By William A. Niskanen
This article appeared in the Wall Street Journal on June 23, 2006.

Ben Bernanke and the Fed face a critical test at the Federal Open Market Committee meeting next week that will demonstrate whether they are serious about constraining inflation.

The consumer price index has now increased at a 3.3% annual rate for two years, neither a transient condition nor consistent with Mr. Bernanke’s proposed inflation target of 1% to 2%. At the same time, the prices of commodities, housing and equities show signs of a slowing economy. Should the FOMC continue to increase the Fed funds rate in order to reduce the inflation rate? Or should it pause for a while, given the selective signs of a slowing economy and a concern by many about the potential effects on the mid-term congressional elections this fall?

My vote is for another 25-basis-point increase in the Fed funds rate. Nominal demand has increased at a 7.4 % annual rate for two years, far too high to reduce inflation. As of the first quarter of 2006, nominal demand was even higher above the 5.4% trend than it was in the peak quarters of 1990 and 2000. In order to reduce the inflation rate to around 2%, given an expected real GDP growth rate of 3% to 3.5%, the increase in nominal demand must be reduced to the trend rate of 5.4%.

The danger is that a reduction in demand growth may fall below the trend rate and trigger a weak recession like those of 1991 and 2001. That is not a wholly satisfactory outcome. But the alternative is an increase in the inflation rate and a larger recession following the demand restraint necessary to bring the inflation rate down to a tolerable level.

The next FOMC meeting is on Aug. 8, when the first estimates of the national income accounts for the year’s second quarter will be available. If the increase in nominal demand is still substantially above trend, there will be no alternative to another increase in the Fed funds rate. But if the increase in nominal demand has fallen sharply toward the trend rate, it will be time for a rate pause. The direction of subsequent changes in the Fed funds rate should thus be based on whether nominal demand is above or below the trend rate of increase.

Mr. Bernanke and other members of the FOMC should stop speculating about future changes in the Fed funds rate. They could provide a lot of useful information to the financial markets, however, if they were more explicit about the conditions that affect their decisions on the Fed funds rate.

Mr. Niskanen, chairman of the Cato Institute, was a member and acting chairman of the Council of Economic Advisers under President Reagan.