Economic News Blog
Posted by: Steven Kline, Jr. 16. May 2013

Real Fed Funds Rate Pointing Toward Slower Growth

The Fed funds rate is the earliest leading indicator of the durable goods industry and capital equipment spending. Typically, changes in the the Fed funds rate lead changes in capital equipment spending by several years. Historically, I've used the Fed funds rate to indicate the direction of housing permits and consumer durable goods spending because both houses and durable goods are almost always bought with debt. Therefore, as rates go down, both houses and durable goods become relatively more affordable and consumers buy more of them. Of course, as more of these goods are bought manufacturing needs more equipment to make those goods. Also, our economy is structured in a way that requires more debt for growth to occur.

However, since the Fed funds rate has been essentially zero since December 2008, the real Fed funds rate has become a better leading indicator. The real Fed funds rate is simply the Fed funds rate minus inflation. Even though nominal rates can't go below zero, the Federal Reserve can push real rates below zero if price inflation is greater than the interest rate. Since March 2010, the Fed funds rate has been negative because inflation has been higher than the interest rate.

The real Fed funds rate is particularly important leading indicator for housing permits and real consumer durable goods spending. Because the nominal Fed funds rate has been held close to zero since December 2008, the main factor in the real rate is inflation. As inflation increases, which is the hope of the Fed right now, the real rate goes down and vice versa. But, in April annual inflation was at its lowest rate since June 2010, according to the official CPI. Therefore, the real Fed funds rate has been getting less and less negative. This means that compared to one year ago the real rate has increased for eight straight months.

As the real rate increases compared to one year ago this puts a damper on housing permits and consumer durable goods spending. However, we may be near the end of the cycle of the real Fed funds rate increasing year over year. If the nominal rate and inflation stay at current levels then the year-over-year change in the Fed funds rate will start going down next month and continue to do for the rest of 2013. If inflation increases, then the year-over-year change will go down even faster. I believe this is one of the main goals of current Fed policy. While the policy of negative rates is not good in the long run, this trend could be a boost to durable goods manufacturing in 2014.

The Fed funds rate is an important leading indicator for the following industries: appliances; automotive; custom processors; furniture manufacturing; hardware; HVAC; metalcutting job shops; off-road and construction machinery; petrochemical processors; plastics and rubber; pumps, valves, and plumbing products; textiles, clothing, and leather goods; and wood and paper.

Comments are reviewed by moderators before they appear to ensure they meet Gardner Business Media’s submission guidelines.
blog comments powered by Disqus