top of page

The Federal Funds Rate-connecting the dots.

In yesterday’s Federal Open Market Committee (FOMC) meeting, it was voted that the current 0% to 0.25% target range for the federal funds rate is consistent with facilitating the Fed’s employment and inflation goals. This is the same range the committee has set since December of 2008. Note, although the rate target is 0% to 0.25%, the effective rate is an actual rate banks charge each other for overnight loans. See chart below for a historical perspective of the target and the effective rate.

Source: www.newyorkfed.org

In summary, the Fed feels the recent global economic and financial developments (Though not stated, I imagine this to be the China slowdown in addition to the mentioned collapse of commodity prices) may restrain economic activity and may put near-term pressure on inflation. It was encouraging to hear that household spending and business fixed investment have been increasing moderately as this could help alleviate the downward inflation pressures. The Fed reiterated a target inflation of 2% and a ‘maximum employment’ objective. In their closing paragraph, it was noted that even if employment and inflation targets are met, the fed funds rate could be kept at below normal levels for some time. This is not to say that it will be kept at 0% to 0.25%, but rather below the normal range of 3%-4%

What inflation index does the Fed use? There are many different variations of inflation. For the Fed, they consider several different indexes due to the different products & services tracked as well as the calculation methods. However, the primary measure is the annual change in the personal consumption expenditures price index (PCE). In the July release from the Bureau of Economic Analysis, the annual change increased +0.3%. If we strip out food and energy, the change was +1.2%. Given the Fed’s inflation target of 2%, and the depressed state of energy prices, one can understand the reasoning for keeping the rate target at 0% given inflation levels.

What does the Fed consider to be ‘Maximum Employment’? There is no formula or set of data points that they use. Rather, it is based upon the non-monetary factors that affect the job market. Further, the FOMC relies upon its members’ input on the assessment of the employment market. It is noted that the FOMC participants’ estimates for longer run normal rate of unemployment ranged from 4.7% to 5.8%, with a median value of 4.9%. As such, I can guess ‘Maximum Employment’ would coincide with an unemployment rate of approximately 5%, among the other non-monetary factors. In the most recent release from the Bureau of Labor Statistics, the U.S. unemployment rate for July was 5.3%. This has been a steady decline from the 10% seen in 2010.

Looking Ahead:

The Fed released the following chart detailing the various projections of the federal funds rate target as made by the committee participants. Each dot represents a participants’ expectation of where the fed funds rate target will be at the end of the specified calendar year. I found the following noteworthy. First, the range of expectations increases for the end of year projections for 2016 and 2017. In a reading of the end of 2016 projections, there is one participant who feels a 0% target is appropriate, and another who feels 2.75% is appropriate. This is a large variation, and may perhaps be an indication of the interest rate uncertainty that could be expected through 2016. Secondly, it appears rate normalization is expected by the end of 2018. This would be consistent with the duration of the most recent rate hike environment (June 2004 to June 2006) in which the target increased from 1% to 5.25%. The Fed increased the target by 0.25% at each of the FOMC meetings during that time span in a deliberate and predictable fashion. Markets do not like uncertainty and thus reacted favorably in light of the consistent policy response. Looking at the dots below, one can hope the FOMC will consider a similar and steady path of rate increases should it be congruent with their duel mandate of employment and inflation.

Source: www.federalreserve.gov

Cory Nakamura CFA, CFP®

Chief Investment Strategist and Financial Advisor

CFA Charterholder

CERTIFIED FINANCIAL PLANNER™ professional

Honolulu|Hawaii

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Recent Posts
Archive
bottom of page