Monetary Policy Stays Put
On January 31, 2006, the Federal Open Market Committee voted to leave the federal funds target rate at 5.25 percent for the fifth consecutive time. The primary credit rate has also been maintained at 6.25 percent. In its press release, the Committee explained that its decision to maintain the status quo was based on the fact that “readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time.” But it also noted that “some inflation risks remain” due to “firmer economic growth” and a “high level of resource utilization.” The next meeting is scheduled for March 21.
The real federal funds rate—defined as the effective federal funds rate less core inflation in personal consumption expenditures (PCE)—remains stable at 2.96 percent. Since January 2004, it has gained 3.61 percentage points.
The monetary authorities’ decision to leave their key interest rate unchanged hardly came as a surprise. At the close of business on January 30, the Chicago Board of Trade’s federal funds rate futures revealed that investors were assigning a 98 percent chance to the possibility that the Committee would leave the target rate unchanged, and a mere 2 percent probability that the Committee would decrease the rate by 25 basis points, from 5-1/4 percent to 5 percent.
Since the end of 2006, investors in federal funds futures have revised their estimates of the likelihood of monetary policy softening in the very near future considerably. In mid-November 2006, they viewed a rate cut by March 2007 as almost as probable as a rate hike or no change. By the beginning of December, the probability of a cut (to 5 percent or 4.75 percent) had climbed to more than 50 percent, thanks to steady inflation numbers and some signs of slowing economic activity (such as GDP growth). Since then, new data have been released indicating both inflation risks and sustained economic activity, and at its latest meeting, the Federal Open Market Committee reaffirmed that “the extent and timing of any additional firming that may be needed to address [inflation] risks will depend on the evolution of the outlook for both inflation and economic growth.” As a consequence, the probability of a federal funds rate target at 5 percent or below has fallen dramatically, and investors now view a federal funds rate at 5.25 percent the most likely event, with a probability above 90 percent.
Similarly, at the beginning of January 2007, the probability of an interest rate cut to 4.75 percent or 5 percent by June 2007 was close to 50 percent. Within a month, this probability had fallen below 20 percent. Currently, investors in federal funds futures believe that interest rates will stay unchanged until the middle of the year, with a probability of close to 2/3.
As the Committee emphasized in its press release, “the evolution of the outlook for both inflation and economic growth” are considered when determining the target federal funds rate. The Federal Reserve monitors price level indices such as the personal consumption expenditure (PCE) deflator and the consumer price index (CPI), and it tightens its policy when inflation risks build up. For instance, the sequence of 17 rate hikes after June 2004 followed increases in the core PCE and core CPI of 0.7 and 0.8 percentage points, respectively, in the first half of 2004. Since August 2006, core PCE inflation has decreased from 2.44 percent to 2.22 percent, and core CPI inflation has decreased from about 2.83 percent to 2.61 percent. The expectation that these core inflation rates would continue to fall to some acceptable levels warranted a pause in the policy of interest rate hikes in 2006.
The Committee also considers its objective to promote effectively maximum employment when determining the stance of monetary policy. The increase in interest rates since the second half of 2004 has accompanied the steady tightening of the labor market. Since the beginning of 2004, the economy has posted large employment gains, approximately 188 thousand workers per month on average. During the same period, the unemployment rate fell from 5.7 percent to 4.6 percent, indicating a high utilization of input factors. Despite higher interest rates, economic activity remains strong. From November 2006 to January 2006, employment increased from 136.9 million to 137.3 million, and real GDP grew at 3.5 percent (in annualized terms) over the last quarter of 2006. The economy has added an average of 171 thousand jobs per month since November.