Last week, we looked at the historical range of Federal Reserve Funds since 1946.
It was a simple mean reversion, and did not incorporate the post WWII price controls, the 1970s inflation spike, or the Bretton Woods agreement.
As such, some implied that it overstated Fed Funds rate. Marketwatch’s Rex Nutting had the suggestion that it would be instructive to look at real versus nominal Fed rates (see update 2).
After the Fed meeting, Rex did just that, and analyzed the real (after inflation) Fed Funds Rate. His conclusions?
"Adjusted for the increase in the consumer price index, the real federal funds rate has averaged 1.75% since 1956. Currently, the real rate is about 1.10%, with a fed funds rate of 4.75% and a trailing inflation rate of 3.65%.
To bring rates back to the 50-year average, the Fed would need to raise rates or lower inflation by a cumulative 0.65%."
Ahhh, but that’s a simple mathematical exercise (like ours) that does not consider all the variations in economic time periods — including periods of "low inflation and modest growth, times of high inflation and no growth."
Which raises the obvious question: What has the Fed Funds Rate looked like in similar periods of high productivity and high growth?
"The Fed achieved a soft landing in the economy in 1995. From late 1994 through mid-1998, the Fed managed to keep the fed funds rate relatively steady between 5.25% and 6%. The economy prospered, growing at an average rate of 3.7%. Inflation averaged 2.5%.
During that time, the real fed funds rate averaged 3.1%, two full percentage points higher than today.
This analysis suggests that, in a period of high productivity and high growth, it may take a somewhat higher real funds rate to keep inflation low.
If the Fed wants a 3.1% real funds rate, it might have to boost nominal rates another 2 percentage points to 6.75%. The Fed probably wouldn’t have to do all eight quarter-point hikes, because that much tightening would probably have some impact on lowering the inflation rate (otherwise, why do it?).
If inflation rates moderated to 2.5% or so under the pressure of Fed tightening, the Fed could probably stop at 5.50%
That’s my number (as well Lehman Brothers). To get there requires three more 1/4 point hikes.
As to that soft landing, I would point out that the 1995 was a period in the middle of a secular Bull Market. Technology, networking and computers were the prime drivers, creating a virtuous cycle that powered the economy and markets higher. It was an organic business cycle expansion that kept going until it reached an upside blowoff in Spring 2000.
That is quite different than the present stimulus driven economy. The Fed’s tools are not being used to moderate this hot economy; Rather, they are slowly removing the economic stimulus namely, pulling interest rates up from 46 year lows.
Those are the prime differences between 1995 and 2005: a secular bull market driven by organic economic expansion, versus an economy that has been driven purely by a combination of government (war spending, tax cuts, deficit spending) and Monetary (rate cuts, increased money supply) stimulus.
Monetary policy still far from normal
MarketWatch, 8:24 PM ET Mar 28, 2006