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Posts tagged with: "FEDFUNDS"

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Getting back to normal? Part 2

Are real interest rates trending down to "normal"?

In our previous post, we mentioned that the Federal Open Market Committee (FOMC) is trying to normalize interest rates by gradually increasing the target for the federal funds rate. But what is the “normal” interest rate? Some people are arguing that it’s actually lower than what it has been before. One way to try to identify this normal state is by looking at long-term trends in interest rates: Presumably, long-term forces are what move the normal level of interest rates. (In contrast, interest rates respond in the short term to economic fluctuations rather than trends.) So we’ve graphed three popular interest rates that have a longer time series: the 1-year Treasury bond rate, Moody’s Aaa corporate bond rate, and the federal funds rate.

Can you see a trend? Of course, you can. There’s a trend increase until the end of the 1970s and then a trend decrease. And, of course, this has to do with the history of inflation. This is why people tend to discuss trends in real interest rates without the inflation component. But it’s not perfectly clear how to determine that inflation component: Indeed, interest rates are driven by markets and what they think inflation will be over the life of the bond or the period of credit. The data we have cover past inflation. While past and future inflation may be correlated, they’re not the same thing. Over the longer run, however, using realized inflation as a proxy for expected inflation works reasonably well, with exceptions. So we move to the second graph, where we’ve taken the same three interest rates and subtracted the CPI inflation rate from each. Do we see a downward trend? It looks like there’s one from 1980 to the Great Recession. After that, it’s subject to debate.

How these graphs were created: For the first graph, search for “1- year treasury rate” and take the monthly, constant maturity series. Then from the “Edit Graph” section, use the “Add Line” option and search for and add “aaa” and then also “fed funds rate,” each time taking the monthly rate. Finally, start the graph in 1955. For the second graph, repeat this process for each line: search for and add “CPI,” modify its units to “Percent Change from Year Ago,” and apply formula a-b.

Suggested by Christian Zimmermann.

View on FRED, series used in this post: AAA, CPIAUCSL, FEDFUNDS, GS1

Getting back to normal?

Normalization of the federal funds rate may not look so normal

This FRED graph shows the federal funds rate for approximately the past 10 years. This is the interest rate that the Federal Open Market Committee (FOMC) targets. It’s easy to see that this interest rate has been low for most of the period shown here. But lately it’s been soaring. Or so it seems.

The FOMC is currently pursuing a policy of normalization: They’re getting the federal funds rate back to “normal.” Of course, in the graph above, the rate doesn’t look anything like normal. One has to keep in mind, however, that monetary policy has been exceptional (that is, not very normal) for the past ten years. Interest rates have been low like never before. Actually, they’ve been very close to zero for a long period. So long, in fact, that some young adults have never witnessed higher interest rates. But if you play with the the slider at the bottom of the graph to expand the time range, it quickly becomes obvious how exceptional this recent period has been and how far we still are from “normal” interest rates. Except for the period around 2003, one has to go all the way back to 1961 to find a rate as low as the current 1.5%.

How this graph was created: Search for “federal funds rate,” take the monthly series, and restrict the graph to start on 2008-12-01.

Suggested by Christian Zimmermann.

View on FRED, series used in this post: FEDFUNDS

The Taylor Rule

This graph shows in blue the Taylor Rule, which is a simple formula that John Taylor devised to guide policymakers. It calculates what the federal funds rate should be, as a function of the output gap and current inflation. Here, we measure the output gap as the difference between potential output (published by the Congressional Budget Office) and real GDP. Inflation is measured by changes in the CPI, and we use a target inflation rate of 2%. We also assume a steady-state real interest rate of 2%. These are a lot of assumptions, and you are welcome to change them on the graph by playing around with the formula to see how the Taylor Rule matches up with the effective federal funds rate. To read up on the Taylor Rule, see the original article or an article by former St. Louis Fed president William Poole.

How this graph was created: To create a new series from several series, first add the series by modifying the existing series in the “Graph” tab. Once you have assembled them all, expand the series section in the same tab and “create your own transformation.” Finally, as the axis legend has become unwieldy, remove it by checking off the mark in the graph tab.

Suggested by: Christian Zimmermann

Update: A previous version did not multiply the output gap by 100.

View on FRED, series used in this post: FEDFUNDS, GDPC1, GDPDEF, GDPPOT


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