Tuesday, July 24, 2018

The "real" Fed funds rate and recessions

 - by New Deal democrat

I've seen several posts recently that might be summarized as "don't worry, be happy" because, despite a series of Fed funds rate hikes, the "real" inflation-adjusted Fed funds rate is still negative, on the order of -1%.  I beg to differ.

Let me cut to the chase: below are two graphs covering the lat 60 years (before about 1954, there really wasn't any official "Fed funds" rate). The "real" Fed funds rate is shown in red. The YoY change in the Fed funds rate is shown in blue:

Typically, the Fed funds rate was higher than the inflation rate before recessions. BUT, notice that there were three lengthy "false positives," i.e., the "real" Fed funds rate was also higher than the inflation rate during most of the 1960s, 1980s, and 1990s expansions, two of which were among the best economies the US has ever had.  Further, there was one "false negative," as the Fed funds rate never exceeded the inflation rate before the 1980 recession.

In other words, using the "real" Fed funds rate as your metric gives you correct calls for only 5 of the last 9 recessions, although to be fair, if you simply imply that a "loose" Fed funds rate is inconsistent with an oncoming recession, that improves your score to 8 out of 9.

But the simple fact is, using the *velocity* of Fed funds hikes is the most reliable guide over this time period.  When the Fed funds rate has been raised by 1.75% YoY or more during this period, at very least a sharp slowdown has occurred (1984 and 1994), and on all other occasions a recession followed.  Without such an increase, no recessions occurred.

Presently the Fed funds rate has been rising at 0.75% YoY. This is similar to the first half of the 1960s expansion.

So, is my conclusion "don't worry, be happy"?  No. The issue is found at the far left of the graphs, in the mid-1950s. That was the tail end of the low-interest-rate, low-inflation period similar to today.  Because we don't have data for that entire expansion, we really can't make a conclusion. But (not shown) the Fed funds rate did increase, somewhat slowly, by a total of 3%.

And if there isn't a Fed funds rate before 1954, there was a Fed discount rate, going all the way back to 1914 (NY Fed rates shown), and uniform for the country since 1935. Here's what that looks like compared with long term government bonds:

No yield curve inversions from 1930 to the mid-1950s. During lengthy periods of time, no changes at all. And yet four recessions happened -- one of which, in 1949, followed a two year period of up to 20% inflation(!) from 1946 to 1948, during which time the Fed pretty much sat on its hands. 

In other words, I strongly suspect that relying upon the "real" interest rate to forecast recessions only works on those occasions where the Fed raises rates in order to lower a rate of inflation that it considers too high. 

I'll take a more detailed look at what the Discount Rate might teach us in another post.