Real Fed Fund Rates

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
Rex Nutting
MarketWatch, 8:24 PM ET Mar 28, 2006

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  1. quints commented on Mar 29

    As I read this post, I drew a parallel between the 1995 to 1998 period and the current expansion. At that time, american workers were losing clout to automation and the resentment was from displaced workers replaced by computers. Is that not somewhat analogous to the current effect of globalization on the developed world’s economies? What difference that it was a computer in 1995 vs a person in India or China in 2006. The effect is the same. A boon for business and productivity and a loss for the Developed World’s workers. The same result, namely, higher business profits.
    I think the deflationary pressures of globalization are in some ways similar to the deflationary pressures of the advances in computers and networking 10 years ago.
    Barry, let me know if you agree.

  2. joe commented on Mar 29

    If fed funds goes to 5.50, we are in for a serious recession. Not that I think that would be a bad thing, we certainly need to flush the excesses out of the economy. I’m just not certain Bernanke wants to be fingered as the cause of the first consumer recession in over 15 years. We’re going to have a recession no doubt anyway at some point in the next year or two, the question is whether the fed wants to be seen as having caused it, or instead wants to raise rates just high enough for some exogenous event to be the “proximate cause” of the recession.

  3. GRL commented on Mar 29

    I still like the ring of “6% by the end of ’06.” (3% real FFR + 3% inflation)

    But the more interesting question is, what happens if you do the analysis using non-distorted statistics on growth, employment and inflation (think: John Williams’ “Shadow Government Statisitcs”)?

    What does that do to the relationship of fed funds to these other factors?

    For example, does it validate Paul McCulley’s thesis about where real rates should be?

  4. RJ commented on Mar 29

    Everything you point out about ’94 vs. today is correct, but dont forget that the Fed was much less transparent then, and thus while they were tightening the market incorrectly thought that they were heading to 8% Fed Funds. So, once it became clear that they were not, there was an easing in financial conditions, as long end of the curve rallied.
    During the present tightening the market (both stocks & bonds) has, as you have pointed out, incorrectly thought that the Fed was/is ‘one and done’. The point being that the market did experience monetary relief in ’94 once it became clear where the Fed was ultimatley going. No such relief can be expected presently, as markets have/are continously pricing in a finished Fed.

  5. Sestina commented on Mar 29

    You brought this issue up in your previous post, but does it really make sense to compare real rates before the Boskin CPI adjustments and after? Whether the pre-Boskin CPI adjustment overstates inflation or the post-Boskin one understates it, it seems like the real rates aren’t measuring the same thing so shouldn’t be compared directly.

  6. I, Hans. commented on Mar 29

    Where will hikes stop ?

    The Big Picture: Real Fed Fund Rates: “…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

  7. jeffolie commented on Mar 29

    In the last 6 years the market in MBSs, CDOs and derivatives have exploded. The systematic risk is immense. Address this in your class. For example:


    Should a strike be called, GM could be bankrupt by June, Boulanger said. After that any scenario might play out, but the status of GMAC will be crucial.
    GMAC has traded at a premium to its parent in the credit markets on hopes a controlling stake will be sold, ring-fencing the company and possibly returning it to investment grade. Yet, despite GM’s best efforts, no buyer has emerged.

    Further complicating the outlook, if GMAC is not sold, and GM does go bankrupt, it is uncertain GMAC would be consolidated in the filing.

    For bond investors, a GM bankruptcy would be hard, but a GMAC bankruptcy would be disastrous. GMAC is home to three quarters of the group’s bonds, and is found in a large proportion of outstanding synthetic CDOs.

    “The high degree of portfolio overlap between synthetic CDO transactions sets this asset class apart,” said Standard & Poor’s analyst Andrew South. “A rating action on GM could have a widespread effect on many CDOs.”

    The complex market in CDO squared, or CDOs of CDOs, also faces significant risk following a GM downgrade, one London-based hedge fund manager said.

    “To be blunt — it would be carnage,” he said.

    Part of that carnage would be in the back offices of financial institutions, which will have literally millions of transactions to unwind, and banks are already under regulator pressure over backlogs in credit derivatives.

    Housing bubble

    The wizard of Omaha, Warren Buffett got a very hard lesson and a huge loss. Warren Buffett has stated that derivatives are weapons of financial mass destruction, due to their incredible leverage. “A given [derivatives] contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.” Warren Buffett. March 1, 2006


    Buffett also has some insight into derivatives and the danger they pose to the world (not to mention Berkshire Hathaway’s balance sheet):
    “Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

    We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

    Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.”

    The rest of the Buffett letter to shareholders is on the company web site.


    A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.

    credit derivative

    A contract between two parties that allows for the use of a derivative instrument to transfer credit risk from one party to another. The party transferring risk away has to pay a fee to the party that will take the risk.

