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March 24, 2006

The Joy of Neutrality?
by Michael Panzner

There is a widespread belief that the U.S. Federal Reserve remains on track to boost interest rates back towards more "neutral" levels. The only question is: what is neutral?

To figure that out, it makes sense to look at what has been the norm over several decades. Not only for nominal interest rates, but for inflation-adjusted -- or "real" -- interest rates, too.

As it happens, the median monthly nominal and real effective federal funds rate during the past 50 years has been 5.31% and 1.76%, respectively, while comparable yields on 10-year Treasury bonds have been 6.31% and 2.65%. The monthly year-on-year gain in consumer prices has averaged out to 3.30%.

Under the circumstances, one could argue that with February's 4.49% fed funds rate lying 82 basis points beneath the median -- and the 0.89% inflation-adjusted rate 87 basis points shy of its average -- we should be looking for at least three more 25-basis point hikes.

Moreover, with February's 4.57% 10-year Treasury yield 174 basis points below normal -- and the real rate of 0.97% a similarly wide 168 shy of its 50-year median -- we should expect to see much higher bond yields -- and sharply lower prices -- than we have now.

Not to mention the fact that if reported inflation turns out to be understated -- as many now believe -- the rate rises to come are likely to be far more dramatic.

Whatever the case, it seems wrong to assume that the 25-basis point rate hike set to occur at next Tuesday's FOMC meeting will be the last -- as bullish proponents of the so-called "one-and-done" perspective have been arguing.

Or that the sell-off in bonds, which has boosted longer-term yields by around 40 basis points over the past two months, will be ending any time soon.

So much for the joy of neutrality?

Michael J. Panzner
financialarmageddon.com

Michael J. Panzner is a 25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, published by Kaplan Publishing.