- The Washington Times - Wednesday, August 2, 2006

After raising short-term interest rates by a quarter-percentage point at each of its last 17 meetings, which were convened over a two-year period, the Federal Reserve’s policy-making committee meets again next week amid rampant speculation that it still hasn’t reached the end of its tightening cycle. If 17 consecutive quarter-point interest-rate increases are not enough, then how many are?

Well, that depends on several factors. Perhaps the most important of those factors involve the rate of inflation and its relationship to nominal short-term interest rates. In particular, the inflation-adjusted, short-term interest rate, which is the one that matters most, is the nominal interest rate less the rate of inflation. The short-term interest rate over which the Fed exerts direct control is the federal-funds rate, which is the interest rate banks charge each other for overnight loans. A good proxy for the inflation rate is the 12-month change in the consumer price index (CPI). So, how have these factors interrelated in the past?

In June 2004, just before the Fed began tightening monetary policy, the nominal fed-funds rate was a historically low 1 percent; and the inflation rate was 3.3 percent. That produced a real fed-funds rate of negative 2.3 percent, reflecting an extremely loose monetary policy. A year later, following eight quarter-point increases, the fed-funds rate was 3 percent; and the inflation rate had declined to 2.5 percent. Thus, the real fed-funds rate was a positive 0.5 percent. Over the next year, the Fed raised its target overnight rate another 2 percentage points to 5 percent. Inflation, however, increased by 1.8 percentage points, rising from 2.5 percent to 4.3 percent. As a result, the real fed-funds rate increased by only 0.2 percentage points, rising from 0.5 percent in June 2005 to 0.7 percent in June 2006. At the end of June, the Fed raised short-term rates another quarter point, lifting the real rate to 0.95 percent.

Thus, although the Fed has lifted the nominal fed-funds rate by 4.25 percentage points over two years, the real fed-funds rate today is still less than 1 percent. That is because the tightening cycle began when the real fed-funds rate was well below zero and because the rate of inflation has increased 1 percentage point since the Fed began tightening.

How does today’s rate compare to its level at comparable periods in previous business cycles? The trough of the last recession occurred in November 2001, making August 2006 the 57th month of the current economic expansion. In December 1995, the 57th month after the trough of the 1990-1991 recession, the real fed-funds rate was 3.1 percent, which represented the difference between its nominal level of 5.6 percent and an inflation rate of 2.5 percent. In August 1987, the 57th month following the November 1982 trough, the real fed-funds rate was about 2.5 percent.

Interestingly, today’s 12-month rate of consumer-price inflation (4.3 percent) is the same as the 12-month inflation rate in August 1987. But the nominal fed-funds rate in August 1987 (about 6.75 percent) was 1.5 percentage points higher than today’s. At least by historical standards, the Fed is probably not yet finished tightening monetary policy.

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