South-Western College Publishing - Economics  
Real Federal Funds Rate Approaches Zero
Subject Federal Funds Rate
Topic Monetary Policy
Key Words

Short Term Interest Rates, Economic Growth, and Inflation

News Story

For the fifth straight time, the Federal Reserve raised the federal funds rate by a quarter point, to 2.25 percent. The federal funds rate is the rate that banks charge one another on overnight loans to meet reserve requirements. In raising the target rate, the Fed has reinforced its intent to raise borrowing costs in the U. S. at a "measured pace".

The Fed's action pushed overnight lending rates in the U. S. above those in Europe for the first time since March, 2001. The Fed offered no indication that it intended to change its pace of raising interest rates from their lows last June.

"The committee believes that, even after this action, the stance of monetary policy remains accommodative," the central bank said. In assessing potential inflation and future economic growth, the Fed's statement indicated that the "upside and downside risks remain roughly equal"-- inflation being the upside and economic growth being the downside.

Even with the five straight increases in the rate, the Fed has a long way to go before interest rates are back to neutral--a rate that neither provokes inflation or reduces economic growth. When the current 2.25 percent rate is adjusted for inflation, the result is a "real" interest rate very close to zero, falling well below any definition of neutral. Chief economist at PNC Financial in Pittsburgh Stuart Hoffman predicted that the federal funds rate would rise to about 4 percent by early 2006. "Four percent is kind of like home base for neutral," Mr. Hoffman said, "but it may not reach that level next year."

When Fed chairman Alan Greenspan was asked about what a neutral rate might be, he gave a rather elusive response. Mr. Greenspan told a Congressional committee in July that people would recognize one when they had it.

(Updated February, 2005)

Questions
1.

How does the Fed use open market operations to achieve its targeted higher federal funds rate?

2. What is meant by the term "real" federal funds rate?
3. Discuss the notion of a "neutral" federal funds rate and its effects on the economy. When was the last time that the fed funds rate was in the "neutral" range?
Source Edmond Andrews, "Fed Panel Lifts Rates and Says More Increases Are Probable," The New York Times Online. December 15, 2004.

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