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Benson's Economic & Market Trends

Interest Rates Stay "Real Easy"

June 30, 2004

The Fed is raising interest rates but continues an easy Monetary Policy. How can this be?  How can the nominal level of interest rate for Fed Funds be raised from 1 percent to 1.25 percent while Greenspan is still considered "easy"?  The reason is this policy lives in a land of "Inflation and Money Illusion".  Money illusion occurs when you give the consumer more money to spend, when it actually buys less.  The consumer is left thinking they still got something for their new money because they are still thinking about yesterday's prices.  Because most people, including investors, can be fooled this way year in and year out, inflation can continue to be used by the world's central banks to cheat savers and subsidize borrowers.

Here's how it works. There are really two interest rates " the reported interest rate and the "real interest rate".  The interest rate on Fed Funds has been raised but to understand what the actual policy is, the Fed Funds rate needs to be adjusted for Inflation.  This inflation adjusted interest rate is what economic scholars call the "real rate of interest". After inflation, an investor would like to see if he really made or lost money.    

Now, if the Fed keeps the interest rate on Fed Funds below the level of inflation, as they do now, anyone who can borrow will actually owe less in real terms at the end of the year.  If a speculator can borrow at 2 percent, when inflation is actually 5 percent, the speculator's real rate of interest is a negative 3 percent!   In this Money Illusion world, institutions such as banks, Wall Street broker dealers and Hedge Funds, are stepping up and borrowing and will increase their holdings in commodities and precious metals that do well in inflation.

Since the Federal Reserve is in the business of providing all the money anyone wants at the interest rate they fix, there is no actual limit to how much money might be borrowed or how high the resulting money growth might be. 

To accurately gauge the Fed's policy with respect to interest rates, it is important to understand that if the real Fed Funds rate is positive, savers are getting something on their money and borrowers actually have to pay something for it.  If the real Fed Funds Rate is negative, savers are getting robbed and borrowers are getting subsidized. Investors should note that the Real Fed Funds rate started the year at "0.93 percent in January and has dropped to an even easier "2.01 percent in May!  Surprise; the Federal Reserve has been easing the first six months of 2004!

Recent data of the Consumer Price Index (CPI) is showing inflation; a lot of it! The year over year CPI is up 3.1 percent and the CPI for the three months ending in May, was 5.5 percent at an annual rate. 

Given the timing of inflation flowing into the United States, the rise in the CPI on a year over year basis, is back loaded into the end of 2004.  The following chart is a highly likely projected reading for the Real Fed Funds rate assuming: 1) for the remainder of 2004, the monthly CPI fluctuates between 0.3 percent and 0.4 percent (which is less than the current monthly rate of increase; and 2) the Federal Reserve raises the interest rate on Fed Funds by 0.25 percent at its scheduled FOMC meetings in August, September, November and December.