Monday, October 23, 2006

How Long a Pause for the Federal Funds Rate?

This week the Fed mulls over whether or not to change interest rates. Market participants seem to agree think there's virtually no chance of interest rates being changed, and most economists would concur.

In fact, it seems quite likely that interest rates will remain where they are for a little longer. But perhaps not for too much longer.

If we look at the three previous episodes when the Fed raised interest rates consistently for a period of time (i.e. tightening cycles), we find that in two of the past three instances the peak interest rate was maintained for only a few months before the Fed reversed course and began cutting interest rates again.

In the third instance (in 2000) the peak was maintained for a bit longer... but as I've argued before, even that seven month pause is short enough that I worry that it illustrates that the Fed has a tendency to overshoot when it raises interest rates.

Of course, it could turn out that after the present pause in interest rate changes, the Fed will see renewed strength in the economy, and decide to resume raising interest rates (similarly to what happened in 1988, with a three-month pause in the rate-tightening cycle). But I don't think so. Right now almost all signs are pointing to moderating growth, not accellerating growth (see David Altig and Jim Hamilton for some other perspectives on this, however). To me, it seems unlikely that that will change anytime soon, because I can't really see what sector of the economy has enough 'umph' left in it to drive a strongly renewed expansion.

That's why my bet is that, in another two or three months, we'll be ready to start looking for interest rate cuts from the Fed.

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