FED Funds and Natural Rate of Interest: Levels, Ranges, Targets

John Maynard Keynes in the General Theory defined the Neutral Interest rate as the rate when inflation is zero and full employment reaches full capacity. Keynes redefined the terms as neutral to mean the intersection of output and employment. Keynes definition derives from the Swedish economist Knut Wicksell.

Wicksell in 1898, long before Keynes and accepted by the Austrians defines the Natural Rate of interest as the ratio of prices between present and future consumption. Its a price indicator and employs price as the foundation. The price today is CPI. When demand for loans is in balance to supply of savings then the market automatically balances the Natural Rate but its an open and trade able rate and market determined rather than central bank imposition from on high.

The role of central banks in the Austrian and Swedish schools of economics is add or subtract monies to the economy to maintain the natural rate until or unless demand and supply deviate. What causes deviations is what Wicksell terms the Real Yield of capital in production. An increase in demand in relation to supply then interest rates rise and vice versa. Demand and supply of capital constantly change and why the natural rate is a floating, market determined rate.

To understand the Natural Rate based on Wicksell, the long term view must be known. The 20 year Fed Funds Effective monthly average is 2.44 and Inflation last at 0.80. The 20 year Natural Rate is therefore 1.64 to subtract the average from CPI. The 17 year Fed Funds Effective average is 1.94 so the Natural Rate is 1.14. The 15 year average at 1.44 determines a Natural Rate at 0.64.

Moving along, the 10 year average is 1.02 so Natural Rate is 0.22. The 5 year average at 0.14 so Natural Rate is 0.66. Correct is to subtract the average from CPI therefore in actuality the Natural Rate is not only negative but negative from monthly averages 1 to 9 years and in successive order.

On a 20 year average basis, the Natural Rate range is 1.64 to negative. From the 15 year average the Natural Rate range is 0.64 to negative and 0.22 to negative for the 10 year.

Fed Funds averages from 1 to 9 years are not only low and severely overbought but range from 0.14 to the 9 year at 0.55. Subtract the 9 year then the range becomes 0.14 to the 1 year average at 0.27. The averages are low and why the severe overbought condition from present Fed Funds at 0.40. Over 8 years since the crisis, the averages remained stasis under an immovable Fed Funds Rate. Targets range from 0.46 to 0.22 to offer how overbought are averages.

The demarcation average is the 10 year at 1.02 then travels to the 20 year at 2.44. Averages from 10 years, 12, 15 and 20 are in good condition and not oversold. Viewed from averages 1 to 9 years, Fed Funds looks horrendous but in good shape from 10 to 20.

Fed Funds is far above Medians from averages 1 to 15 years and range from lows at 0.11 at the 3 year to 0.38 and 0.39 at the 1 and 15 year. Serious convergence occurs at the 1.01 Median in the 17 year and 1.02 at the 10 year average. both are big breaks far down the road yet its the overall target for Yellen when or if the Fed decides to raise.

Brian Twomey, Inside the Currency Market, btwomey.com