The 'Real' Real Interest Rate
The Economic Cycle Research Institute (ECRI) calculates a Future Inflation Gauge (FIG) each month. As its name suggests the FIG was designed to predict changes in the inflation rate with a lead-time of several months. However, neither the money supply growth rate nor the single most important influence on the money supply growth rate - changes in the level of long-term interest rates - are considered when calculating the FIG. It is therefore not a good leading indicator of inflation (a list of the FIG's components can be found at www.dismal.com/dismal/dsp/release_def.asp?r=usa_ecrifig). As the following chart shows it has, however, been an excellent leading indicator of Fed policy during Greenspan's tenure as Fed Chairman (the chart was taken from the ECRI's web site). In our opinion the FIG should be re-named the FGG - Future Greenspan Gauge.
Since 1934 the US has experienced inflation, and only inflation, in varying degrees. During those times when the inflation manifested itself in the prices of commodities and the widely-watched (and manipulated far beyond the point of usefulness) price indices, the inflation was perceived to be a problem. During those times when the inflation was only evident in the trade deficit and/or asset prices, the inflation wasn't perceived to be a problem. In fact it wasn't (isn't) perceived at all.
Our view of inflation/deflation - that inflation is an increase in the money supply and deflation is a decrease in the money supply - may appear to be overly simplistic. However, it is only by starting with the premise that inflation/deflation relate purely to what is happening with the supply of money that One can make sense of what has happened over the past decade.
Asset price bubbles can only occur when the real rate of interest (the nominal interest rate minus the inflation rate) is extremely low. However, during 1996-1999 anyone who calculated the real interest rate by subtracting the CPI from the nominal interest rate would not have perceived that real interest rates were unusually low. They would therefore, in all likelihood, have found the need to resort to "new era" and "new economy" fantasies in order to explain the asset price explosion. For those who understood the true meaning of inflation the explanation was far more logical - negative real interest rates propelled a massive expansion of credit that, in turn, pushed asset prices and the trade deficit into the stratosphere.
Below are two charts that illustrate our point. The first chart shows the real Fed Funds Rate calculated by subtracting the year-over-year change in M2 money supply from the Fed Funds Rate (let's call this the 'real' real interest rate). Note that the 'real' real interest rate peaked in early 1995 at 6%, went decisively negative in late-1997 and didn't turn positive again until the first half of 2000. Recall what happened to the stock market when the 'real' real interest rate poked its head above zero last year. The second chart shows the real Fed Funds Rate calculated by subtracting the annualised percentage change in the median CPI from the Fed Funds Rate and represents the consensus view of the real interest rate. (The median CPI, calculated monthly by the Cleveland Fed, is the best official measure of consumer price changes because any outlying values are excluded from its calculation. For example, if tobacco prices spike higher and computer prices spike lower during a particular month then both will be excluded from that month's calculation.) Note that this real interest rate remained stable in the +2.5% to +3.5% range throughout the course of the asset price bubble.
The above charts also confirm that both the real interest rate and the 'real' real interest rate are now extremely low (deeply into negative territory). The conditions are currently very much in place for another bubble with the big question being where the next bubble will appear.
The US is presently experiencing an extremely high inflation rate and extremely low real interest rates, yet the Future Greenspan Gauge tells us not to expect any change in Fed policy for at least a few more months. This means the inflation problem is going to get much worse.
28 November 2001
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