*EPF414 05/20/2004
Excerpt: U.S. Interest Rates Likely to Rise Gradually, Official Says
(Gradual approach would allow central bank to adjust policy, Bernanke says) (1250)

Economic developments over the next year are "reasonably" likely to allow the Federal Reserve -- the U.S. central bank -- to raise short-term interest rates gradually when it decides to end its current accommodative monetary policy, a Federal Reserve Board governor says.

Speaking May 20 in San Francisco, Governor Ben Bernanke said that a gradual rate adjustment would allow the Federal Open Market Committee (FOMC) of the Federal Reserve to monitor the evolution of the economy and the effects of its actions, and to make adjustments as needed.

At its last meeting May 4, the FOMC said it believes that its accommodative monetary policy, which has brought interest rates to the lowest level in 40 years, "can be removed at a pace that is likely to be measured."

Bernanke said that although the inflation rate rose in the first quarter of 2004, "core inflation appears likely to remain in the zone of price stability during the remainder of 2004 and into 2005."

He cautioned, however, that his remarks represent a "forecast about the future evolution of policy, not an unconditional commitment," and added that not everyone agrees with his "relatively" sanguine inflation forecast.

Following is an excerpt from Bernanke's remarks:

(begin excerpt)

In my talk I discussed three sets of reasons for gradualist policies: policymaker uncertainty, improved control of long-term interest rates, and the reduction of financial stress. The debate about the sources of gradualism is ongoing and I cannot hope to render a definitive verdict today on the relative merits of these rationales. My sense, though, is that policymakers' caution in the face of many forms of uncertainty and their desire to make policy as predictable as possible both contribute to the gradualist behavior we seem to observe in practice.

I will close by briefly discussing some implications of the gradualist approach for current monetary policy. Before doing so, I remind you once again that the views I express are my responsibility alone.

As you know, in reaction to gathering economic momentum and an apparent stabilization in inflation, the FOMC at its May 4 meeting characterized the risks to both sustainable growth and inflation as being roughly in balance. The Committee's statement ended with the following sentence: "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."

As a number of FOMC members have noted in public forums, the federal funds rate's current setting of 1 percent (which implies a negative real funds rate) cannot be sustained in a growing economy and eventually will have to be normalized. The Committee's statement suggests that, based on current information, it appears likely that this normalization can proceed gradually. As I have discussed today, given the highly uncertain environment in which policy operates, a gradual adjustment of rates has the advantage of allowing the FOMC to monitor the evolution of the economy and the effects of its policy actions, making adjustments along the way as needed. On the margin, a more gradual process may also help ease the transition to higher rates for participants in money markets and bond markets, as well as for households, banks, and firms.

In my own view, economic developments over the next year are reasonably likely to be consistent with a gradual adjustment of policy. It is true that the inflation rate rose in the first quarter, a point to which I will return in a moment. However, policy involves lags and thus must of necessity be based on forecasts. As we look ahead, core inflation appears likely to remain in the zone of price stability during the remainder of 2004 and into 2005. Although slack utilization of resources, which moderates wage and price pressures, is an important reason that inflation is likely to remain subdued, my forecast of controlled inflation is based on more than output gap arguments. Other factors likely to keep inflation at modest levels include continuing rapid gains in productivity, which have kept growth of unit labor costs at a very low level; unusually high price-cost margins in industry, which provide scope for firms to absorb future cost increases without raising prices; globalization and intensified competition in product markets; and the recent strengthening of the dollar. There are also indications that commodity prices, with the important exception of energy prices, may be peaking. Long-term inflation expectations also appear well contained, although inflation expectations over shorter horizons have risen, perhaps partly in reaction to the rise in energy costs.

Not everyone agrees with my relatively sanguine inflation forecast; indeed, some observers have questioned whether the current low level of the federal funds rate is not already excessively stimulative in light of the gathering recovery and the recent inflation data. I would like to make two observations.

First, I do agree that the flare-up in inflation in the first quarter is a matter for concern, and that the inflation data bear close watching. Should the rise in inflation show signs of persisting, I am confident that the Federal Open Market Committee will adjust policy as necessary to preserve price stability. As the qualified and probabilistic language of the FOMC's statement makes clear, the likelihood that the pace of rate normalization will be "measured" represents a forecast about the future evolution of policy, not an unconditional commitment on the part of the Committee. Although I expect policy to follow the usual gradualist pattern, the pace of tightening will of necessity respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front.

Second, however, concerns that that monetary policy is "behind the curve" may not fully take into account a point I made earlier, that the level of the federal funds rate by itself does not fully describe broad monetary conditions. A given level of the funds rate can be consistent with easing or tightening monetary conditions, depending on market expectations about future short-term rates. In part because of the FOMC's communication strategy, which has linked future rate changes to the levels of inflation and resource utilization, and in part because of the gradualist policies that the FOMC has pursued in the past, markets have responded to recent data on payrolls, spending, and inflation by bringing forward a considerable amount of future policy tightening into current financial conditions. Notably, in the past few months, long-term interest rates have risen 100 basis points or more, equity markets have been subdued despite robust earnings reports, and the dollar has strengthened. These developments -- the sort of "front-loading" of monetary tightening predicted by our analysis of gradualism -- will reduce the financial impetus being provided to the economy and thus provide some check to nascent inflationary pressures.

In short, the low level of the federal funds rate not withstanding, broad monetary conditions have already begun to normalize, a development that should tend to limit future inflation risks. Of course, at some point the FOMC will have to validate the general expectation of rising short-term rates; expectations management is not an independent tool of monetary policy. The good news is that, because of the impact of private-sector expectations about policy on current long-term rates, a significant portion of the financial adjustment associated with the tightening cycle may already be behind us.

(end excerpt)

(Distributed by the Bureau of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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