Fed funds neutral rate & Fed put

Investment Analysis Clubs Macro Economic Trends and Risks
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I have posted several times about Jerome Powell’s stated intention of bring the fed funds rate to “neutral,” which will neither stimulate nor slow the economy.

There are two widely watched inflation measures: the Consumer Price Index (currently 9.1%) and the Fed’s preferred measure, the Personal Consumption Expenditures Price Index, which is 6.3%.

https://www.bls.gov/cpi/
https://www.bea.gov/data/personal-consumption-expenditures-p…

Even after yesterday’s 75 basis-point increase, the fed funds rate is only 2.25%-2.5%. The June Fed median forecast is 3.25%-3.5% by 1Q2023. Unless inflation falls sharply, this will still be a negative real yield.

The bond market is predicting a recession by next year that will cause the Fed to go back to its “Fed put” strategy of cutting the fed funds rate at the first whiff of recession. Powell says he won’t cut if inflation is still high, but the bond market doesn’t believe him. The bond market is predicting falling rates after next year. The Treasury yield curve has been falling for the past couple of weeks.

https://stockcharts.com/freecharts/yieldcurve.php

The real fed funds rate is way below zero. The Fed is still paying borrowers to borrow money. This is stimulative, not a “neutral” rate.

As I posted earlier, the 1970s Fed did cycles of raise – lower – raise – lower three times. Each time, inflation came roaring back. It wasn’t until Paul Volcker decisively raised the fed funds rate above inflation in 1980 that inflation was quelled, at the cost of the difficult recession of 1980-1982 which at the time seemed like it would never end.

It’s nice to see that the Wall Street Journal Editorial Board has just published an editorial saying essentially word-for-word the same thing.

https://www.wsj.com/articles/investors-love-jerome-powell-fe…

The WSJ didn’t mention the Treasury (which, of course, is separate from the Fed). The Treasury uses an internal (bogus) inflation number to report positive real yields on Treasury bonds. I don’t know why someone doesn’t slap the analyst upside the head since anyone can look up inflation rates from the neutral agencies (BEA and BLS). Even a child could subtract the 10 year yield from inflation and see that it’s negative. Whom do they think they are fooling?

https://home.treasury.gov/resource-center/data-chart-center/…

The most important Macroeconomic factor in the U.S. is the fed funds rate since all other interest rates are pegged to it.

For investors, the most important question is whether the “Fed put” is still the rules of the game, or whether the Fed will actually fulfill its mandate of stable prices regardless of what the asset markets do.

If the Fed were to raise the fed funds rate to a true positive real yield, the 10% of listed companies that are zombies (barely able to pay the interest on their low-interest loans) would default when they needed to roll over their debts.

It would be carnage.

Wendy

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Wendy,

The 9.1% inflation rate wont carry forward year over year again. It is a fiction even now comparing to last year as gasoline falls during the reading.

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<The 9.1% inflation rate wont carry forward year over year again.>

I expect it to fall, but I don’t expect it to fall to 2% in a matter of 6 months.

Of course, nobody knows and only time will tell.

Wendy

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Wendy,

I have seen this reasoning quite a bit. The two rates need to meet in the future at some time. The neutral rate is academically thought to be in the 3.25% range,absent exogenous influences. We have plenty of those right now. Raising the fed funds rate takes 12 to 18 months to work into the economy,at which point perhaps the supply chain will have worked it’s way out.
The Fed is skating to where the puck will be 12 months out,which by it’s very nature is imprecise. They are also working with blunt tools.
Your posts read to me as if you expect the Fed to be much more aggressive raising rates, but perhaps I have misunderstood.

Jk

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Everything should be taken in perspective. I was cleaning out a drawer today and came across a CD I owned in the early 1980’s which was paying 14%.

Jeff

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Powell says he won’t cut if inflation is still high, but the bond market doesn’t believe him.

Well, they should believe him. It is pretty well known that he admired Volker’s courage in raising rates so boldly. And it’s pretty clear that Powell is willing to raise rates quickly. Two 3/4% raises in a row isn’t exactly a timid move.

On the other hand, since we have an economy constrained by supply issues, we don’t want to try to keep the economy growing. Trying to grow the economy when there are significant supply constraints will only result in inflation. So we actually NEED the economy to be stagnant or even shrinking slightly so that supply can catch up with demand. That calls for a restrictive interest rate from the Fed, not a neutral rate.

The Fed’s only tool is interest rates. Which means all they can do is attempt to restrict demand by restricting the supply of money. They can raise their overnight rate. And, for the moment, they can also affect longer term rates a bit by selling off their book of securities. Some can be accomplished by simply letting securities mature and not replacing them. But they can always step that up a bit by actively selling securities.

So while we usually think of the Fed only affecting short term rates, we need to remember that they currently have a book of longer term securities that they can use to affect longer term rates. If they so desire, they can push rates up all along the yield curve. That would also help limit the money supply by taking money out of circulation as they unload their bond portfolio.

It’s a very unusual time for Fed watching.

In a perfect world, the government would help deal with the supply issues more directly with fiscal policy. That would help us There are a number of ways to do that. But I won’t attempt to address those as they are inherently political.

In short, batten down the hatches. There’s a hurricane on the horizon and it’s not going to be small or quick. Let’s hope we have enough room to move about a little so as to avoid the eye of the hurricane.

–Peter

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Even after yesterday’s 75 basis-point increase, the fed funds rate is only 2.25%-2.5%. The June Fed median forecast is 3.25%-3.5% by 1Q2023. Unless inflation falls sharply, this will still be a negative real yield.

The real fed funds rate is way below zero. The Fed is still paying borrowers to borrow money. This is stimulative, not a “neutral” rate.

hi Wendy.

Curious, what is your calculation for the real fed funds rate?

Seems like you and the WSJ are somehow using the 1-year CPI change for the trailing 12-month period ending June 30, 2022.

The Fed funds rate is a current, overnight rate. To get a comparable real rate, wouldn’t one need to use an estimate of inflation that is comparable, basically a real-time estimate of current inflation (not a lagging measure over the trailing 12 months of historical inflation)?

Powell mentioned in his comments that the Fed estimates the current Fed funds rate to be near neutral (this is also noted in the WSJ) and Jk noted the same above: “The neutral rate is academically thought to be in the 3.25% range, absent exogenous influences.” Seems like the Fed’s reasoning to arrive at a neutral rate is different than the inflation rate logic that you might have in mind, but I don’t know the details of Fed methods.

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