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Why The Fed Isn't Finished Raising Rates

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by Rex Nutting, MarketWatch

Last Update: 8:24 PM ET Mar 28, 2006

WASHINGTON (MarketWatch) - If the Federal Reserve follows its historic patterns, it'll raise interest rates between two and eight more times before stopping.

After 15 straight rate hikes by the Federal Reserve, real interest rates are still more than a half percentage point below the long-term average.

And the current real federal funds rate is 2 percentage points lower than it was the last time the Fed found the sweet spot of high growth and low inflation.

On the heels of the Fed's decision Tuesday to raise its federal funds rate to 4.75%, the question everyone wants to know is: How high will the Fed take rates? 5%? 5.50%? 6%? Or more?

No one really knows. It will depend on the data, especially inflation, jobs and economic growth. See our complete Fed coverage.

While every economic cycle is different, it's instructive to figure out what the Fed has usually done in similar circumstances.

What's normal for the Fed? A simplistic historic analysis shows that the federal funds rate is normally higher than it is today.

Over the past 50 years, the fed funds rate has averaged 5.85%, but that average is distorted by several years in the early 1980s when the fed funds rate was in double digits, as was the inflation rate.

A better way to judge the impact interest rates have on the economy is to look at the real interest rate: that is, the fed funds rate minus the inflation rate.

Adjusted for the increase in the consumer price index, the real federal funds rate has averaged 1.75% since 1956. Currently, the real rate is about 1.10%, with a fed funds rate of 4.75% and a trailing inflation rate of 3.65%.

To bring rates back to the 50-year average, the Fed would need to raise rates or lower inflation by a cumulative 0.65%.

Maybe 50 years is too long of a period to tell us anything meaningful. That period includes times of low inflation and modest growth, times of high inflation and no growth, and the times of a so-called Goldilocks economy of low inflation and strong growth.

The Fed achieved a soft landing in the economy in 1995. From late 1994 through mid-1998, the Fed managed to keep the fed funds rate relatively steady between 5.25% and 6%. The economy prospered, growing at an average rate of 3.7%. Inflation averaged 2.5%.

During that time, the real fed funds rate averaged 3.1%, two full percentage points higher than today.

This analysis suggests that, in a period of high productivity and high growth, it may take a somewhat higher real funds rate to keep inflation low.

If the Fed wants a 3.1% real funds rate, it might have to boost nominal rates another 2 percentage points to 6.75%. The Fed probably wouldn't have to do all eight quarter-point hikes, because that much tightening would probably have some impact on lowering the inflation rate (otherwise, why do it?).

If inflation rates moderated to 2.5% or so under the pressure of Fed tightening, the Fed could probably stop at 5.50%.

Rex Nutting is Washington bureau chief of MarketWatch.

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