The real fed funds rate is the difference between the nominal rate and inflation. The inflation rate used here is based on the Personal Consumption Expenditure Deflator (PCED) — a price index that is similar to but broader and more sensitive to shifts in spending habits than the Consumer Price Index (CPI). The "core" inflation rate — the 12-month change in the PCED excluding food and energy — is now about 1.8%. Hence, the real fed funds rate is about 2.7% or 270 basis points — the 4.5% nominal fed funds rate minus the 1.8% inflation rate.
What is so important about the real fed funds interest rate's level?
The reason it is important to know that the real fed funds rate is around 270 basis points is that there has never been a recession until sometime after the real fed funds rate rose above 450 basis points. The 450 
basis point level has been the "tipping point" where the Fed's policies restricted or reduced borrowing and spending, resulting in a broad and sustained economic decline. Recession risk has been and remains low because the real fed funds rate has been nowhere near 450 basis points since before the 2001 recession. The real fed funds peaked around 335 basis points last summer. It is 270 basis points now and there is no reason whatsoever to expect the Federal Reserve to raise it soon. (Figure 2.)
This seems to have worked in the past but is it relevant now? Could the severe weakness in residential construction and/or the sharp rise in oil prices pull the economy down into recession despite low real rates?
First, until now, the weakness in residential construction has been much more a reaction to the extreme 
run-up in home prices than to a rise in interest rates or to otherwise restrictive credit conditions that would threaten the broad economy. (Figure 3.)
Second, despite the surge in oil prices since 2001, household expenditures on energy as a percentage of income and as a percentage of total spending are about where they were before the first oil "shock" in 1973-75. This plus low real interest rates explains why the economy has remained solid outside housing. (Figure 4.)
Third, if recession is imminent, then initial or first-time unemployment insurance claims should be on the rise. Jobless claims, which have jumped 15% or more before all past recessions, have remained rather flat on balance so far in 2007. The fact that jobless claims have not soared implies that recession fears have been overdone. (Figure 5.)
Fourth, if recent real interest rate levels had reached restrictive levels, commodities prices should have dropped. The CRB Raw Industrials Commodities Price Index — a spot index that excludes food and energy prices — has tended to fall whenever recessions approached and took hold in the past, but it has not done so now. Commodities prices slipped somewhat in August but have since rebounded to peak levels. Commodities prices' failure to plummet is consistent with the idea that no recession has started or is about to do so. (Figure 6.)
Do these numbers matter when the financial 
markets are in turmoil? Could the crisis in the financial markets this summer cause a recession even without the usual statistical preliminaries?
Shocks and crises have not been uncommon in financial market history. There have been 12 crises since 1970 — 13 with the current mortgage-related episode.
About half the shocks and crises since 1970 occurred after a recession had started or just after a recession had ended. The Penn Central Railroad bankruptcy in 1970, the Franklin National Bank failure in 1974, the First Pennsylvania Bank failure in 1980, the Penn Square failure in 1981 and the banking crisis in 1990 — all these resulted from economic downturns that in turn resulted 
from restrictive Federal Reserve policies. (Figure 7.)
Most other shocks and crises resulted from loans or investments that were made based on interest rate expectations that proved to be incorrect. This applied to the Continental Illinois Bank's problems in 1984, Orange County's bankruptcy in 1994, the Long-Term Capital Management crisis in 1998, and the current mortgage default and funding problems. Wall Street's "Black Monday" occurred after the stock market reached an extremely overvalued level — and it neither came from nor resulted in an economic recession. The crises that arose overseas — Mexico (twice), Asian/PacRim, Russia and Brazil — had rather limited economic and market 
effects here. (Figure 8.)
On balance, the historical evidence does not support the idea that financial shocks and crises cause recessions and bear markets. Rather, such shocks and crises either resulted from a recession, or did not in themselves have sufficient power to cause deep and sustained economic or stock market declines. This has been all the more true when the Federal Reserve responded to a problem like it did to the current one — with interest rate reductions and otherwise easier credit policies.
