A day after Ben Bernanke was named successor to Alan Greenspan, traders of Fed fund futures reminded the Fed chairman-nominee that interest rates should keep rising well into next year. Or, perhaps traders are expecting Bernanke to take a tough stance on inflation by hiking rates in order to prove himself a muscular monetary hand early on. In any case, the price of the the April 2006 contract dropped today in anticipation of Fed funds rising to around 4.5% by next spring.

But even a higher rate wouldn’t necessarily surprise Janet Yellen, president of the San Francisco Fed. Last week she was quoted by Reuters as saying that a neutral Fed funds rate, in her opinion, might be anywhere from 3.5% to 5.5% these days. Yellen’s a voting member of the FOMC, which sets interest rates on behalf of the central bank. Her next opportunity to put her monetary beliefs to the test comes on November 1, when the FOMC convenes once again.
It may be a foregone conclusion that the Fed will keep tightening the monetary strings, but the Maestro in his final days on the job can expect no grace period before he leaves his post at the end of this coming January. “Be Careful, Mr. Greenspan,” today writes Alan Reynolds, a senior fellow at the Cato Institute, a free-market-oriented think tank. Reynolds opines that raising rates further risks damaging the economy.
“The non-energy CPI has averaged 2.2 percent since 1996 — compared with 5.5 percent from 1967 to 1995,” Reynolds recounts. “On a year-to-year basis, non-energy inflation was still 2.2 percent the last time I checked. It was even lower if you look at a more accurate chain-weighted index, and lower still in Japan and Europe.”
With the futures market expecting a Fed funds of around 4.5% early next year, and seeing additional hikes as 2006 unfolds, there’s a danger that the central bank will go too far. “Unless something unexpected happens to lift the non-energy CPI above its stubborn 2.2 percent trend, a 4.5 percent funds rate suggests a real interest rate on cash of about 2.3 percent. That’s not the end of the world, Reynolds admits, noting that the comparable real interest rate hit 3.5 percent in 1990 and 2000, in both cases just ahead of a recession. “Unless bond yields rise substantially, however, a funds rate of 4.5 percent or more would nonetheless be higher than the yield on 10-year Treasury bonds. By this measure, the yield curve would be at best flat and probably inverted,” he observes. “That has never happened in the midst of an energy price spike without the economy slipping into the tank. Never.”
Whether any of this has any influence on Fed policy in the future remains to be seen. Meantime, the issue of non-core CPI vs. top-line CPI rears its ugly head. Indeed, Reynolds correctly points out that inflation’s a mere 2.2%, to judge by core CPI. Yet headline inflation at last count is 4.7% (the highest since 1991), above the current 10-year Treasury yield of around 4.53%, which, by the way is up by roughly nine basis points today from the previous close. The sharp rise in energy prices accounts for the higher top-line CPI number.
Meanwhile, The Times in Britain published an interview with Bernanke that was conducted last week, on October 18, just a few days before Bush chose him to take over Greenspan’s job. Among Bernanke’s comments to the Times: “I have confidence the Fed is going to remain vigilant and ensure inflation is contained within the more volatile energy sector.” In addition, “I don’t think either an upsurge in core inflation or a recession is a likely consequence of what we have seen.”
Do those comments last week reveal Bernanke to be someone who thinks headline inflation is the true measure of price trends? Or is he more of a core-inflation man? Inquiring bond traders want to know.