It’s been 36 months since the Fed strapped its benchmark interest rate to a range of 0 to 0.25%. Since then the effective federal funds rate has averaged 0.145% on a monthly basis. There are some encouraging noises from the housing market with housing starts increasing by 9.3% in November to their highest levels since 2010, and homebuilder confidence rising to its highest level since 2010. On top of all this we’ve got growing amounts of dumb money chasing the yield fairy all over town, which suggests that monetary conditions may be getting a bit too easy.

So is it time to start preparing ourselves for a return to a less accommodating interest rate environment? Two interesting sources say yes.

In 2001 Harvard econ professor Greg Mankiw wrote a (very digestible) paper that tried to explain why the monetary policies of the 1990s produced such exceptional results: not just favorable, but extremely stable conditions for inflation, unemployment and real growth.  Was it sheer luck or some kind of magic from the somewhat-discredited“Maestro”, Alan Greenspan? Mankiw concluded that it was a little bit of magic and a whole lot of luck, the latter being in the form of new productive technologies like the Internets.

Since Alan Greenspan obviously understood that the biggest secret to having major swag is to never reveal the source of said swag, subsequent policymakers and interested economists really had little clue as to how he managed to pull it off:

Imagine that Greenspan’s successor decides to continue the monetary policy of the Greenspan era.  How would he do it?  The policy has never been fully explained.  Quite the contrary: The Fed chairman is famous for being opaque.  If a successor tries to emulate the Greenspan Fed, he won’t have any idea how.  The only consistent policy seems to be: Study all the data carefully, and then set interest rates at the right level. Beyond that, there are no clearly stated guidelines.

So Mankiw came up with his own formula to roughly explain how he thought the Greenspan Fed went about calibrating their most crucial weapon, the benchmark Fed Funds rate:

Federal funds rate = 8.5 + 1.4 x (Core inflation – Unemployment)

Recently fellow blogger Eddy Elfenbein used this formula to create a model that shows what the implied recommended policy rate is given today’s conditions:

The blue represents the model’s recommendation while the red is the actual Fed Funds rate. And while it’s obviously dependent on what happens to core inflation and unemployment going forward, it does rather seem like the model may start flashing a “please-return-to-positive-rates” signal soon.

Read More: http://financeaddict.com/2012/01/is-it-time-for-uncle-ben-to-raise-the-roof/

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