- The Washington Times - Monday, May 15, 2006

In its press release issued last week following its latest action, the Fed reported that its interest-rate-setting committee “judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.” Thus did the Fed formally announce the possibility of its anticipated pause.

While attention has focused on the 4-percentage-point increase in the nominal fed-funds rate (to 5 percent), it is even more crucial to understand how the inflation-adjusted fed-funds rate has changed. After all, it is the real interest rate that matters most. To calculate how that rate has changed over time, we shall subtract the 12-month change in the consumer price index from the nominal fed-funds rate. Moreover, while “incoming information” will be crucial to Fed policy-making, an examination of the historical record would also be worthwhile.

In May 2004, a month before the Fed began raising short-term interest rates, the fed-funds rate stood at 1 percent and inflation, measured by the consumer price index, was 2.9 percent. Thus, the real fed-funds rate was a negative 1.9 percent. By May 2005, the Fed had lifted its target rate to 3 percent. Thus, the real fed-funds rate in May 2005 was a positive 0.1 percent. While consumer price inflation over the latest 12-month period has increased to 3.4 percent, the Fed has added another 2 percentage points to its target rate, which now stands at 5 percent. As a result, the current real fed-funds rate is 1.6 percent.

Historically, at this stage of the business cycle, when the economy continues to show significant strength, a real fed-funds rate of 1.6 percent is relatively low. For example, during second half of the previous expansion, which lasted 10 years (from March 1991 to March 2001), the real fed-funds rate was: 2.45 percent (May 1996); 3.3 percent (May 1997); 3.8 percent (May 1998); 2.65 percent (May 1999), which reflected the Fed’s extraordinary (and temporary) 0.75-percentage-point reduction in the fed-funds rate in response to the Asian financial crisis; and 3.4 percent (May 2000). In May 2001, in the midst of a recession, the rate had fallen to 0.4 percent. By May 2003, when the recovery was beginning to accelerate, the funds rate had been pushed down to a negative 0.85 percent, on its way to a negative 1.9 percent a year later.

The U.S. economy, now in its 55th month of expansion, remains quite strong, having grown at an annual rate of 4.8 percent last quarter. Compared to the funds rate of 1.6 percent today, in May 1987 (the 55th month of expansion following the 1981-82 recession), the real fed-funds rate was 3.15 percent; and in September 1995 (the 55th month of expansion following the 1990-91 recession), the real fed-funds rate was 3.25 percent. Those two expansions continued for another 34 months and 66 months, respectively.

Clearly, at 1.6 percent, today’s real federal-funds rate is quite low relative to real rates that have prevailed at comparable moments in previous business cycles. Thus, any tightening timeout taken by the Fed in the immediate future will almost certainly be followed by additional “policy firming.” Under the circumstances, that seems quite appropriate.


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