Long Term Perspective

The real (inflation-adjusted) rate of interest indicates the degree of constraint in the financial market. In this case, the federal funds rate (controlled by the Fed) is compared to the yearly change in the core personal consumption expenditure price index, that is, the PCE price index excluding food and energy prices. A wide gap is evident in the late 1990s, and this points to relatively restrictive monetary policy, not an unusual occurrence during an economic expansion. When the core PCE price index and the fed funds rate were equal in 2002 and 2003, it signaled an accommodative policy stance. The gap widened in 2004 as the Fed tried to achieve a more neutral policy. The fed funds rate finally became higher than the inflation rate in 2005 after several the Fed raised rates several times in 2004 and 2005. The gap remained high in 2006 as the Fed continued to boost the fed funds target during the first half and held steady in the latter half and into 2007. The core PCE price index in the first half of 2007 has begun to respond to the Fed’s earlier tightening and by mid-2007 had eased into the upper portion of the Fed’s implicit target range of 1 to 2 percent inflation.  However, on November 20, 2007 the Fed began releasing its economic forecast on a quarterly basis and with a three year forecast horizon. The longer forecast now seems to imply that the Fed’s implicit target for inflation is 1-1/2 to 2 percent.  The central tendency forecast for 2010 for the core PCE price index was 1.6 to 1.9 percent.

Short Term Perspective

The Fed cut the fed funds target rate by 50 basis points at its September 18 FOMC meeting in order to keep the recent turmoil in the credit markets from spreading to other sectors of the economy and then cut again on October 31 over credit concerns and also due to weak economic data. The Fed indicated that risks to the economy between weak growth and too high inflation are basically balanced. The fed funds target rate currently is at 4.50 percent. The Fed’s favorite inflation indicator, the core PCE price index, has come down to inside the upper ceiling of the Fed’s comfort zone (1-1/2 to 2 percent). The Fed remains concerned about tight labor markets and that higher energy costs could fuel overall inflation.