0
$\begingroup$

According to the Fed's own forecasts inflation should reach 2% (as vowed) shortly after 2025 under normal circumstances from the below chart.

enter image description here

I know that generally as Federal funds rate increases, core PCE inflation rate decreases because the Fed fund rate puts pressure on the core PCE inflation rate. However, if the Federal funds rate starts to decrease from 2023 onward and core PCE inflation rate also decreases from 2023 onward, then what is the relationship between Fed funds rate decreasing and core PCE inflation rate decreasing? If the Fed funds rate drops, then why does core PCE inflation rate also drops?

$\endgroup$

1 Answer 1

1
$\begingroup$
  1. You can't figure out relationship between two variables from forecasting values in the table. The table does not imply that there is positive relationship between interest rate and inflation.

    Here you can see plotted values for US spending on space research and suicides. Obviously there is no relationship yet the values move together.

    Now to be clear inflation and interest rates are related but the relationship is negative not positive. You can't see that from a single table you need to actually do some serious data analysis.

    Serious data analysis using vector autoregressions (VAR) shows that higher interest rates lead to lower inflation (see Ch 15 of this IMF report). There are also other careful studies that show this as well. You can find lot of references in any macro textbook.

enter image description here

  1. The models Fed is using are not in public domain so exact reason why the forecasts are as they are is hard to say, but the reason why Fed rate and inflation is moving together is that Fed probably believes that the shocks that lead to the inflation (such as supply shocks caused by covid lockdowns or demand shocks caused by all the spending), will slowly die out so to keep low level of inflation Fed will need lower interest rate than to keep low level of inflation now.
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.