As homebuyers and industry professionals look for an economic beacon to follow in order to avoid crashing on the rocks, Realty Times finds itself inundated with forecasting requests, many of which center on what the FED is going to do in terms of raising or lowering short term interest rates in the spring.

A Realty Times reader writes:

Blanche, Just finished reading your article on the Fed Funds rate and would like to know the answer to the following two questions:

• how does one measure core inflation, and

• where are the inflationary signs that would cause the Fed to ratchet-up the target Federal Funds rate in 2007?

I keep hearing various and sundry economists claiming that the Fed will reduce rates by at least 75-basis points, in the coming year ... which does not sound like they are concerned about inflation. Also, they are saying that Greenspan said that the "inverted yield curve" does not presage a recession in this particular instance and the nature of the inversion is different from those quoted in historical times. Thanks, Steve

Realty Times responds:

I assume you are couching your question in terms of real estate, so we'll respond that way.

Putting a box around economic data is difficult because economic strategists assign different values to data and their impact on real estate sales. Measuring core inflation is just one of those data points.

Inflation simply means rising prices. Core inflation is a calculation of consumer goods and their prices, including retail and service establishments and rents from 87 urban metro areas, which is measured monthly in the form of the Consumer Price Index , (CPI) a service provided by the U.S. Department of Labor, Bureau of Labor Statistics. This index excludes the most volatile items, energy and food. There are other ways to measure core inflation, such as indexes which track consumer prices and throws out those products with the largest price changes, but the CPI is generally the most closely followed index.

The CPI covers the most major consumer expenditures for urban households -- food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services. Then energy and food prices, due to their volatility, are excluded, to provide the monthly CPI.

There is also the Producer Price Index (PPI), which measures selling prices by domestic producers of goods and services. Formerly known as the Wholesale Price Index, the PPI is industry-based and includes industries such as goods manufacturing, fishing, agriculture, and other commodities, via information collected from over 100,000 firms. Says the Bureau, "The PPI is also used extensively used by company officials for determining future supply or sales contracts. For example, a sudden rise in the PPI could mean that future sales contracts will also rise." The PPI has a huge weakness, however, particularly considering the current trade deficit. It doesn't include prices for imported goods.

"As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy," says the Bureau.

The policy to which the Bureau is referring is the rate of funds set by the Federal Reserve, or central bank, which occurs after the Fed governors review CPI, PPI, and other data. The Fed raises or lowers short-term interest rates -- the terms that banks receive in order to borrow money from the central bank. When banks, in turn, loan money to businesses and consumers, they make a profit by loaning money out at a higher rate than they pay the central bank. It follows that mortgage interest rates typically exceed the Federal Funds rate, currently at 5.25 percent. When borrowing rates fall below Fed Fund rates, that usually signals a slowing of the economy because banks can't afford to lend money at lower rates than they are paying for funds.

According to Senior Forecast Economist Lawrence Yun of the National Association of Realtors, mortgage rates have historically had the biggest impact on home sales and prices -- particularly over the short run. When mortgage rates are low, more people buy homes, but that doesn't always hold true either. For example, mortgage interest rates slowed considerably in Q3 and Q4, after a rapid run up to nearly 7 percent for a 30-year-fixed rate mortgage loan. Yet, sales slowed considerably, too, suggesting that consumers pay attention to other indicators besides mortgage interest rates.

"Income growth and job gains also impact, but more on a steady basis over the long term," says Yun. "Also affordability (e.g., where home prices rise very fast) can impact demand because people simply cannot afford to buy. Interestingly though, psychology is evidently playing a role in the current environment. Sales weakened in 2006 despite job growth, income gains, and low rates because people think that prices may decline and want to hold back."

Whether the Fed will raise or lower short-term interest rates is anyone's guess, because the smartest minds in America disagree about what the Fed will do and that's because the Federal Reserve governors aren't always in agreement about the meaning of economic indicators, how much impact they will have, or if they are long-term trends. For example, a jobs report that suggests that 9,000 more people lost jobs last week might spook some economists, but the Fed governors might take a wait-and-see approach. Is there a trend developing where people are losing jobs week after week? Does that correspond with lack of job creation?

So, to answer your question between the lines - how does inflation impact mortgage interest rates? "Lenders (global bond holders) want to protect that their money when returned does not get chipped away by inflation," explains Yun. "Therefore, if the bond holders feel confident that inflation is under control, then they will demand lower inflation premiums. If inflation is on the horizon, then the bond holders want higher rates to compensate for the loss in the purchasing power when the money is returned."

How do we know if inflation is advancing or receding? "The Federal Reserve and bond holders pay more attention to core inflation because the core provides a better picture about the underlying trend in inflation," says Yun. "It is rare to see prices decline. The focus is on acceleration or deceleration (inflation rising faster, or inflation rising slower).

The indicators the Fed is most likely to consider to raise or lower short-term rates are those that indicate the economy is overheating or overcooling. As has been proven the last near decade, it's possible for consumer prices to rise, yet for the economy to stall which is why short-term interest rates were lowered two years ago to a near nadir. Conversely, raising short-term rates over the last two years hasn't cooled the economy, but has aided in holding inflation in check.

Since 1968, when the NAR first began tracking home sales, home prices have beaten the rate of inflation by about one or two percentage points annually. If prices are rising at a rate of 3.5 percent a year, then home prices will return 4.5 to 5.5 annually. Since 2001, home prices have handily beaten inflation rates, but now they are returning to more normal gains, which suggests that while sellers may sell their homes for less than their neighbors received a year ago, homeowners will still "make money" on their homes in most cases.