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Eddy Elfenbein submits: I wanted to help shed some light on the Fed debate Wall Street has been having. The futures market indicates that Wall Street thinks there’s a 30% chance of a rate hike coming next Tuesday. Personally, I’m surprised so many people feel that way. It seems obvious to me that the Fed will raise rates, or at least, they ought to raise rates.

Let’s take a step back and look at what’s happening. Everybody always wants to know what indicator the Fed is watching. Some people think the Fed should watch gold. Others think it’s employment and wages. Still others think it should monetary aggregates.

I think the best variable to watch is real interest rates. By real, I mean the after-inflation return of short-term Treasury bills. Here’s a graph of the real return of 90-day T-Bills going back more than 50 years (12-month rolling period):

Granted, this isn’t a perfect measurement. Monetarists will say that it’s not a cause but an effect of inflation. The biggest problem is that you never know what future inflation will look like. You only find out the real return after the fact. Still, I think it’s the best way to look at the Fed’s policies.

For example, you can see that rates were too low during much of the 1970s. Real rates were negative for nearly eight straight years. In other words, you got paid to borrow money. That’s the problem with inflation. If it isn’t stopped early, it can spiral out of control.

In my opinion, the Fed lowered rates far too much after 9/11. You can see that real rates were negative for over three years. That’s less than the recession of 15 years ago, which was much worse than the fairly shallow recession earlier this decade. I think we’re seeing the effects of the Fed’s easy money in today’s (still modest) inflation.

Ideally, real rates should be at 0% during a recession, and around 3% during an expansion. The most recent report on core CPI showed that inflation increased 2.64% over the last twelve months (that’s through June). I should also point out that the T-Bill rate is about 30 basis points below the Fed funds rate.

I’d like to see the Fed take rates up another 25 basis points, before pausing. I don’t think pausing now would be a huge error, but it’s better done sooner rather than later.

There’s another fact to keep in mind: There’s a lot of new blood at the FOMC. Two governors joined the Fed earlier this year. Plus, there are two other vacancies (Frederic Mishkin has been confirmed by the Senate but he won’t be sworn in until after Labor Day).

This means that there will be only ten voting members at the FOMC meeting. Since the Fed presidents take turns each year (the New York Fed President is a permanent member), this means that a minority of votes on Tuesday will be cast by people who never agreed to the start of the Fed’s rate hikes two years ago.

We often forget that the FOMC is in fact a committee, but I wouldn’t be surprised to see some dissension next week.

Source: Why The Fed Should Raise Rates