January 2006

On December 13 the Federal Reserve’s Open Market Committee (FOMC) raised the federal funds rate, the principal tool for setting monetary policy, by 25 basis points to 4.25 percent. At the same time, the Federal Reserve Board of Governors greatly simplified what had been a tortured statement explaining the basis for their actions and the factors that will govern future actions. The statement was remarkably brief:

Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives. (emphasis added)

Markets broadly interpreted the statement as implying 25 to 50 basis points of additional tightening to come. Most analysts leaned toward two additional increases--one on January 31, 2006 (Chairman Alan Greenspan’s last meeting), and another 25 basis points on March 28, 2006, the first meeting to be led by incoming Federal Reserve chairman Ben Bernanke.

Markets May Underestimate Need to Tighten

As is often the case, the market’s current view of the future path of Fed actions may be misguided. The American economy, and especially the American consumer, is not behaving as if monetary policy is restrictive. And in fact, with real interest rates (market rates minus inflation) at about 2.25 percent and growth at 4.25 percent, monetary policy is not restrictive.
 
The Fed is fully aware of the possibility that monetary policy may need to tighten more than markets expect. One of the four sentences in that December 13 press release, “Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures,” says as much.

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