Fed Funds V Inflation: Long Term Views

To what degree does long term Fed Funds averages explain actual Fed funds when monetary policies over 25 years, since 1992, were completely different. In the 1990’s, monetary policy was fairly normal while monetary policy today is non normal and Ultra Loose.
Under 1990’s normal monetary policy, Fed Funds was 5.0’s. Fed Funds at 5.0 is a reflection of the price of money in percentage terms at a fairly normalized level and strictly based on money supplies. The value of the money was based on money supply. As money is added to an economic system then money becomes loose or better stated, cheap. Fed Funds then drops to reflect the cheapness and abundance of money in the system.
An inverse relationship exists from Fed Funds to money supplies and seen in opposite Correlations. If money supply was positively Correlated to interest rates, speculation is markets wouldn’t exist and political systems would be ruled by dictators in the spirit of Robert Mugabe in Zimbabwe. Why the standard in opposite Correlation is to allow the exchange rate to reflect the interest rate to reflect the exchange and interest  rate in traded markets.
Overall economic rules are higher Fed Funds equates to a tight to normal monetary policy as money supply is low yet the cost of the money reflected in Fed Funds may or may not be appropriately priced. Alternatively, Loose money, cheap or money in abundance as is the case since 2009 results in lower Fed Funds which may or may not be appropriately priced. Banks and central banks once performed this research and traded on the information but no longer.
The BOE for example stopped in 1998. My favorite Model is the IS/LM Keynesian Model from John Hicks 1937. Investment Savings and Liquidity Preference for Money Supply. See PP 31 to 32 for John Hicks and IS/LM in Inside the Currency Market. See PP 33 for Mundell – Fleming as well. Both models and interest discussion applies to all interest rates and all central banks.
Fed Funds is a market instrument and represents a price. A price has an average and the average reflects levels over time. The average answers what was / is the level of money supplies. Yet the average is valid as an assessment to Fed Funds. Possibly the more appropriate method would be to measure not the dominant interest rate but the money supply in M1 and M2 to reflect overbought / oversold conditions and ranges.
The second question is how much does long term Fed Funds averages allow CPI to move and what role does CPI perform in this relationship. The main question was will CPI nullify and skew long term Fed Funds averages to the point long term averages are invalidated. I took the challenge. In this regard to digress, long time friends and followers would know Peter and my thank you’s to his 43 years in FX, friendship and assistance.
CPI monthly averages dating from 1 to 25 years was factored from the BLS data in the All Urban Consumer category and this is the reporting information month to month. Fed Funds V CPI was viewed from averages v Medians, Skew V Kurtosis, 10 year Regressions, range stats, noise ratios, Correlations.
The last monthly reported in January CPI was 0.6. The most striking revelation in Fed Funds V CPI in 10 year monthly averages is CPI and Fed Funds factor low Correlations. The highest Correlation is located at the 1 year average at 23% then 3 year at 21%. The overall Correlation range is 0.09% at the 8 and 9 year averages and highest at 23%. Range 0.09% to 0.23%.
The 0.6 level is the highest in 23 months and 0.6 as an point met or exceeded 32 times in 300 months or 25 years. The overall high to low range in monthly averages 1 to 25 years is 1.0 seen 2 times and lows at minus 1.9 and seen 1 time. Compared to Fed Funds averages 1 to 25 years, lows at 0.07 was seen 5 times and one time high at 6.54.
The location of CPI in 25 years is priced well below Fed Funds. The CPI 0.6 average is well above every CPI average from 1 to 25 years while Fed Funds at 0.66 is also well above every average from 1 to 10 years but far below every average from 10 to 25 years. Low CPI and higher Fed funds is the optimum position so as not to have Inflationary CPI to high to erode the purchasing power of money. High Inflation results in worthless consumer, borrow and lend money therefore sufficient distance is needed from CPI to Fed Funds. The Fed wants higher CPI therefore Fed Funds must rise otherwise economic problems will ensue.
The current distance is CPI 0.6 V Fed Funds 0.65 or 59 basis points. To compare, when Fed Funds reached its highest 6.54 mark 198 months ago, CPI registered 0.0 as an average. When 1.0 CPI was last seen 71 months ago or nearly 6 years, Fed Funds was 0.16 and an 86 basis point difference. When minus 1.9 CPI was seen 99 months ago or 8 years, Fed Funds was 0.97 or 93 basis point distance. The overall question is what is sufficient distance from Fed Funds to CPI.
The range of CPI averages 1 to 25 years runs from highs at 0.19 to lows at 0.10 while Fed Fund averages from 1 to 10 years runs from 0.16 to 0.41 then 10 to 25 years runs from 0.69 to 2.54 at the 25 year mark. Fed Funds at 0.66 runs 50 basis points above its 0.16 lows and 26 basis points from its highs while Fed Funds is running from 56 to 47 basis points from all CPI averages .
To quantify prices in Peaks and valley range terms, Fed Funds from 1 to 10 year averages is running from 2.8 times at the 8 year average to lows at 1.2 at the 2 year average against Inflation. A nasty switch then occurs at 10 to 25 year averages when Inflation runs above Fed Funds. From the 10 year average, no effect occurs yet the 10 year average at 0.69 is closest to 0.66 so no effect is explained. CPI then runs 2.3 times above Fed Funds at the 12 year average, 2 times at the 15 year, 2.3 times the 17 year. Then Inflation skyrockets to 4.3 times at the 20 year and 5.6 times at the 25 year. Medians from 1 to 10 years runs 0.1 while a jump occurs to 0.2 from averages 10 to 25 years.
Two factors inform the CPI V Fed Funds relationship. Current signals for CPI and Fed Funds are high yet not at alarming rates but both are close to exorbitant peaks. Raise Fed funds and CPI then the words nervous and worry enters the lexicon. Raise CPI and Fed Funds one time then Yellen and the Fed are pushing the range limits. CPI averages vary currently from 0.30 to 0.77 against high high signals. The inflection mark in Variations is zero and a raise pushes Variations even lower.
The drivers overall for CPI and Fed Funds is the 9 and 10 year averages. Based on 10 year Regressions, Fed Funds informs CPI at 0.6 is out of range at averages 2, 5, 7, 9 and 10. CPI is at top range in averages 1, 3, 4 ,6 and 8.
CPI informs Fed Funds at 0.66 is 15 to 40 basis points to high from averages 1 to 8 years but in range from averages 9 and 10 years. Under assumption the 2% target achieves destination then Fed Funds at the 1 and 2 year averages is at top range while 17 to 33 basis points out of range from averages 1 to 8 years. The 9 year average is the main driver from an average line at 0.64 to top at 1.30.
Fed Funds is not only to high, at top peaks but its far overbought. CPI on the other side is low and oversold yet not terrible at 0.6 but higher is not the way.
CPI and Fed Funds shares an historic relationship and the association is found in the question of distance. The time frame doesn’t matter and its why long term Fed Fund averages hold and are valid as an insight, as a trade and an economic view. Fed Funds informs CPI and vice versa. Over time we’ve seen a love / hate relationship yet both are dependent on each other. Currently based on Correlations, CPI and Fed Funds is out of sync.
I hold my views today as I did in August and agree with Bullard, don’t dare raise Fed Funds.

One factor to view today V August is CPI and FED Funds are small numbers and trade in small ranges over long periods of time. Therefore the averages are slow to move month to month.


Brian Twomey


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