Effect of Federal Funds Rate on CPI and PPI

Abstract

One of the crucial jobs of central banks is to rein in inflation as it creates uncertainty in the economy and in private investment and ultimately negatively impacts the economy. If the source of inflation is positive demand shock, then raising the federal funds rate target is the right way to rein in inflation. If the source of inflation is negative supply shock, then raising the federal funds rate target will make things worse. In this study, the impact of FFR (federal funds rate) on CPI (consumer price index) and producer price index (PPI) is examined. Findings indicate that raising the federal funds rate will have a negative impact on both CPI and PPI with a 2-period lag. The possible explanation of this finding is that raising federal funds rate lowers aggregate demand, lowers the price level and thereby the CPI. And when CPI falls, it lowers per-unit profit, prompting producers to cut supply, which in turn lowers the demand for producer goods and services, and thereby lowers PPI.