By David Enna, Tipswatch.com
When I was a kid, my parents encouraged me to open a “passbook savings account” at a nearby savings & loan. As I recall, that account was paying 5% interest. At the time, I wasn’t impressed. Sixty years later, I’d jump for joy over 5% interest.
In the mid 1960s, the Federal Reserve was raising its effective federal funds rate after a recession in the early 1960s pushed it down to 1.17% in July 1961. In mid 1961, U.S. inflation was running at 1.4%, but it began moving higher and by November 1966 it had reached 3.8%. Where was the effective federal funds rate in November 1966? 5.76%, much higher than the rate of inflation.
The point is: Over the last 70 years, it’s been very rare to see the federal funds rate anywhere near zero and well below the annual rate of U.S. inflation. That is to say: Rare, until the last 10 years, when the Federal Reserve has adopted an accommodative policy to keep the U.S. economy (and stock market) ticking higher.
Here is a historical view of the federal funds rate from 1954 to today:
As you can see in the chart, the Federal Reserve kept its key short-term interest rate much higher than the current 2.33% until market crashes/recessions in 2000, 2008 and (briefly) in 2020. The current rate of 2.33% is a historical anomaly, and it has room to move higher based on historical precedent.
Federal funds rate vs. inflation
This next chart shows the federal funds rate in comparison to the annual U.S. inflation rate:
This chart clearly shows that the Federal Reserve, through much of the last 70 years, has attempted to keep its federal funds rate tracking higher than the annual U.S. inflation rate, even going to the extreme of 19.1% in July 1981, at a time when U.S. inflation was running at 10.8%. That extreme action eventually brought inflation down, but the federal funds rate lingered at a high level through much of the 1980s, reaching only 9.85% in March 1989 before beginning a slide downward.
Even after the dot-com crash of 2000, the federal funds rate tracked pretty closely with U.S. inflation. The dramatic change came after the financial crash of 2008, when the effective federal funds rate reached the unprecedented level of 0.16% in December 2008.
Since 2008, the federal funds rate has remained well below annual U.S. inflation except for a brief time in 2019 — for example, 2.4% in July 2019 at a time when inflation was running at 1.8%. This accommodative policy has led to our current surge in inflation. The gap is shockingly high now … 2.33% versus the current inflation rate of 8.3%.
Federal funds rate versus stock market
This chart compares monthly annual gains or losses in the total stock market versus the federal funds rate, from April 1980 to August 2022:
The key point to notice that when the stock market rises, even dramatically, the federal funds rate tends to hold steady. When it declines, especially in advance of a recession, the federal funds rate tends to track lower. The Federal Reserve acts quickly to hold off recessions, and that in turn supports lofty stock market values, at times. When the economy and stock market are booming — especially when inflation isn’t a severe issue — the Federal Reserve stands pat.
Federal funds rate vs. GDP
This next chart provides a historical perspective on the effect of the federal funds rate on the U.S. gross domestic product:
Again, for most of the last 70 years, the Federal Reserve held its key short-term interest rate higher than the annualized changes in the U.S. gross domestic product. If you look at the chart carefully, you can see that the federal funds rate tends to lag behind changes in the economy, rising during times of prosperity and falling during times of recession. But it does not appear to have a dramatic effect on GDP, which tends to tick along in the 2% range, even when the federal funds rate approached zero after 2008.
By historical standards, the Federal Reserve has room to continue to raise the federal funds rate, at least to a level that begins to approach the annual core inflation rate of 6.3%. But that won’t happen, and maybe it doesn’t need to happen. If you assume that inflation will begin drifting lower in future months, it is possible that a federal funds rate of 4% to 5% will hit the mark to keep inflation under control
But the fact is, before the August inflation report was released yesterday, many “experts” were predicting that the Fed would begin rolling back short-term interest rates in 2023 as the economy weakens. And I think that is all too likely.
My preference would be for the Fed to find a true neutral level — say 4.25% to 4.5% — and hold short-term rates at that level for a reasonable period of time, say throughout 2023. No more fiddling. Allow savers and the overall market to find a solid ground for future investments.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.