Magazine article Economic Trends

Monetary Policy

Magazine article Economic Trends

Monetary Policy

Article excerpt

On May 10, the Federal Open Market Committee (FOMC) voted to raise the intended federal funds rate 25 basis points (bp) to 5.00%. That move brought the rate within 150 bp of its most recent high, 6.50%, reached at the last business cycle peak in May 2000. Although the May 2006 press release stated that "some further policy firming may yet be needed," it emphasized that "the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."

The May meeting marked the sixteenth consecutive increase of 25 bp by the FOMC, raising the fed funds rate a total of 400 bp from its low of 1% in June 2004. Although this tightening cycle has brought a larger total increase than the previous two, it has also lasted much longer (679 days). In comparison, the 2000 tightening cycle brought a rise of 175 bp over 321 days, and the 1994 cycle increased the target 300 bp over 362 days.

Since the beginning of April, the expected outcome of the June meeting has alternated between 5.00% and 5.25%. After the GDP report on April 28, participants in the federal funds options market seemed to settle on a 60% probability of a pause at the next meeting. However, the CPI report released on May 17 sparked fears of inflation and another 25 bp increase in the fed funds rate. Currently, the odds of a further rate increase are 55%.

The Taylor rule views the federal funds rate as reacting to a weighted average of inflation, target inflation, and economic growth. According to this equation, the current federal funds rate is well within its recommended range. …

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