The Fed Should Cut Rates By 0.25%

The Federal Reserve is meeting this week, as it’s almost universally expected that nothing will happen. I agree, the Fed won’t raise or lower rates, but I think it’s time that the Fed should lower interest rates. I’m not pushing for a big cut, just a small 25-basis-point cut for now, and we can see where that leads us.
Historically, there have been “fine tuning” measures from the Fed. Ten years ago, the Fed bumped up rates from 5.25% to 5.5%. That was the only move in nearly two-and-half years.
The main reason for my outlook is the sudden drop in short-term interest rates. The 90-day T-bill and the Fed Funds rates almost always track each, but not lately. Last week, the yield on short-term Treasuries dropped below 4.4%. That’s a difference of over 85 basis points from the Fed, and it’s the widest such spread in six years.
Clearly, the market wants a cut. I think the Fed has been most effective when it has given the market what it wants instead of trying to push it where it doesn’t want to go.
The other reason is that inflation seems to be cooling off. Last October, the core rate of inflation got to 2.9% and now it’s backed off to just 2.2%. Most surprisingly, that’s exactly what the Fed said will happen (here’s my exclusive coverage of Bernanke’s testimony from last July).
I know there are many concerns about the government’s measure of inflation, and the use of the core rate. I think these arguments are correct, however, my concern here isn’t the level of inflation but the direction. Inflation maybe higher than they’re telling us, but it’s lower than where it was. This means that the “real” Fed Funds rate, meaning the difference between the Fed’s target rate and inflation, has been increasing. So in effect, as inflation has cooled off, it’s been as if the Fed has continued to raise rates.
The real Fed Funds rate is now slightly over 3%. Historically, anything more than that is trouble for the economy. I also don’t get how gold can be around $650. With 3% real rates, that seems massively overpriced.
Here’s a chart of 90-day T-bills (yellow), the Fed Funds rate (blue), core inflation (black) and the real Fed Funds rate (red) going back to 1991.

Posted by Eddy Elfenbein on June 26th, 2007 at 10:00 am

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