The Fed is likely to stop raising rates soon. What will be the final signal that enough is enough?
Commentators seemed to read the minutes from the December FOMC meeting as signaling that we may be nearing the end of interest rate hikes. To summarize a few of the reactions:
the tone now seems to be that most of the heavy lifting is done.
I left the minutes with the sense that another rate hike at the end of the month is in the bag, but beyond that, future changes in policy are not automatic but instead data dependent.
The Fed announced their plans today to “only invert the Yield Curve somewhat,” rather than the deeper and more extensive inversions some traders feared.
So what will cause the Fed to pause? We already know that it’s not concerns about the employment effects of the energy price shock. For whatever reason, the Fed has decided that its mission in response to such disturbances is to worry about the inflation rather than the unemployment that such events may produce.
And I agree with Tim Duy that it will take more than just the disappointment in the December employment report, which, since it accompanied a revision of the November figures, left the two-month average at a still-respectable 206,000 new jobs per month.
And we’ve already seen that an inversion of that little old yield curve doesn’t scare the Fed. As I noted earlier, the main reason that Greenspan seems unafraid of the yield curve inversion is a belief that it is only when the nominal interest rate is high relative to inflation that there is much concern of an economic downturn.
The graph at the right plots the nominal yield on 3-month Treasury bills minus the median change in the CPI components over the preceding 12 months, with U.S. recessions indicated by the shaded areas. This “real interest rate” series averaged 1.29% over the last 40 years, and was above that average value prior to each of the last five recessions. Up until October, this measure was below its average historical value, and indeed even negative during the overstimulus of the economy of 2001-2004.
But whatever comfort the Fed (or you) may have taken from this fact is about to be taken away. With the tbill rate now at 4.22% and the median CPI over the last 12 months of 2.4%, this measure would currently stand at 1.82%. If we get another 25 basis point bump at each of the next two FOMC meetings, or even more after that, not much comfort in that little factoid at all, I would say.
|Measure||Implied real rate|
|TIPS due 2007||2.50|
|TIPS due 2011||1.98|
|CPI (as of Nov 05)||0.72|
|CPI (as of Sep 05)|| -0.48|
Ah, but the fun part about the “real interest rate” is that it’s not real at all, but depends on investors’ expectations of inflation, which nobody can actually measure. If you look at the rate on inflation-indexed Treasuries maturing in 2007 or 2011, you get an even higher current real interest rate. On the other hand, if you use the change in the actual CPI over the last 12 months of 3.5%, rather than the median CPI as I have done above, you calculate a real rate of only 0.72, leaving lots of room for the Fed to keep reaching up. For that matter, if you used the change in the actual CPI for the 12 months ended September 2005, you get a real rate of -0.48%– another year of “measured pace”, anybody?
Of course, that last observation– that we would get a wildly different prescription for policy depending on whether we use data from September or November– is one of the main reasons I hope that the Fed would be paying more attention to something like the median CPI. And, if the Fed-watchers quoted above have it right, that’s what the Fed is doing.