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 www.secorp.org.
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.
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
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
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
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 www.secorp.org.
If you would like more information about investment services at Southeast
Corporate, contact Greg Wirthmann at 800-342-0203, ext. 201.