    February 2006 issue:
    Versatility For Long-Term Success
    by Howard Schneider

    Mortgage lending has become harder for the Fed to manage as lenders have gone from holding loans in portfolio to selling them in the capital markets. Since the Federal Reserve controls the money supply, it also rationed credit when banks could only lend the cash they had collected from depositors. But now lenders can restore their liquidity by securitizing loans. Selling off the debt makes it easier for them to encourage more borrowing, and the Fed can’t do much about it. Right now it’s easier for the Federal Reserve to control mortgage lending through its role as a banking regulator, and to limit credit expansion by curtailing the use of exotic mortgages.

    They will deflate by having the overseas investors taken down while sparing the T-bill market with the “NewBank”. In a flight to safety investors will jump on treasuries strengthen the dollar and crashing gold. Searching NewBank, check out
    Very funny.
    The first US bank to go down will be JP Morgan. Over 800 US banks hold derivatives. Check out: You’ll see that the amount of derivatives in “insured” commercial bank portfolios increased by $2.6 trillion in the third quarter of 2005, to a whopping $98.8 trillion. 98% of these are concentrated in 5 banks. Total assets of these top 5 banks is $3.3 trillion if I am reading the chart correctly. Just look at the charts like the year ends 91-2004 chart (Graph 3) and you’ll see a chart shooting straight to the moon. Maybe these bankers are smarter then me, but this is a house of cards in my book.

    Most of the $570 trillion in derivatives are held by overseas investors. These will collapse from the housing bust causing defaults. The default follow like dominos to mortgage backed securities, then collaterized debt obligations and lastly to derivatives.

    Controlled deflation will be the Fed’s goal so that the dollar will rise. This will help the US government as investor, institutions and countries buy Treasuries as a safe haven. US Treasuries held as reserves will not be sold off (by China and Japan) avoiding a dollar devaluation. Win -Win for the Feds. Lose-lose for derivatives, MBS (which are explicitly not backed by the US).

    Controlled deflation is the Fed best choice among bad choices.

    I doubt the deflation can be controlled by lowering Fed rates to zero, but the Fed will try to “mop up”.

    I predict a head and shoulder top in the stock market. The bottom may not drop out until the mortgage defaults are large enough to collapse mortgage backed bonds, collateralized debt obligations and lastly derivatives.

    Collateralized debt obligations are securitized interests in pools of—generally non-mortgage—assets. Assets—called collateral—usually comprise loans or debt instruments. A CDO may be called a collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO, offering investors various maturity and credit risk characteristics. Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO’s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranch is afforded by tranches that are subordinate to it.

    A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other financial institutions or investment managers, as described below. Expenses associated with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring organization retains the most subordinate equity tranch of a CDO.

    The Fed plans to save the banking system by shedding the coming mortgage defaults to overseas investors in MBSs and derivatives:

    “The Fed’s fully aware that the deteriorating U.S. housing market and subsequently the sustainability of the U.S. consumers spending spree have raised level of concerns among foreign investors of the U.S. Treasury Bonds. But, that’s just part of the grand design. The unloading or the “portfolio-switching” by global bond investors, as so termed in a research paper – International Capital Flows and U.S. Interest Rates – prepared for the Fed in September by Francis & Veronica Warnock, associate professor at the Darden School and assistant professor in the School of Architecture, respectively, has thus far caused the 10-year bond yield to rise 20% since June, 2005.”

    The hard landing will be world wide and the Fed will not control it:

    “As the delinquencies and losses on mortgages flow through to subordinated mortgage- and asset-backed securities, who will be affected? Who buys these securities? The interesting part about these private label subordinate pieces is that for the most part, they’ve ended up in CDOs [collateralized debt obligations] and have been sold outside the U.S. Subordinated pieces are trading at their most expensive levels ever primarily because of the demand from structured deals—CDOs are underwriting the risk in the mortgage market. The lender (buyer of the CDO) is the person in line to lose money. While CDOs often have higher yields for a given rating level, they also usually have higher risk for a given rating level. Because the investors are CDOs, the bonds are outside the banking system, and the regulatory agencies cannot police the market. That has been a frustration for the regulators—they can’t do as much about the situation as they had hoped.”

    Housing will decline for 5 to 15 years. Prices will decline the fastest in the places where ARM & options ARM were near 100% of the mortgages (I know of some very high priced zipcodes were this is true). Areas with little or no rapid price expansion will decline the least.

    I look for 75 to 95 % declines in the worst situations, using Tokyo and the whole of Japan as a model.

    The whole problem is when the collateral fails through foreclosures and bankruptcy pushing the houses (collateral) into the hands of the GSE’s (Freddie and Fannie). This causes the mortgage backed bonds to fail or be seriously impaired. Borrowing against homes added $600 billion to consumers’ spending power in 2004, according to research by Federal Reserve Chairman Alan Greenspan.

    Banks will fail and cause commercial loans to medium or small businesses to disappear. Credit risk and credit ratings will fall slowing the “velocity” of money and the GDP. The hundred of trillions world wide in derivatives based on mortgaged backed bonds will unwind destroying worldwide liquidity. The feds will step in to salvage and consolidate the surviving banks and thrifts after the collapse as the lender of last resort. The fed will be “pushing on a string”, unable to stimulate the world’s economy.

