fed chairman, was until recently more worried about high unemployment and a prospect of deflation.
In an effort to keep long-term interest rates down, the central bank took the unusual step last year of declaring that it would keep the benchmark federal funds rate low "for a considerable period." It backed away from that pledge in January, saying only that it would be patient, and then again in May by saying that future rate increases would be "measured."
The Fed appears determined to avoid the experience of 10 years ago, when it raised rates more sharply than investors had been expecting, jolting the markets.
But Richard DeKaser, chief economist at National City Bank in Cleveland, said the circumstances were far different now.
"In 1994, the Fed was famously pre-emptive," DeKaser said. "They were raising rates with virtually no evidence of inflation, and the Fed was having to do back flips to justify its actions. In the current environment, we've gotten an upturn in the trend of inflation. There is no way it can be characterized now as pre-emptive."
Greenspan has thus far taken a different view on inflation. Testifying to Congress last month, he acknowledged that prices had been rising but said the overall "slack" in the economy -- relatively high unemployment and substantial unused factory capacity -- made it unlikely that wages or prices were about to rise rapidly. Even if wages did rise, he added, corporate profits have been so high in the last year that businesses are more likely to absorb the costs than risk losing market share.
Lawrence Meyer, a former Fed governor and now a senior adviser at Macroeconomic Advisers, a forecasting firm, said, "The Fed has a very benign interpretation about inflation, and the markets have a much more pessimistic view."
The big question is how much the Federal Reserve will raise short-term rates before it decides that monetary policy is no longer encouraging inflation.
Robert Parry, president of the Federal Reserve Bank of San Francisco, noted recently that the federal funds rate had averaged some 2.7 percentage points above the rate of inflation. If inflation settles around 2 percent a year, that would imply that the benchmark short-term rate would eventually have to reach nearly 5 percent -- a huge increase from 1 percent now.
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