January 15, 2021

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.0% higher than the inflation rate.  So for years the Fed regarded a 1.0% “real” funds rate as relatively “neutral”.  If the Fed wanted an inflation rate of 2%, and believed that its policy is neutral when the funds rate was 1.0% higher than that, then the Fed regarded a 3.0% funds rate as roughly “neutral”. But times have changed.

Since 2000 — the past 20 years — the real funds rate has averaged -0.5%,  Since 2010 — the past 10 years — the real funds rate has averaged -1.2%.  So which period should it use?  We would suggest that 20 years is a reasonable period of time and encompasses two business cycles so, perhaps, right now the Fed should view a funds rate that is 0.5% below the rate of inflation as a “neutral” funds rate.  If the Fed still wants a 2.0% inflation rate and a neutral rate is 0.5% below that inflation rate, then in today’s world a “neutral” nominal funds rate would be 1.5%%.  Since today the funds rate is 0% then Fed .policy today is clearly accommodative.

.Why would the real funds rate drop?  Because technology has gradually been gradually lowering the rate of inflation.  Today when we buy anything we shop first on the internet to check prices.  We can find the lowest price for that item not only in our area but throughout the country and we will probably buy it from the lowest cost seller and perhaps get next day delivery and free shipping.  As a result, goods-producing firms in the U.S. today have absolutely no pricing power.  Since 2012 goods prices have declined 0.1% while services have risen 2.7%.  That is quite a difference.  And of all the things that consumers buy 40% are goods.  If  you do the math, then the fact that goods prices have risen 2.8% more slow than services, that has knocked 1.1% off the average inflation rate during the past decade.  Another way of looking at that is, if the Fed still wants a 2.0% inflation rate, then it needs lower rates to make that happen.  So perhaps a -0.5% real rate is the new “neutral” funds rate.

Stephen Slifer


Charleston, SC