Capital Markets

Fed-Funds Rate in the Danger Zone?

Now at its deepest discount relative to nominal GDP growth since 1978, before a severe recession.
Ed ZwirnFebruary 18, 2004

With continued economic growth coinciding with an accommodative Fed policy, will financial markets be vulnerable to any surprises on the inflation front?

Tuesday’s weekly market wrap by Moody’s analyst John Lonski, analyzing the reaction to last week’s congressional testimony by Federal Reserve chairman Alan Greenspan, noted that the chairman has signaled his intention to keep priming the pump for as long as he can get away with it.

“The Federal Reserve has indicated its intention to keep supplying punch to the party,” stated Lonski. In the testimony, “Alan Greenspan noted, ‘the real federal funds rate will eventually need to rise to a more neutral level.’ However, an accommodative monetary policy will remain in effect until both core inflation and rates of resource utilization climb higher.”

According to Lonski, Greenspan said that “neither credit nor liquidity has been growing rapidly enough to suggest that Fed policy has been excessively accommodative. Nonetheless, after slowing from the +12.1% of June 2003 to the +6.1% of December 2003, the annual increase of bank credit outstanding subsequently rose to January’s prospective +7.2%.”

Will this increase pave the way for inflation? Is the Fed policy a self-fulfilling prophecy?

“One of the bigger risks has the credit market overreacting to unexpected economic vigor especially in terms of jobs growth,” said Lonski. “If the Fed does not hike interest rates in response to expectations of faster price growth, the Fed risks reinforcing the conviction with which expectations of higher inflation are held. In turn, bond yields might be bid even higher. Sometimes, the less the Fed does in terms of reining in a perceived upturn by inflation risks, the more the market will compensate for the Fed’s inaction by sending benchmark yields higher.”

The federal funds rate is now at its deepest discount relative to nominal GDP growth since 1978, said the Moody’s analyst. Added Lonski, after 1978, “inflation’s runaway pace necessitated a tightening of Fed policy that triggered one of the most severe recessions since the Great Depression.”