The January 31 FOMC Meeting
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 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 a “high level of resource utilization.” Because of these inflationary pressures, the committee’s statement continues to suggest that the next move might be up (“the extent and timing of any additional firming”). The next meeting is scheduled for March 21.
The monetary authorities’ decision to leave their key interest rate unchanged did not surprise market participants. At the close of business on the day before the January 31 announcement, the Chicago Board of Trade’s federal funds rate futures revealed that investors judged that there was a 98 percent probability that the Committee would leave the target rate unchanged, and a mere 2 percent that the Committee would decrease the rate by 25 basis points, from 5-1/4 percent to 5 percent.
Although the committee’s language suggests future rate hikes, market participants have, if anything, been predicting that the next move would be a rate cut. In December, they expected the funds rate to be just above 5 percent by midyear, a decrease of nearly 25 basis points. Since then, however, their expectations of the fed funds rate path have risen, and they now anticipate a near-constant funds rate going forward.
Although the committee continues to assert that “some inflation risks may remain,” there is no evidence that long-term inflation expectations have crept up over the past several months. In fact, anticipated inflation, as derived from the liquidity-adjusted, 10-year Treasury inflation-protected securities (TIPS), has fallen from around 2.3 percent at the beginning of the year to just under 2 percent today. It appears that the Federal Reserve has the credibility to keep long-term inflation at bay despite short-term inflationary pressures.
This is undoubtedly why participants’ anticipation of a rate cut has lessened. News on economic activity has generally been stronger than expected since the beginning of the year. With a rate cut, this may not be consistent with stable inflation; therefore, market participants no longer feel that the committee will cut rates going forward.
Certainly, one reason that participants expected the next move to be a cut was underlying uneasiness about the real economy. The fact that the yield curve has been sloping downward over many maturities makes some people uneasy about the future of the real economy; the reason is that yield-curve inversions frequently portend a recession. Currently, the closely watched 10-year, 90-day spread stands at –38 basis points.
The stance of monetary policy is shown not by the funds rate and the future path of the funds rate but by the real funds rate and its future path. The real federal funds rate (defined as the effective federal funds rate less core inflation in personal consumption expenditures) remains nearly steady at 3.0 percent. Since its trough in 2004, however, it has gained more than 4 percentage points.