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The Fed Searches For the Neutral Interest Rate, Where the Heck Is It?

To bring down inflation, Chicago Fed President Charles Evans said the Fed might have to hike above neutral. Where is that?
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Image clip from Bloomberg video interview.

Image clip from Bloomberg video interview.

Bloomberg reports Fed’s Evans Sees Rates Rising Above Neutral Level

Twelve Key Video Quotes

  • Interest rates are very low. They've been low for three years.
  • We need to position monetary policy much closer to neutral. 
  • Economy has a tremendous amount of momentum.
  • The economy should do well in a neutral setting.
  • I would say a neutral setting for monetary is somewhere in the 2.25 to 2.50 percent range. 
  • It would be good if we got there by the end of our next March meeting. 
  • If we accelerated that so we were there in December, that would be OK too. 
  • By the time we get to December we ought to see if there is rollover in the inflation data.
  • The optionality of not going too far too quickly is important. 
  • Fifty [basis points] is obviously worthy of consideration. 
  • If you want to get to neutral by December, that would probably require something like nine hikes this year and you're not going to get there is you just do 25 at each meeting.
  • So I can certainly see the case [for 50 basis point hikes]

Those quotes are my transcription of the video. 

In Search of Neutral 

Serious Mistakes and Bubble Blowing Policy

Please note the severely asymmetric policy of the Fed. In response to every recession, they cut rates quickly and dramatically well below any neutral rate.

Then the Fed is slow to respond to the inflationary bubbles the Fed blows. 

Neutral right now could easily be 4%. In December it could easily be  1.5%. 

People confuse neutral with the CPI. Neutral most assuredly isn't 10.5%. 

Fed Compounds the Problem Multiple Ways

  • Not counting the bubbles it blows as part of inflation
  • Asymmetric policy
  • Constantly chasing its tail 
  • Constantly promoting more debt and not debt writeoffs as the solution to downturns
  • Never letting a cycle finish naturally 
  • Viewing 2% CPI inflation as a good thing when the CPI is a very poor measure of inflation

Home Prices

Case-Shiller Home Price Index data from St. Louis Fed, chart by Mish

Case-Shiller Home Price Index data from St. Louis Fed, chart by Mish

Those are obvious bubbles, no matter what anyone says. People justify the prices because of low interest rates. 

But now what?

Mortgage Rates   

30-year mortgage rates courtesy of Mortgage News Daily (MND)

30-year mortgage rates courtesy of Mortgage News Daily (MND)

In an effort to slowly get back to neutral, Evans hopes to get to neutral by March of 2023.

Inflation is raging now. But what happens to demand (and thus prices) in a housing bust? 

Key Mistake 

Instead of hiking into strength, once again the Fed is slowly hiking into weakness. The  key mistake by the Fed is promotion of 2% CPI or PCE inflation while ignoring obvious asset bubbles.

Some asset bubbles are hard to quantify, but given the Case-Shiller home price index measures resales of the same home, that makes for an easy measurement of home price inflation.

Case-Shiller National, Top 10 Metro Percent Change From Year Ago

Case-Shiller Home Price and CPI data from St. Louis Fed, chart by Mish

Case-Shiller Home Price and CPI data from St. Louis Fed, chart by Mish

Home prices were up 19.17 percent from a year ago. The Fed did not ignore this bubble, it promoted this bubble.

Percent Change From Year Ago Notes (January 2022 is latest CS Data)

  • CPI: 7.48%
  • OER: 4.09%
  • Rent: 3.76%
  • Case-Shiller 10-City: 17.52%
  • Case-Shiller National: 19.17%

CPI Understated?

Yes, by a lot.

Owners' Equivalent Rent (OER) is the mythical price one would pay to rent one's own home from oneself, unfurnished and without utilities. 

I do not believe OER is only up 4.09%. Nor do I believe rent is only up 3.76%.

Moreover, home prices are not directly in the CPI, only OER and and Rent.

Real Interest Rates 

Scroll to Continue


Real Interest rates a Mish Calculation

Real Interest rates a Mish Calculation

My Case-Shiller Adjusted CPI is calculated by substituting the year-over-year percentage rise in home prices for OER in the CPI.

By that measure real interest rates are negative 10.21 percent!

The chart is as of January because that is the latest Case-Shiller data. 

Common Misconceptions 

The BLS discusses Common Misconceptions about the Consumer Price Index

The CPI used to include the value of a house in calculating inflation and now they use an estimate of what each house would rent for -- doesn't this switch simply lower the official inflation rate?

No. Until 1983, the CPI measure of homeowner cost was based largely on house prices. The long-recognized flaw of that approach was that owner-occupied housing combines both consumption and investment elements, and the CPI is designed to exclude investment items. The approach now used in the CPI, called rental equivalence, measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.

The rental equivalence approach is grounded in economic theory, receives broad support from academic economists and each of the prominent panels, and agencies that have reviewed the CPI, and is the most commonly used method by countries in the Organization for Economic Cooperation and Development (OECD). Critics often assume that the BLS adopted rental equivalence in order to lower the measured rate of inflation. 

The problem with the broad support for economic thinking is that it ignores obvious bubbles.

OK, housing is not a "consumer" expense. La dee da. Housing is a measure of inflation. 

Inflation, all of it, is what's important, not just alleged consumer price inflation.

Spotlight on the Previous Housing Bust

Real Interest rates a Mish Calculation

Real Interest rates a Mish Calculation

Repeat Play Coming Up

  • Please pay close attention to the above chart because a repeat performance by the Fed is underway.
  • When the Greenspan Fed finally started hiking, I calculate real interest rates of -4.57 percent via home price substitution for the OER as described above.
  • Then a housing crash started that the Fed ignored. 
  • Real interest rates were already very positive by mid-2006 but rates looked negative as measured by the CPI. 
  • Nonetheless, and no doubt in search of "neutral" the Fed kept hiking.
  • The Greenspan Fed thought it found neutral and stopped hiking at 5.25%.
  • Meanwhile, real interest rates by my calculation kept rising to 4.07%. 
  • Nearly everyone then had a spotlight on oil which rose to $140. 
  • I repeated stated ignore oil because a very deflationary bust was in the cards. 

Where is neutral?

I have no idea. More importantly, neither does the Fed, nor anyone else. 

Only the free market, not a bunch of group-think wizards can possible understand.

St. Louis Fed President Says "Fed is Not Far Behind the Curve"

Please note St. Louis Fed President Says "Fed is Not Far Behind the Curve"

Curiously, the Fed is so far behind the curve that the curve is about to bite the Fed in the ass from behind. 

Neutral is Constantly Changing 

My message is the same today as it was in 2006. Another deflationary bust is coming. 

The Fed will not see it because it clueless not only about where neutral is, but also because the Fed is clueless about the asset bubble boom-bust cycles that it is perpetually blowing. 

Given the massive amount of debt and leverage, neutral is likely far lower than most presume. 

Meanwhile, the asymmetric policy of the Fed continually adds to the problem. Look again at my previous chart to see what's happening.

If I am correct, betting on long-durations bonds at these prices will be a winning bet by the end of the year.

A housing bust is already underway. For discussion, please see Existing Home Sales Decline Again, But the Big Bust Starts Next Month

This post originated at MishTalk.Com.

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