Healthy Economic Recovery and Rising Real Interest Rates

At the last SOMC meeting in mid-October 2001, amid the post-terrorist attack recessionary environment, my forecast was decidedly contrarian and upbeat: "Aggressively stimulative monetary and fiscal policies point toward rebound?The result will be a V-shaped pattern in economic performance," and cautioned that the Federal Reserve's dramatic easing "eventua lly must be reversed to avoid long-run inflation risks." Indeed, the underlying structure of the economy has proved sound, and the combination of assertive countercyclical economic policies and rapid private adjustments has generated a healthy and rather typical rebound that is expected to gather steam in 2002. Real GDP growth is projected to far exceed its sustainable trend, which raises real interest rates, and nominal GDP growth is projected to accelerate well-above productive capacity, which potentially rekindles inflation pressures. The Fed must promptly raise short-term interest rates. Failure to do so on a timely basis risks exacerbating future swings in interest rates and nominal aggregate demand, generating more erratic economic performance.