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Minyan Mailbag: Real Interest Rates



Prof. Succo,

The U.S. Treasury has reset the 6 month CPI rate for Series I savings bonds to 2.85% (obviously 5.7% annual) - based on the All Urban CPI. At that rate and with ECRI's future inflation gauge pointing towards continued inflation pressures, that means that the current real rate is lower (i.e. more negative) than it was when the Fed Funds rate was at 1%! I realize some of your data is likely proprietary, but I was wondering if you could add some color regarding what you are seeing that shows monetary contraction?

I envision a point where the Fed, probably Bernanke by then, has to raise rates a bit faster than most expect to prevent inflation from getting out of control. Bernanke is surely not a tight money advocate but new Fed chairman are famous for trying to establish their inflation fighting credentials early in their terms. I see the market forcing higher interest rates and setting the stage for a consumer/housing driven recession late in 2006 into 2007, and then potentially a deflationary credit crunch. This flies in the face of Mr. Scott's analysis, so what do you think? Have the imbalances become so extreme that the market is destroying liquidity even with negative real interest rates or is the bond market in for a rude awakening and a 6% 10 year yield?


Minyan James


We use a monetary variable that attempts to incorporate the velocity of money in addressing the liquidity question. This figure shows "real" money is falling fast. This makes sense as the Fed raises short term rates.

This is not being done out of choice by the Fed. Foreign lenders are demanding higher rates for new debt and are forcing the Fed to raise them. Whatever liquidity is being injected by the Fed is not enough to drive rates down: it would have to be a monumental amount that would send a clear signal to the markets thus causing a severe drop in the dollar.

The Fed has little choice and it is just a matter of time before first the housing market and then the stock market understands that liquidity is being reduced not because central banks want it to, but because the markets are demanding it.

I agree with your conclusions. Real rates are negative even more so but it seems debt levels have reached such extremes that they are having less and less effect.


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