The FOMC: 5 More Months?

November 2, 2005 – The FOMC voted on Tuesday to raise its Fed funds target by 25 basis points to 4% – the twelfth 25 basis point increase (Chart 1).

Chart 1. The target Fed funds rate. Nominal and real. January 1987 through October 2005.

According to the post-meeting policy statement, monetary policy remains “accommodative” – a signal that the FOMC is not done tightening yet.

With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” In other words, contingent as always on the economic data, the FOMC expects to continue to raise its Fed funds target in small 25 basis point increments.

The policy statement also reminds us that any hurricane-related slowing in real economic activity will probably be followed by a hurricane-related rebound. Thus, the FOMC will remain inclined to ignore any near-term weakness in real economic activity.

Finally, the FOMC will continue its heightened inflation watch, but judged that its worst inflation fears have yet to be realized. “Core inflation [excluding food and energy prices] has been relatively low in recent months and longer-term inflation expectations remain contained”.

The FOMC’s policy goal is to restore its Fed funds target to a neutral level. According to the best guess here, the neutral real Fed funds rate is about 2.7%.[1]

The chained price index for personal consumption expenditures excluding food and energy (the FOMC’s preferred inflation indicator) rose by 2% for the 12 months through September (Chart 2).

Chart 2. The chained core consumption price index. Year-ago percent change. January 1987 through October 2005.

Assuming a steady inflation trend, this suggests a neutral nominal Fed funds rate (the rate directly targeted by the FOMC) of about 4.7% (2.7 + 2.0).

A 25 basis point increase at each of the FOMC’s next three policy meetings would bring the Fed funds target to 4.75% (roughly neutral?) by the end of March next year.

Suzanne Rizzo