  8. thecynic commented on Mar 29

    what is the deal with gold and silver today? i think its a big slap in the face to Bernanke that silver is behaving this way the day after he hinted at higher rates. seems like gold and silver markets are daring him to stop raising rates. who will fold? they can’t both be right..

    i find it very unlikely that he will stop raising rates if gold and silver and other commodities continue to trend higher. this is a very interesting development today. much more than a short squeeze in NDZ on a SUNW upgrade (zippidee do dah)

  9. B commented on Mar 29

    That’s some pretty radical stuff Jeff. 90% correction? You put in your order for a bomb shelter, some AK-47s and convert all of your assets to gold yet?

    The interesting thing about predictions are they seldom come true from even the most brilliant. Although many predicted the bubble in 2000, it was based on historical precedence of more than once through long wave cycle analysis.

    I don’t know what the future holds but have you ever considered the alternative in your thinking? ie, What if just the opposite happens. We get a standard correction of X amount, then we see a market rise of 90%. Is that a possibility as well?

  10. B commented on Mar 29

    What happened to his post? I wasn’t done reading the book of Revelations yet? It was cut off?

    (snipped the comment on his prior post) — ed

  11. M commented on Mar 29

    Don’t understand the line, “in a period of high productivity and high growth, it may take a somewhat higher real funds rate to keep inflation low.” Monetarists define inflation as an excess supply of money. With a high growth/high productivity economy, it will require more money to transact, increasing the demand for money and diminishing the excess supply of money.

  12. jkw commented on Mar 29

    Housing will definitely not drop 90% in real prices. It will almost certainly revert to the mean with a bit of an overcorrection due to panic selling. That means that all the price runups of the past 6-9 years will be reversed, but only in inflation-adjusted dollars. For some areas, the runup was 300-400% (in nominal prices), which would mean the correction could be as high as 70% in a few areas.

    The normal way for real house prices to fall is mostly for prices to level off and wait for inflation to catch up. I think housing has become more overextended than ever before, so nominal prices will probably fall a fair bit in the most bubbly cities. I’m in Boston and I expect nominal house prices to fall by 20-50% from the peak last August over the next 2-5 years around here, assuming inflation remains around where it is.

    Personally, I think the government is going to run inflation up fairly high because that is the least painful way we can get out of our current mess. Over 2/3 of the population owns a home. Letting nominal prices fall even just 30% will be politically difficult. Inflation will also erase a large portion of the government’s debt. This scenario would be more likely if the government had been issuing mostly long-term debt recently. The only thing that makes it costly is the amount of debt that has to be rolled over every year and TIPS. Even so, it still seems more likely that prices (excluding houses) will double then that nominal house prices will drop 30% over the next 5-10 years.

  13. B commented on Mar 29

    No way will housing prices fall 70%. We’ve had housing bubbles before and they’ve created mini messes but the world would effectively come to an end as we know it if that were to happen.

    Frankly, if we got to that low odds point, I’d rather have the Fed inflate the hell out of the economy. I could give a sh*t if my house was worth less in inflation adjusted terms.

    We’ve been inflating since we went off of the gold standard and most people haven’t suffered from it……..yet.

  14. jkw commented on Mar 30

    Most house prices won’t fall very far (the national average will probably be 5-15%), but in a few areas it could be over 50%. Phoenix and Miami are some of the worst cities. The housing supply in Phoenix is 2-3 times as large as it was 10 years ago. House prices have been running up so fast there that a lot of people that have no intentions of moving there bought houses and condos. Local reports indicate that an unusually large percentage of the houses are empty with either for sale or for rent signs. In a place like that, house prices could fall by 70% from their peak.

    Miami is also in bad shape. It’s a large city, so the overbuilding will be somehat absorbed, but they are still building new high-rise condo towers even as some of the recently built ones sit nearly empty. If Miami is hit by 2 or more major hurricanes this year, people are going to start moving out in large numbers. If lots of people leave Miami, prices there will drop significantly.

    San Francisco and a few other cities might also have drops over 30%. The major question is how the mortgage market will be affected by falling prices. If liquidity drops far enough that banks aren’t willing to give out many mortgages, we will have a housing crash and a depression. Personally, I think Bernanke won’t let that happen. His academic interests include studying depression and deflation. Inflation is probably the only way out of it. If the Fed manages things perfectly, then things will work out. If they tighten the money supply too much, we will get deflation and a depression. If they loosen it too much, we will get high inflation, and possibly even hyperinflation. The difference between causing inflation and causing a depression is probably very small, so it is likely that we will get one or the other. My current guess is a small amount of deflation followed by hyperinflation, as that is the easiest sequence to cause.

  15. Charlie Mann commented on May 2

    Do you have any other articles or info on credit derivatives pricing or trading? Been looking to find out more info on the player in the market… I’ve some interesting information on the following sites:

    Know where I can find any additional info on the other players?

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