Fed to Markets: Slower isn't lower

[WendyBG]

All METARs know that the fed funds rate is critical to the markets and that the Federal Reserve is in a rising rate cycle. The Fed has announced that it wants to bring the fed funds rate to a “neutral” rate which neither stimulates nor slows the economy. Any fed funds rate below inflation is a negative real rate which pays borrowers to borrow. Today’s fed funds rate of 3% is well below the inflation rate.

Median CPI

The history of the fed funds rate shows that holding a neutral fed funds rate for a long time, with only minor tweaks to discourage inflation, led to a growing economy from 1995-2000. The fed funds rate was about 5.5% and inflation was roughly 2.5 to 3% so the real fed funds rate 2.5% to 3%.

Federal Funds Effective Rate

Inflation, consumer prices for the United States

However, after the dot-com crash and mild recession of 2001, the Fed adopted a policy of cutting the fed funds rate extremely low and holding it long past the crisis had resolved. This addicted the markets to negative yield money.

Every time the Fed tried to raise rates, the markets reacted badly. The Fed hardly tried to hold rates steady before dropping them.

Now the markets are conditioned to expect the Fed to cut rates every time there is a whiff of inflation receding even a little bit. The market reaction (dropping the yield of the 10 Year Treasury overnight) is making the Fed’s job more difficult since the market’s moves are stimulative.

The message from the Fed – that they may slow the pace of rate rises – is being interpreted by the markets that the Fed will only hold the higher rate for a short time before lower it … because that’s what they did in 2000, 2007 and 2019.

But the Fed is trying to get out the message: Slower isn’t lower. Even if they slow the pace of rate increases, they will continue to increase until inflation recedes to their target. And then they will hold it, even if a recession results, until they are sure that inflation will not increase. Which may be a long time, if they judge that the rate is the neutral rate they have been seeking.

The markets are acting the way they did in June 2022. The warnings from the Fed are coming from several directions. The message is clear: Don’t fight the Fed. Slower isn’t lower.

Fed Official Warns Inflation Fight Has ‘Ways to Go’

Markets Zoom Toward Collision With the Fed

Fed Official Warns Against Prematurely Concluding Inflation Has Peaked

Wendy

[Leap1]

@WendyBG

The history of the fed funds rate shows that holding a neutral fed funds rate for a long time, with only minor tweaks to discourage inflation, led to a growing economy from 1995-2000.

The growth was meager. Nothing at all worthwhile. There was no industrial policy so the manufacturers were outsourcing. The reality was a papered over disaster that later we would live out till this day.

We are not in a period where monetary policy makes the sole decisions on economic matters. In fact we are in a period were the FED makes the secondary decisions in economic matters in the US.

The study on how big the federal budget is as regards its economic impact matters far more to inflation and GDP growth. We are living in a very opportunistic time as all the current bad news settles out in 2023.

[mostlylong]

@WendyBG

Any fed funds rate below inflation is a negative real rate which pays borrowers to borrow. Today’s fed funds rate of 3% is well below the inflation rate.

Why do you think that a Fed funds rate below the current inflation rate implies a negative real rate that is applicable to most participants in the economy and hence would be stimulative by “paying borrowers to borrow”?

(by the way, today’s Fed funds rate is about 3.75%, not 3%)

Participants in the economy - businesses and consumers - do not borrow at the Fed funds rate, they borrow at much higher rates (Current real interest rates)

In September, Powell said, when the Fed funds rate was 3.00%-3.25%, lower than today’s 3.75%-4.00%, “…we’ve just moved [the Fed funds rate] I think probably into the very lowest level of what might be restrictive…”
This means Powell and the Fed thought in September that current real rates, as experienced by participants in the economy, are most likely at least somewhat above 0%.

In November, Powell said “…I would say, as we come closer to that level, move more into restrictive territory…” and “…I think as we move now into restrictive territory…”
This means that Powell and the Fed think that we are already in a restrictive interest rate environment, and that rates are not stimulative.

Powell is saying the opposite of what you are saying. You are saying rates are stimulative, Powell and the Fed are saying rates are restrictive.

I’m inclined to treat the Fed’s view as expert opinion and it is backed by a small army of research economists. Beyond that, there is a ton of evidence now that inflation is lessening (housing purchase and rental markets, shipping trends, announced job cuts, inventories building, retailers reporting soft sales, discounting and weak outlooks, etc).

Also, what number would you use for a “current” inflation rate?

A trailing 12-month year-over-year rate is certainly not current in the sense of measuring how prices are changing right now - it’s the change in prices over the last 12 months. In contrast, the Fed funds rate is literally a current, short-term rate (as in overnight short-term).

Powell November (https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221102.pdf)
Powell September (https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220921.pdf)