Trekking Toward Neutrality

The latest Federal Reserve Board interest rate increase is likely beginning of a monetary tightening cycle. Read an analysis of the short and long term ramifications of a neutral monetary policy.



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The full economic impact of interest rate changes is often hard to comprehend. Here are selected highlights of Southeast Corporate Federal Credit Union’s analysis of the short and long term ramificationsof the latest Federal Reserve Board hike. For the full article, visit September’s Corporate Insight archives at

Surprising almost no one, the Federal Open Market Committee (FOMC) voted to raise the targeted Fed funds rate by 25 basis points, to 1.75%, at the conclusion of its Sept. 21 meeting. The increase was largely anticipated by market participants, especially in light of the August employment report which, although not robust, was sufficient to alleviate the concern that the nation’s job-generating ability had become suspect. The unemployment rate declined by one-tenth of a point, from 5.5% to 5.4%.

Although it is not surprising that the Fed now has engaged in three rate increases, it is fairly surprising to find that the coupon Treasury curve now is lower than just prior to the first tightening on June 30. On June 29, for example, the two-year Treasury provided a yield of 2.82%, while as of this writing, it stands at 2.59%. Even more surprising, the 10-year Treasury was 4.69%, while it currently stands at 4.09%, having shaved off 60 basis points.

Given the simultaneous increase in the overnight rate, the differential between the targeted Fed funds rate and the 10-year Treasury rate has declined from 369 basis points to 234 basis points. Granted, a flattening or steepening of the curve is not an unusual event. What is unusual, though, is that this flattening has occurred in what we at Southeast Corporate would consider the early portion of a monetary tightening cycle. Generally, such a flattening will occur toward the end of a tightening cycle.

Pacing Inflation
We believe the driver of this current narrowing spread is, if not the approaching culmination of a tightening cycle, a substantial reduction in the market’s inflationary fears. The inflation flare-up of last spring has subsided sufficiently for the 10-year Treasury to no longer carry an inflation premium.

The moderation in the pace of inflation is indicated by the core Consumer Price Index, which has averaged a 0.1% increase over the past three months, after an average 0.3% increase during the March-through-May period. The Fed’s preferred inflation measure, the core Personal Consumption Expenditures Deflator (PCE), has shown a similar decline during the period.

This clearly places the Fed in the enviable position of having the leeway to return to a neutral monetary position without the pressure to tighten rapidly due to accelerating inflation. The economy appears to be rebounding from the soft spot it encountered during the summer, yet inflation appears to be less of a threat than it was last spring. The Fed indicated that it believes both of these to be the case when it stated that “inflation and inflation expectations have eased in recent months,” yet “output appears to have regained some traction.” Under this scenario, the Fed can continue to engage in the methodical tightening schedule that it has utilized thus far – namely, 25 basis points every meeting.

We look for these tightenings to continue to occur, despite the current flatness of the curve. An adequate level of growth should be maintained by a resilient consumer sector (despite the increase in inelastic goods such as oil), continued productivity gains, a resurgent manufacturing sector and increased business investment.

Looking Forward
The assessment that monetary policy remains accommodative is not surprising. Fed funds, less inflation (or “real” Fed funds), have been negative for nearly the past two years, and just became positive with the most recent tightening. As indicated in the graph below, despite the fact that real Fed funds now are positive, the rate remains well below the average of the last 16 years.

Using the Fed’s preferred inflation measure, the core PCE, the average real Fed funds rate has been 2.43%, yet it currently resides at 0.35%. (Using the current 1.75% Fed funds rate and 1.4% core rate for August, the chart below actually uses the August data of 1.5% for Fed funds and 1.4% for the core PCE because the September data have not yet been released). Using this long-term average as a benchmark, a neutral monetary policy would entail returning the targeted Fed funds level to approximately 3.75% to 4%. Therefore, look for the Fed to continue with its methodical increase of 25 basis points per meeting until this level is achieved. Most likely, this level will be obtained in late 2005.

Article was originally written on Sept. 29, 2004 for Corporate Insight publication. Corporate Insight is a bi-monthly publication of Southeast Corporate. Previous editions of Corporate Insight are archived at If you would like more information about investment services at Southeast Corporate, contact Greg Wirthmann at 800-342-0203, ext. 201.


Oct. 11, 2004


  • If you apply the "real" Fed Funds rate you speak of (approx. 1%-2% over the rate of inflation) with such low 10-year rates then the "real" yield curve is close to inverted, often an indicator of an oncoming recession. Will the Fed then look to keep the rate artificially lower than the "real" rate to prevent an inverted yield curve? Does it matter - are the economic fundamentals of the 10-year rate being lower than the "real" Fed rate enough to induce the consequences generally associated with an inverted yield curve? It's pretty tough make any money, net of inflation, off of 10-year Treasuries these days.
  • "You are correct," the real rate of return earned by clipping coupons off of the ten-year appears quite meager these days. It is interesting to note though, that by extending the analysis performed on the targeted Fed funds rate to the Treasury curve it becomes apparent that the "real" curve is still upwardly sloping. Additionally, should the Fed tighten enough to achieve neutrality, it is likely that other rates/yields will also approach, if not entirely achieve, their long-term real average.