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.

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  1. Anonymous

    Re: 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.

    >Geometric substitution is my favorite statistical trick, where you substitute steak for chicken and tweak the model to conform to your bias; fun stuff!

    Re: Aggressive rate cuts are justified if there’s “conclusive evidence” that household income prospects are in danger

    > By overreacting to stock market trivialities, like an index going down 3%, or 5%, we have a Fed panic to sustain the good times for speculators, by setting up the possibility of successive rate cuts to continuing goosing the market.

    Even in a casino, you kind of expect the invisible hand of economic uncertainty to be a probability factor to hedge against (people do lose cash in Vegas), but when The Fed is on an outright Mission From God To Save The Stock Market, they are synthetically removing variables for market efficiency and increasing future risk. If they create the implied illusion that they can subsidize risk and failure and become an insurance agency, this goes back to Greenspans warning of moral risk!

    If they had collective Fed brain cells, they would keep the Fed powder dry and begin an aggressive program to have audits performed and game the regulation side of this equation coin, instead of being part of the casino collusion, where they design new ways to rig the game.

    We need accountability, and if you listened to that link about The Economic Summit, Blair is to have said we need the equivalent of a UN rapid reaction force to step in, or some type of early warning system linked to global accounting regulation; he also says the worst is to come. If The Fed keeps putting more free chips on the blackjack table, they will come, they will play….

  2. Brock

    I’m in Singapore, and the inflation is in my opinion much, much higher than their stated figure. I think the government is just full of it. Unfortunately, when I communicate to my North American friends that the stats are likely political mumbo jumbo they compare this position to 9/11 “truthers”.

  3. Independent Accountant

    I blasted the Boskin Commission when it was first formed. It was designed to reduce reported inflation and it did as told. No one should believe any government statistic.

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