Problem: In his semi annual testimony to the Senate banking committee last summer Alan Greenspan commented on the recent Fed funds rate hike in late June 2004: "With the growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary. In May, the FOMC believed that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured." Since then, the Fed has boosted its Federal Funds target from 1% to 2% and another increase to 2.255 is widely expected this month.
Why did the Fed begin to raise interest rates at a point in the economic recovery with concerns over terrorism and rising energy prices causing great uncertainty, the unemployment rate still at 5.7% and inflation outside of the energy sector still fairly low, although a bit higher than the 1.5% typical of the last few years. (The CPI advanced at an annualized rate of 2.6 % in the first half of 2004 if volatile energy costs are excluded?) Explain your answer carefully and illustrate it with an AS/AD diagram.