How high will the fed need to go? From Philadelphia
<<Every rapper and hip-hop artist knows you've got to keep it real. Same thing for economists. When you talk the talk - about growth, production and interest rates - reality is where it's at.
But what's real? In simplest form, it's growth or rates after inflation; the point being to filter out the background noise in order to track meaningful change.
This is of particular interest right now, when the Federal Reserve is trying to bring a meaningful slowdown to the U.S. economy. Since June of last year, the Fed has raised its key interest rate six times, from 4.75 percent to 6.5 percent. The last hike, which took place May 16, brought the Fed rate to its highest level since January 1991.
But that's in nominal terms; that is, before subtracting out inflation. As best we can tell from the government's various measuring sticks, inflation right now is about 2.4 percent. So the "real" short-term interest rate is currently 4.1 percent, give or take a hair either way.
The reason anyone cares about this is, you need to know the real interest rate to determine just how hard the Fed is leaning on the monetary brakes.
It's known that Alan Greenspan and his crew are seriously concerned about an overheating economy. Rampant consumer spending, a rambunctious stock market, and so on could cause wages and prices to spiral out of control, leading to the kind of misery we survived back in the 1970s.
What's not so clear is whether the Fed's rate-hiking to date is having its intended effect. Is the central bank nearly done administering its medicine, or is it just warming up? The answer could make a big difference, particularly for investors trying to negotiate the stock market's recent gyrations.
Looking at real rates is one way to get a fix on things. Economist Ron Talley of the Wefa Group in Eddystone, Pa., has averaged real short-term rate levels going as far back as 1960, and he concludes that by comparison, the current real rate is high - but probably not high enough to accomplish the Fed's goals.
The current level is "not exerting much in the way of a restraining influence on the economy," Talley wrote recently. He looks for a benchmark at the rate in 1989, when, like today, unemployment was low and growth had been booming along for a couple of years.
The Fed went into slowdown mode that year, raising the nominal short-term rate to nearly 10 percent. In real terms, however, the rate was between 5 percent and 5.5 percent.
Talley believes that would have been the right level to accomplish the Fed's goal, which was to slow the U.S. economy without starting a recession. Unfortunately, Alan Greenspan wasn't the only one pulling the economy's strings back then.
Saddam Hussein's invasion of Kuwait in 1990 caught the U.S. economy at a vulnerable moment, Talley said. "It created tremendous uncertainty. The price of oil doubled in a short time, and people put spending on hold because they didn't know what was going to happen. . . . I don't know if we would have gone into recession if the invasion hadn't happened."
Assuming that's a correct reading of history, Talley thinks a 5 percent or 5.5 percent real Fed funds rate might be what Greenspan & Co. believe is necessary to really slow things down. And if that is right, then we can conclude that at the current level - 4.1 percent, remember? - we ain't there yet.
Talley thinks the Fed will hike again, maybe as soon as June 27, which is the next time the central bank's policymaking committee is scheduled to meet. If there isn't convincing evidence of a slowdown by the end of this year, Talley suggests, nominal short-term rates could be up to 7.25 percent. Depending on what happens to inflation, that could put real rates back at roughly the level of 1989.
There's a high degree of uncertainty about all of this, of course. Inflation has become noticeably less predictable in the last 10 years, remaining tame when many economic models would have predicted a jump. Other economic forces have also become more squirrelly: The Nasdaq, for example, surpasseth human understanding.
As a result, forecasters expect the Fed to keep its options open - and the rest of us guessing.>>
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