Academic journal article ABA Banking Journal

The Fed's Policy on Real Interest Rates

Academic journal article ABA Banking Journal

The Fed's Policy on Real Interest Rates

Article excerpt

In early 1994 Chairman Alan reenspan of the Federal Reserve nard characterized the policy orientation of the time as needing to "...move toward a posture of political neutrality--that is, a level of real short term rates consistent with sustained economic growth at the economy's potential. That level, of course, is difficult to discern and, obviously, is not a fixed number but moves with developments within the economy and financial markets." Something more than a year later it is still not clear to observers what the Federal Reserve believes that level to be. Indeed, in his February 1995 semi-annual review of monetary policy, Chairman Greenspan made no reference to neutrality or to any other characterization, such as restraint.

In theory, real interest rates are based on inflation expectations. Using the midpoint of the inflation range expected in 1994 by Federal Open Market Committee members in early February of that year, the real rate (nominal Federal funds rate of 3% minus, in this case, expected CPI inflation of 3%) was zero. This was the level from which the Federal Reserve sought to move to neutrality.

A year later, with the nominal funds rate 6% and the midpoint of 1995 inflation expectations of FOMC members 3% to 3 1/2%, the real rate at the time of Chairman Greenspan's review approximated 2 1/2% to 3%. As the chart indicates, this range is higher than at any time since mid-1990. It is also above the roughly 2% average of the past ten years. Based on the trailing 6-month (annualized) core-CPI performance, in only five quarters over the past decade were real rates above 4% and in only eight others were they above 3%. Thus in a historical context---other things equal--we should be within 1/2% to 1% of a near-term peak in the nominal Fed funds rate.

Such an expectation has at least three kinds of vulnerability to error. First, it presumes no upward revision--either for the balance of 1995 or for 1996--of the FOMC's expected inflation. Indeed, many expect inflation will be 1/2% to 1% above the 3% to 3 1/2% range espoused by the FOMC. …

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