Long Term Perspective

The Federal Reserve targets the federal funds rate (the rate that banks charge each other for the use of overnight funds) in order to loosen or tighten monetary policy. The nominal fed funds rate target, on its own, doesn’t tell us whether monetary policy is tight or loose. It is easier to see whether policy is restrictive or accommodative by the relationship between the funds rate target and the inflation rate. We use the year-over-year change in the core (excluding food and energy) PCE (personal consumption expenditure) price index. When policy is accommodative, the gap between the two series narrows; when policy is tight, the gap widens. The core inflation rate, measured by the PCE price index excluding food and energy prices has eased below the upper level of the Fed’s implicit target range of 1 to 2 percent. Changes in inflation tend to have long lags from changes in monetary policy.

Short Term Perspective

The core PCE price index has trended down during the middle of 2007 and stood at a 1.9 percent year-on-year rate in October 2007.  This is down from a recent high of 2.5 percent seen in February 2007. Currently, the Fed is in somewhat of a dilemma as labor markets remain tight and oil prices are at record high while at the same time the subprime lending problems have created a tightening in credit that clearly has adversely affected housing but now appears to be spilling over into the consumer sector and manufacturing. The Fed took “insurance” out on September 18 against stopping too weak economic growth by cutting the fed funds target rate 50 basis points and then the Fed cut by another 25 basis points on October 31. Concern over too weak economic growth may be the biggest issue at the Fed’s December 11 FOMC meeting but inflation is still a concern for the Fed.