Fed Approaches Negative Real Interest Rate Territory

While the question of whether the Fed will lower interest rates again after its emergency cut last week is still up in the air, it is pretty clear that further cuts in the Fed’s target rates are in the offing. And the markets believe the Fed will continue to cut quickly, putting the odds of a 50 basis point cut tomorrow at 88%

At a Fed funds rate of 3.5%, some would say the Fed has already created negative interest rates:

This view, that published real inflation rates understate the real level of price increases, is due at least in part to the work of the Boskin Commission, whose work led to changes in the computation of the consumer price index in the mid 1990s. Some believe that these moves lowered reported CPI by 0.5%, others argue for 1%, while others, per the chart above, believe the dispartiy is even greater.

Why should we believe that the old CPI metric is better than the one we have now? Consider the criticisms the Boskin Commission made of the “old” CPI, which then led to changed to address those issues. From Wikipedia:

The report highlighted four sources of possible bias:

Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.

Outlet substitution bias occurs when shifts to lower price outlets are not properly handled.

Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.

New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

Of the list of four supposed problems, all but the second, outlet substitution, are completely at odds with the concept of what an index is supposed to do, which is to track the price of the same grouping of items over time. For instance, the first one says that if the initial CPI included steak once a month and steak prices rise sharply, then the index should substitute hamburger.

But even if you trust the current inflation figures, a cut to 3% reaches the danger zone. And remember that borrowers that can deduct their interest payments from taxable income enjoy an even lower effective rate.

From Bloomberg:

The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974.

The threat of cascading stock and home values and a weakening labor market will spur the Fed to cut its benchmark rate by half a percentage point tomorrow, traders and economists forecast. That would bring the rate to 3 percent, approaching one measure of price increases monitored by the Fed.

“The Fed is going to have to keep slashing rates, probably below inflation,” said Robert Shiller, the Yale University economist who co-founded an index of house prices. “We are starting to see a change in consumer psychology.”

So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are “a substantial danger zone to be in,” said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. “The Fed’s mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.”….

The central bank will probably lower the rate to at least 2.25 percent in the first half, according to futures prices quoted on the Chicago Board of Trade. The chance of a half-point cut tomorrow is 88 percent, with 12 percent odds on a quarter- point.

Inflation, as measured by the personal consumption expenditures price index minus food and energy, was a 2.5 percent annual rate in the fourth quarter, economists estimate. The Commerce Department releases the figures tomorrow.

The last time the Fed pushed real rates so low was in 2005, in the middle of the three-year housing bubble, when consumers took on $2.9 trillion in new home-loan debt, the biggest increase of any three-year period on record.

Aggressive rate cuts are justified if there’s “conclusive evidence” that household income prospects are in danger, said Goodfriend, now a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh.