How high will the Fed push interest rates?

Here’s one way you can figure out if you’ve pulled the car far enough into your garage– if
you run into the wall, you went too far. Hopefully the Fed has another plan for how to decide
when to stop raising the fed funds rate.

Each week David Altig’s href="">Macroblog
provides the very useful service of reporting the probabilities of future changes in the fed
funds target that are href="">implied by the prices
that traders are willing to pay for fed funds options. These reveal that traders think
there’s nearly a 70% chance that the Fed will raise interest rates at least another 50 basis
points over the next two FOMC meetings. href="">William Polley,
Kudlow’s Money Politics, and
have some useful comments on whether the Fed may be going too far with such moves.

fed_funds_graph.gif align="right" vspace="4" hspace="10">

Even without another 50 basis points, the Fed has already driven the fed funds rate up by 225
basis points over the last year. As the graph at the right shows, it is pretty unusual
historically for the Fed to move the rate up that fast and that quickly. Apart from the
volatile 1979-82 period, when we saw interest rates rapidly yanked up and down as the economy
lurched between two recessions, I count 6 other episodes over the last half century in which
there was a 200 basis point rise in the funds rate within a single year. The first three of
these (1959, 1968, and 1973) only ended when we found ourselves in a recession, indicated by
shaded regions on the graph.

In the three more recent episodes (1984, 1989, and 1994), the Fed pulled back before a
recession actually began. In each of these, that meant stopping after about a 300 basis point
hike. If the Fed did the same thing this time, they’d maybe call it quits when the funds rate
hits 4%. However, as I href="">commented earlier,
if we see longer term yields drop back down, that could put us in a position of an inverted
yield curve, which historically has been a fairly ominous development.

Looking at the graph, it appears that the Fed may be trying to replicate the “soft landing”
of 1995, hoping to retrace the U-shape of that episode with the same pattern now, albeit at a
lower level of interest rates. If one thinks of the long-run downward trend in nominal interest
rates since 1982 as being dominated by a reduction in the long-run inflation rate, replicating
the U-shape of 1991-1995 during 2001-2005, but at a lower level, might seem like an ideal

There’s just one problem with that interpretation: the trough in interest rates in 2003 came
not from a continuing reduction in inflation but rather from an excessive creation of liquidity
on the part of the Fed. The inflation rate went up between 2001 and 2002, even as the Fed drove
interest rates much lower, and inflation has continued to creep up since.

And that explains why we’re now on the upswing of another U. It would have been better in my
opinion not to have let interest rates go so low in 2002-2003, in which case it would not have
been necessary to raise them so quickly now. We’re left in a situation now where there could be
problems, either from inflation or recession, no matter what the Fed does from here. But
certainly if the Fed continues long enough sending the funds rate on its current upward journey,
the landing is not likely to be all that soft.

By the way, our son is just learning how to drive. My advice to him is to drive the car into
the garage very, very slowly.


10 thoughts on “How high will the Fed push interest rates?

  1. chris

    Professor Hamilton,
    You wrote:
    “If one thinks of the long-run downward trend in nominal interest rates since 1982 as being dominated by a reduction in the long-run inflation rate …”
    I know this is a basic question, but why do nominal interest rates fall with inflation?
    Is there a mechanism that resists the divergence of these two rates?
    Note: I’m not an economist. I understand the math, but not the theory.

  2. Jim Glass

    “… that could put us in a position of an inverted yield curve, which historically has been a fairly ominous development.”
    Yes, though this would be a rather atypical one. Usually an inverted yield curve has resulted from the Fed driving short rates up high to cool the economy.
    This time the Fed is only getting short rates up from low (negative real) to normal range territory. It’s the abnormally low long rates, which should be quite expansionary, that shape the curve.
    Still, I wouldn’t want to see that curve invert.
    It seems like there’s some persisting structural weakness in the economy still after the recession, in light of its performance with these rates.
    I.e., by objective standards the economy’s doing OK, not great, not bad, normal range, but it’s doing it with real low long rates and short rates that have been negative, very low for a long time, which one would think would have been a big expansionary spur (and maybe have been).
    To use the car analogy, to do 55 mph is fine, but if you’re doing 55 mph with the gas pedal on the floor something’s not right.
    So I hope they’re careful about how fast they bring those rates up.

  3. Economist's View

    Do Tax Cuts for Small Business Owners Stimulate Employment?

    When we talk about lackluster employment figures and worry about why employment is lagging behind output during this recovery, perhaps we should quit debating whether interest rates should be 3.25% or 3.50% and get to the crux of the matter…

  4. Andy

    For Chris -
    Nominal interest rates are the sum of real interest rates + inflation. If you lend me $100 today and inflation is 5%, then if I pay you back $105 a year from now then you have just got your original amount of money back. You need to charge something on top of inflation in order to make a _real_ return from your money. Therefore, real interest rates are nominal interest rates minus inflation. Therefore, if inflation drops, so do nominal (but not necessarily real) interest rates.

  5. jult52

    I would be cautious about interpreting the Treasury curve today. The curve may be artificially depressed due to large-scale buying by overseas investors.

  6. Lord

    How many are going to be willing to borrow long and lend short? Maybe the government. Time to get those long bonds out.

  7. Mcwop

    Many investment managers look at the historical trend for the fed to have rates at around 200bps above the core CPI.

  8. Economist's View

    Who Cares About Inflation? The Fed Cares

    It looks like Mr. Norris would like to see Jim Hamilton’s son on the San Diego freeways learning to drive very fast.

  9. Hal

    That kind of curve seems to illustrate very graphically what a bad job the Fed is doing. Imagine an alternative version with a smooth line that bisects the erratic, sudden peaks and valleys, flowing gently upward to the 1980s and then gently downward to the present day. Isn’t it plausible that such a course would have moderated the excesses in the market just as well, while avoiding the lurching between recession and expansion that the Fed allowed and caused?
    Granted, it’s always easier in hindsight to see what should have been done, but I can’t help thinking that a rule like “whatever change you think you should be making, make 1/2 as much instead” would have been better.
    OTOH maybe the Fed is like a guy balancing a broomstick on his nose. He has to make those rapid back-and-forth movements to keep it in the air. It might seem better for him to use smoother motions but if he did, the broomstick would crash to the ground right away. I wonder if our economy is equally fragile and will instantly crash if the Fed leaves things alone a moment too long.

  10. New Economist

    Should we be worried by low bond yields?

    Alan Greenspan calls it a ‘conundrum’, and at least some econobloggers are worried about long bond yields – and the yield spread – being so low despite higher Fed rates and a relatively buoyant US economy. James Hamilton is worried we could see an inve…

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