Participants in financial markets are beginning to wonder if the Federal Reserve is "behind the curve." Some believe that the Fed is hopelessly behind the curve. The economy has been growing strongly over the past year. Based on our forecast for the second quarter (a 4-3/4 percent annualized growth rate), real GDP in the past year has risen 5-1/4 percent. That is well above almost anybody's estimate of the economy's long-term growth rate. The April employment report strongly suggests that solid growth is continuing in the second quarter. Inflation pressures are building in the pipeline. Basic commodity prices other than food and energy have risen sharply, and in recent months the spillover into prices at later stages of production and processing is increasing. The Fed's favorite measure of inflation, the chain-type price index for personal consumption expenditures (PCE) excluding food and energy, rose at an annual rate of 2 percent the first quarter, and that is probably at the upper end of the Fed's comfort zone. Energy prices have risen substantially, and consumers are facing numbingly high prices for gasoline and fuel oil.

Federal Reserve officials are aware of the need to increase short-term interest rates from their forty-year lows. Federal Reserve Chairman Alan Greenspan acknowledged as much in recent Congressional testimony, and the press release following the May 4 Federal Open Market Committee meeting made it official. The language previously indicating that the Fed could be patient in removing policy accommodation was removed, opening the door for an early increase in the federal funds rate.

The language of the press release clearly indicates, however, that the Fed does not think it is behind the curve. Indeed, the last sentence of the press release states that "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a measured pace."

So who is right? At issue is whether significantly higher interest rates are needed to slow the economy's growth to a sustainable pace. At issue, also, is whether recent indications of inflation pressures bubbling up in the pipeline are a harbinger of more widespread price increases down the road. We deal with each issue in turn.

For some time, our forecast has anticipated a slowing of economic growth to around 4 percent during the second half of this year, even without significant steps by the Fed to raise short-term interest rates. The principal reason is the outlook for consumer spending.

In recent years, consumer spending has been growing robustly, buoyed by large tax cuts and record levels of mortgage refinancings. Over the past year, personal consumption expenditures in constant dollars rose 4-1/4 percent. A year ago, roughly three-fourths of mortgage loan applications were to recast existing mortgages; the percentage is now below fifty percent and falling. Tax refunds stemming from the 2003 tax cut are still helping to sustain consumer buying this spring, but that support will soon end. The withdrawal of these two stimulants is sufficient reason to expect a moderation in the pace of consumer buying, but added to that is the effect of higher energy prices. In the first quarter, consumer purchases of gasoline, fuel oil, other energy goods, electricity and natural gas were $93 billion at an annual rate above the level two years earlier. That is $93 billion that is unavailable for consumer spending on other goods and services. And the toll may yet go higher.

Individuals in their role as home buyers have also been providing strong support to economic growth. Residential investment has increased 9 percent in constant dollars during the past four quarters, and housing starts are at levels not seen since the middle years of the 1970s, when rates of household formation were boosted by baby boomers reaching home-buying age. There are few, if any, indications as yet that housing activity is cooling. But interest rates on 30-year fixed rate mortgage loans are now back to a little over 6 percent, and history suggests that these higher interest rates will produce a moderate decline in home sales and residential building in the months just ahead.

Other sectors of aggregate demand may, of course, help take up the slack created by developments affecting housing and consumer buying. But the latter two sectors constitute three-fourths of total GDP, and it would take a tremendous boom in other sectors to offset a slower pace in these two areas. Bottom line: real GDP growth would be unlikely to sustain the pace of the past year even if the Fed sat on its hands.

Slower GDP growth, however, might not suffice to dampen inflation pressures building in the pipeline. Yet the Fed's assessment is that "…the risks of price stability have moved into balance," which says that the policy officials regard the probability of a decline in inflation as equal to the chances of an increase. What accounts for their optimism? The May press release does not detail the reasons that undergird their thinking, but we can speculate.

First, crude oil prices have risen about $8.50 a barrel (a rise of 30 percent) over the past year. Crude oil prices may or may not go down from present levels, but it is unlikely that they will continue to rise at this past year's pace. Second, prices of basic commodities other than food and energy have increased nearly 50 percent in the past two years to record levels. These prices may also continue to increase, but continuation of the recent pace of advance seems improbable, particularly with China endeavoring to moderate its rate of economic expansion.

As Federal Reserve Governor Ben Bernanke stated in a recent speech, however, "The dominant fundamental factors influencing the inflation outlook are the ongoing resource slack and the remarkable rate of productivity growth." He dwelt at some length on the amount of slack in the labor market, noting that the payroll employment total in March was still below that of November 2001, the official recession trough. Indeed, payroll employment today is still more than 1.5 million below the peak of the previous business cycle. Bernanke also suggested that the 5.7 percent unemployment rate in March-itself above most estimates of the economy's full employment level-may understate the amount of slack in labor markets. That is true because measures such as the labor force participation rate (the proportion of the adult population working or seeking work) and the employment-population ratio suggest that many individuals have stopped looking for work because of weak labor demand. As job opportunities improve, labor force growth may accelerate, keeping unemployment at relatively high levels even as job gains strengthen from the average of the past several quarters.

By far the most critical issue in the inflation outlook is the prospective growth of productivity. Strong productivity growth holds down inflation in two ways: directly by putting a cap on unit labor costs, and indirectly by moderating the amount of job creation and thus maintaining slack in labor markets. Over the past several years, productivity growth has been nothing short of phenomenal. Some slowing seems inevitable, and recent data suggest that slower growth is in process. Over the past two quarters, for example, productivity has risen at a 3 percent annual rate, compared with an increase of 5-1/4 percent during the previous year.

Our forecast assumes that productivity continues to advance at approximately a 3 percent annual rate. With that assumption, unit labor costs-which constitute two-thirds of business costs-are expected to rise by about 1 percent a year. Inflation would then remain moderate, with the PCE chain price index rising by 2 percent or less.

The productivity assumption is critical to this benign outcome for inflation. For example, if productivity growth were one percentage point less, the same growth rate of real GDP would, over a two-year period, create 2.5 million more jobs and lower the unemployment rate a full percentage point. Inflation would increase by a full percentage point, if not more.

We are optimistic that productivity growth will stay robust, and that assumption likely provides the principal basis for the Fed's optimistic views on the outlook for inflation. Accordingly, we anticipate a slow and gradual upward movement of short-term interest rates over the next year or two. We expect the Fed to raise the funds rate by 25 basis points at its late June meeting and another 25 basis points in August. By early next year, the funds rate is expected to be up one percentage point and moving progressively higher over the course of 2005. Long-term rates will move up somewhat also, but the yield curve is expected to flatten considerably.

Quite frankly, the outlook for productivity is highly uncertain. It could rise more slowly than we have assumed. Or it could rise faster. Federal Reserve officials are well aware of that. If productivity growth proves disappointingly slow, policy accommodation may have to be removed at something more than a "measured pace." We may be entirely sure of one thing: the Federal Reserve will not sit idly by and fritter away the hard won gains against inflation made in the past quarter century. If inflation pressures prove to be stronger than we expect, Federal Reserve policy will be adjusted accordingly.

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