May 22 (Bloomberg) -- Most folks listen to Federal Reserve policy makers not because they are students of central banking or they find the dulcet voices soothing. They listen for one and only one reason: They want to know where the benchmark interbank rate will be going forward.

The level of the funds rate, which the Fed sets, affects economic growth and inflation. It determines how certain asset classes perform relative to others. It influences consumer and business decisions about spending, saving and investment.

With policy on hold for the foreseeable future -- a future, Fed officials note, clouded by a high degree of ``uncertainty'' - - those of us who write about such things don't have a whole lot to say.

Cruising for a topic that wouldn't have ``housing'' or ``mortgage'' in the first paragraph, I decided to glance at Fed Vice Chairman Don Kohn's May 20 speech. The major takeaway, at least as far as financial markets were concerned, was this: The Fed is on hold, an assessment already reflected in the prices of fed funds futures contracts.

What grabbed me was something else. Kohn said that ``monetary policy is appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term.''

I had to read the second part a second time to make sure I had read it correctly. How can a 2 percent funds rate be appropriately calibrated to promote moderating inflation when inflation is currently rising at almost 4 percent?

Zero Percent Financing

It costs virtually nothing for a financial institution to borrow. Better yet, they get paid for it.

If you borrow at 2 percent for a year -- and the Fed is doing everything in its power to make sure banks and bond dealers have easy access to cheap Fed credit -- and inflation is rising at 4 percent, the real cost of borrowing is negative 2 percent.

How does that promote a moderation in inflation? To the contrary, it encourages borrowing for the sake of, well, borrowing. Even an asset that yields a low rate of return is a good deal when it can be financed at a negative real rate.

At this point, moderating inflation seems more of a hope than a forecast. By all rights, the credit crisis, closing in on its one-year anniversary, should have constrained inflation: Money and credit are the stuff of which inflation is made. But it hasn't happened yet.

In the minutes of the April 29-30 policy meeting, released yesterday, Fed officials were ever-hopeful once again, expecting ``inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other prices and an easing of pressures on resource utilization.''

1 + 0 = 1

In other words, if only those pesky raw materials prices would stop going up, why the rate of increase in overall goods and services prices would slow!

This is more an arithmetic observation than an economic forecast. If commodity prices stop rising, and all other components of the consumer price index keep to their existing trend, then, yes, the rate of inflation would be lower than it is now.

The prices of commodities, which account for 42 percent of the CPI, rose 4.8 percent in the year ended in April, according to the Bureau of Labor Statistics. Without the jump in food and energy, core commodities rose just 0.1 percent, according to the BLS. So food (up 5 percent) and energy (up 16 percent) are the primary culprits.

At the wholesale level, crude materials prices were up 34 percent in the past year, led by a 52 percent surge in energy. Without food and energy, crude materials prices were up 25 percent, according to the BLS.

Pop Quiz

So yes, if these prices would stop rising, it would make a big difference. We'd be back to that 2 percent ain't-life-great rate of inflation, after four years of consistently overshooting the target, at least with food and energy included.

In the latest forecast, policy makers revised their projection for 2008 inflation (they use the personal consumption expenditure price index, not the CPI) to a median range of 3.1 percent to 3.4 percent. That's a full percentage point higher than the January forecast.

In the medium term -- that would be 2010 -- the Fed expects the PCE price index to rise 1.8 percent to 2 percent, within its target.

Kohn and his colleagues should stop kidding themselves and the rest of us. There is only one reason the funds rate is at 2 percent. Take a guess. The answer isn't, to bring inflation down.

The correct answer is, to prevent the U.S. economy and financial system from cratering. The Fed did what it had to do to prevent what it thought was a greater evil. Better to say that than pretend a 2 percent funds rate is an inflation-moderating level.

History Lesson

Previous episodes of a negative real funds rate haven't worked out so well. There was an extended period in the 1970s; you know how that story ended. Then there was the recent foray from 2002 through 2005, which made adjustable-rate mortgages such a steal at a time when home prices were soaring.

Then again, maybe this time is different.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: May 22, 2008 00:05 EDT