Interest Rates Without the Fed – What’s “Normal”?

Wednesday, October 21, 2009

OscilloscopeIn the Barron’s article I mentioned yesterday (“C’mon, Ben!” October 19, page 20), the effect on savers is discussed: “…consider the plight of the country’s savers, who now are getting less than 1% yields on money market funds and who are being forced to take substantial interest-rate or credit risk if they want higher yields.” The article proposes that the Fed “boost short-term rates to a more normal 2% – still low by historical standards….”

So, when the Federal Reserve Board does change its policy, what should we expect interest rates to be, based on history?

The Fed can effectively control very short-term rates, best viewed by looking at the Federal Funds Rate. When Paul Volker was chairman of the Federal Reserve Board, the rate was run up to 20% to combat double-digit inflation. Now, the rate has been running in the range of 0% to 0.25% to fight the financial crisis and recession. In normal times, the Fed tends to be more in the background, allowing normal forces to determine interest rates.

Probably the best way to see the Fed taking strong action is to look at the yield spread – the difference between the short-term rates and those of long-term bonds, over which the Fed has little control. Here is the 25-year historical look at the Federal Funds rate (Fed Funds), the 10-year US Treasury Bond yield (T-bond) and the spread between the two.

Int rate spread

Note that the Fed Funds rate moves more than the T-bond yield. This is because long-term investors look beyond the current markets and project out longer term conditions and potential risks, such as inflation.

As a result, the spread between the two varies. This is where we can get a measure of the Fed’s actions. If the spread drops to zero or negative, the Fed has “tightened” the money supply to push up short-term rates. The Fed’s purpose is typically to reduce what they believe to be over-rapid economic growth, intense speculation or risk of high inflation. Conversely, when the spread rises to 3% or more, the Fed has “loosened” the money supply to lower short-term rates. Like now, they wish to bolster what they believe to be slack economic activity, weak financial markets or risk of deflation.

Note that the spread has fluctuated between about 3% to 4% (during loosening periods) and -1% to 0% (during tightening periods). This range has been fairly consistent, regardless of the actual level of interest rates. The average spread for the period is about 1.5%, a number we can use to represent “normal” times.

Now, back to our original question of where interest rates might go once the Fed reduces their current loosening activities. Looking at the three previous times the Fed moved away from loosening to a more normal policy, the Fed Funds rate rose about 3%. If that occurred this time, the Fed Funds rate would be between 3% and 3.25%. Applying the “normal” spread of 1.5%, the 10-year T-bond yield would rise to between 4.5% and 4.75%.

Naturally, these are only rough estimates to give us a feel of what might happen. They do give us two important numbers to focus on:

First, Fed Funds at 3%-3.25% mean savings accounts, CDs, money market funds, Treasury Bills, etc. will be back to providing savers with decent yields.

Second, because the 10-year US Treasury Bond yield is about 3.4% currently, a move to a 4.5%-4.75% yield means a bond price decline of almost 9%.

So, as I wrote in “Consider Avoiding Bonds for Now” and “Making Money with Low Interest Rates,” now seems a good time to hold a fixed-income allocation in short-term investments, patiently waiting for higher yields ahead.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

October 2009