Fed Will Be Forced to Cut the Fed Funds Rate Below the Inflation Rate This Year

The Fed will more than likely cut the Fed Funds rate below the inflation rate this year potentially creating an entire new set of problems that will have to be dealt with later. The new problems would in fact be new asset bubbles. For example, if interest rates are below the inflation rate people will rush out to borrow and plow it into new projects (of a dubious nature) such as alternative energy projects, which will in turn fail. Voila, the next asset bubble. The assumption that is made with this analysis is that the banks will be willing to lend even with low interest rates. My prediction is that the willingness of banks to lend this year will be limited regardless of the rate. The banks cannot take anymore losses right now. Rates are not the issue. That sound you hear in the background is credit being crunched. Text in bold is my emphasis. From Bloomberg:

The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974.

The threat of cascading stock and home values and a weakening labor market will spur the Fed to cut its benchmark rate by half a percentage point tomorrow, traders and economists forecast. That would bring the rate to 3 percent, approaching one measure of price increases monitored by the Fed.

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology.''

So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''

The Federal Open Market Committee begins its two-day meeting today and will announce its decision at about 2:15 p.m. in Washington tomorrow. Officials will also discuss updates to their three-year economic forecasts at the session.

Bernanke, and his colleagues on Jan. 22 lowered the target rate for overnight loans between banks by three-quarters of a percentage point. The cut was the biggest since the Fed began using the rate as its main policy tool in 1990 and followed a slide in stocks from Hong Kong to London that threatened to send U.S. equities down by more than 5 percent.

The central bank will probably lower the rate to at least 2.25 percent in the first half, according to futures prices quoted on the Chicago Board of Trade. The chance of a half-point cut tomorrow is 88 percent, with 12 percent odds on a quarter- point.

Inflation, as measured by the personal consumption expenditures price index minus food and energy, was a 2.5 percent annual rate in the fourth quarter, economists estimate. The Commerce Department releases the figures tomorrow.

The last time the Fed pushed real rates so low was in 2005, in the middle of the three-year housing bubble, when consumers took on $2.9 trillion in new home-loan debt, the biggest increase of any three-year period on record.

Aggressive rate cuts are justified if there's ``conclusive evidence'' that household income prospects are in danger, said Goodfriend, now a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh.

They might be. Real disposable income grew at a 2.1 percent annual pace in November, the slowest in 16 months, as higher food and energy costs eroded paychecks. Home prices in 20 U.S. metropolitan areas fell 6.1 percent in October from a year earlier, the most in at least six years. The Standard & Poor's 500 Index is down 15 percent from its record on Oct. 11.

The last time household real estate, stocks and real incomes all declined in a quarter was during the 1974 recession, according to calculations by Macroeconomic Advisers LLC.

``Wealth had been rising because of strong home prices'' and stock gains, said Chris Varvares, president of Macroeconomic Advisers in St. Louis. ``Now, we are losing that prop to consumption, so it all comes down to growth in real income.''

Varvares predicted that housing and investment portfolios will add nothing to consumption this year, while incomes, after inflation, may gradually rise ``so long as oil behaves.'' The firm expects the economy to grow at a 1 percent to 2 percent annual pace in the first half.

``A big part of the 75 basis point surprise was to blunt the worsening of financial conditions'' that may reduce employment and hurt income growth, Varvares said. The firm predicts a half-point cut tomorrow.

``That need not be the end,'' Harvard University economist Martin Feldstein, said in an interview. ``They can keep coming back and revisiting it every six weeks.''

Feldstein, a member of the group that dates U.S. economic cycles, said any recession this year ``could be much more painful because of the fragility of the financial sector.''

The Fed incorporates wealth effects, or the impact of changes in household assets on spending, in its economic model. Americans cut spending by about 5 cents for every $1 of decline in their home values or stock portfolios, economists estimate.

``We are likely to see another wave of problems in the consumer-credit side,'' John Thain, chief executive officer of Merrill Lynch & Co., said at the World Economic Forum in Davos, Switzerland, last week. ``This is going to be exacerbated by the rise in unemployment and we have issues with higher energy prices.''