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Over the past few months, I have recommended that the Fed needs to raise the federal funds rate much faster than it has in the past, and argued that the Fed is not only “outdated” given its failed “temporary” position, but has completely missed the point in taking a “hawkish” stance.
The approach I propose to rate hikes is for the Fed to move within a +100-+125 basis point range at each scheduled meeting (in 2022), with random “emergency” rate hikes during meetings, to set the overall target to at least 8.5% as soon as possible.
Of course, this may seem a bit extreme given the “recency bias” of the current distorted economic situation and current levels of debt held broadly by households, corporations and the federal government, but historically this approach is actually quite conservative.
The following chart shows the annual percentage change in the Consumer Price Index (i.e. the inflation rate) (blue), the 30-year fixed mortgage rate (red), the effective federal funds rate (green), and the upper target for the federal funds rate (light green), illustrating the Fed's actual current targets.
Traditionally, the federal funds rate (green line in the graph above…click to enlarge), especially during periods when inflation has been clearly “volatile”, has always matched or well exceeded the rate of inflation as measured by the year-over-year change in the Consumer Price Index (blue line in the graph above…note: we could also use the annual change in the PCE index, which is the Fed's preferred inflation measure, but historically CPI has been the reported measure of inflation and is also the measure reflected in COLA calculations, etc., so we will stick with this comparison for now).
Of course, there are notable exceptions. For example, during both post-recession periods after the “dot-com bust” and the “Great Recession,” Fed interest rates remained below the rate of inflation for extended periods in order to reinvigorate sluggish economic expansions.
However, when the immediate concern is inflation rather than deflation, the Fed will either target or allow the federal funds rate to be much higher than the rate of inflation in an attempt to shrink the money supply and stave off inflationary pressures.
Shifting our focus to the longer end of the yield curve, another important inflation relationship can be found when comparing the 30-year fixed mortgage rate (red line in the graph above) to both the Consumer Price Index (annual percentage change) and the Federal Funds rate.
It’s interesting to note that since the mid-1970s, 30-year fixed mortgage rates have consistently far exceeded the rate of inflation (and the federal funds rate), which is not surprising given the long maturities of these bonds and the fact that lenders are primarily concerned with the risks associated with a high probability of inflation when pricing this type of debt.
I say “all the time,” but in fact since March 2022, inflation (i.e., again annualized CPI) has exceeded 30-year fixed mortgage rates and has significantly exceeded the federal funds rate, creating a truly extraordinary situation begging for a solution.
We would need either a significant increase in 30-year fixed mortgage rates (a minimum increase of about 300-400 basis points to 8-9%), or a significant decrease in inflation, or a little bit of both.
But one thing is certain: the current federal funds rate of 1.50% is too low to make a noticeable difference in either lowering inflation or nudging the yield curve enough to encourage 30-year fixed mortgage rates to rise.
Please keep in mind that I am not saying that raising interest rates so aggressively is in the interest of debtors (especially large debtors like the federal government), or the Fed, or central banks around the world.
I am simply pointing out the very simple and rational historical relationship between these rates, and as Chairman Powell pointed out today, “[Central Bankers] “We now have a better understanding of how poorly we understand inflation,” they say, but they should also realize by now that recent efforts simply aren't enough.
Either they want to eradicate inflation or they don't.