Long Term Perspective

While the Fed uses changes in the fed funds rate to implement monetary policy, it is the "real" fed funds rate that borrowers and lenders really give attention. The true cost of borrowing is on an inflation adjusted basis. That is, inflation erodes the true cost of paying back the cost of funds borrowed. When making the decision to borrow fed funds, the real rate is nominal fed funds minus the expected rate of inflation. However, the expected rate of inflation is difficult to measure and it is common to estimate the real funds rate using actual inflation rates instead of expected inflation rates. To discount some monthly volatility, it makes sense to use a measure along the lines of a year-ago growth rate. The chart below shows the real fed funds rate based on using headline (overall) PCE inflation and core PCE inflation (excluding food and energy).

 

During the second half of the 1990s, the real fed funds rate was high due to a high nominal fed funds rate as inflation was moderate. In the early part of the last decade and this decade as well, the real fed funds rate was kept low and even negative to fight deflation risks and sluggish economic growth.

 

 

Short Term Perspective

At the June 2008 FOMC meeting, the real fed funds rate became a key debating point over whether policy was too loose and was accommodating inflation. This issue has resurfaced from time to time since. By either measure using headline inflation or core inflation, the real fed funds rate is very low – hitting a low of minus 2.8 percent annualized in September 2011. FOMC members arguing that the real funds rate was not too low took the position that credit markets were still fragile from the subprime crisis and that financial institutions, despite low rates, were reluctant to lend.

 

 

Oil prices rose in 2010 and 2011 and bumped the real fed funds rate back down. But lower energy costs lowered inflation rates in spring 2012, leading the real fed funds rate back up but still in the negative range. A slowing in PCE inflation in 2013 led the real fed funds rate to be less negative while the collapse in oil prices in late 2014 and through 2015 created a separation between the funds rate using the total PCE index, which moved up toward zero, vs. the core PCE which remained in the negative column.