Source: The Economy — and Inflation — Will Continue to Run Hot | NomicsNotes from NumberNomics
March 11, 2015
All eyes this week will be on the outcome of the Fed’s Open Market Committee meeting. The Fed will likely boost the funds rate from 0.0% to 0.25%. That is the initial step of a much longer two-step process. First, the Fed must decide how quickly and by how much it intends to boost short-term interest rates. Second, it must shrink its currently bloated balance sheet to eliminate excess liquidity from the economy. The policy statement released at the end of the meeting will say that it intends do everything it can to bring inflation back down to the 2.0% objective quickly. But the reality is that its current policy is so far out of whack that it will take years to achieve that objective.
The Fed believes the funds rate is “neutral”, i.e. neither stimulating nor retarding the pace of economic activity, when it is about 2.5%. But the appropriate level of the funds rate is determined by the “real” or inflation-adjusted rate. Through periods of Fed tightening, easing, and neutrality since 2000 the real rate averaged 0.5%. Thus the Fed has concluded that its policy is “neutral” when the funds rate is about 0.5% above its 2.0% inflation target, or 2.5%.
