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March 25 2006
at 2006-04-04 01:40:35
I thought it would be interesting to see where real interest rates were at the Fed's last rate hike during the previous three tightening campaigns. I'm using the Fed funds rate less headline CPI as the real rate.
In May of 2000, real interest rates were about 3.15%. The prior tightening campaign had ended in February of 1995 with real rates around 3.05%. When the Fed finished tightening in February of 1989, real rates were around 4.7%.
Based on current data, with the Fed funds rate at 4.5%, and the yoy change in CPI at 3.6, the real rate is still less than 1%.
What if we use the core rate of inflation, instead of the headline number? Well, the results are little changed for 1989, 1995 and 2000, but not so for the current period. The current "core" real rate is 2.43%.
I think the conclusion from this is that, given current rates of inflation, it would be well within historical precedent for the Fed to hike to 5.25%.
An interesting factoid I came across a while ago is that the market tends to not do so well in the 6 months following the last rate hike. I think the S&P 500 has been lower 6 months later about 70% of the time. The reason is simple- the Fed usually goes too far, far enough to precipitate an economic downturn. By the time they stop raising rates, the market is in the process of discounting the upcoming slowdown.
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