Can the economy grow if housing declines further?
Real GDP (Gross Domestic Product) is the most comprehensive inflation-adjusted economic output measure available. Real GDP rose just 2.6% over the four quarters that ended in September 2007. That pace is slow or weak relative to Real GDP's 3.3% average four-quarter growth rate since 1960.
The slowdown in Real GDP's growth rate since mid-2006 is due to declines in residential investment (home construction) and inventory investment. Those two sectors subtracted 1.3% from Real GDP's advance. The other sectors in Real GDP — consumption, government spending, business investment in plant and equipment, and net exports — added 3.9%. Hence, if residential and inventory were to just stop declining, Real GDP's advance would probably rise well above 3%. Figure 9.)
When the real federal funds rate was about where it is now in the past, Real GDP rose at an above-trend 3.6% annualized rate over the next 4-5 quarters. Were all else equal, then, the current consensus forecast that Real GDP will rise just 2.1% in 2007 and 2.6% in 2008 would seem to be too pessimistic.
All else is certainly not equal. Something should be subtracted from Real GDP's future expansion rate for further declines in housing. Something should also be subtracted for the fact that oil prices soared above $90 per barrel in recent weeks. But, if something should be subtracted from Real GDP' for high oil prices, then something should probably be added for the fact that real long-term interest rates remain much lower than usual.
The nominal yield on the 10-year T-Note has averaged about 4.6% so far in October. Subtracting the 1.8% "core" inflation rate, the real 10-year T-Note yield was just 280 basis points. This is more than 90 basis points below the trend since 1987, and much lower than it was in the past when the real fed funds was around its current 270 basis point level. (Figure 10.)
Real GDP should expand 2.5-3% over the next 5-6 quarters because real interest rates remain low. Sustained job creation should continue to support consumer spending. Sustained job creation should also combine with flat-to-lower home prices and low long-term rates to help stabilize residential real estate markets. Economic leadership will shift further toward exports and business investment. Corporate profits and cash flow should support increased business investment in plant and equipment. The dollar's decline has made our export products more and more competitive, and economic prospects outside the U.S. remain quite positive. (Figure 11.)
There is a chance that the correction in residential real estate or increases in oil prices could combine to limit Real GDP's expansion to 2% in 2007-2008. But there is also some chance that low real interest rates here and robust economic expansion abroad could lift Real GDP's advance above 3%. Much more important than Real GDP's precise pace, recession remains quite improbable. And low recession risk is positive for corporate profits and the stock market.
Will the Fed cut rates further?
The Federal Reserve eased its policies in August, September and October specifically to counter "credit crunch" conditions in the markets for mortgage-related securities. The Fed's actions — adding liquidity to the financial system, lending under easier terms and lowering the fed funds rate from 5.25% to 4.50% — 
have alleviated fears and enabled the markets to function. The remaining uncertainties about how to price mortgage-related risks will require more time and more information to be resolved. Information will be much more important in this process than further interest rate reductions.
This is not the first time that the Federal Reserve cut interest rates in reaction to a financial shock. It did so in 1987 (Wall Street's "Black Monday" crash) and 1998 (Long-Term Capital Management crisis). But the Fed has tended not to make deep and sustained reductions in the federal funds rate until and unless initial or first-time unemployment insurance claims have risen sharply and threaten to continue to do so. (Figure 12.)
As noted earlier, unemployment claims have remained stable so far in 2007. This, in combination with the rebound in the stock market, and with concerns about the dollar's weakness and the potential for an increase in inflation, implies that the Fed will not rush to lower interest rates much further. The fact that real interest rates are well below the "tipping point" level that would threaten a recession and a bear market implies that further rate reductions should not be needed.
What is the outlook for the bond market?
The 10-year T-note's yield was near 4.4% late in October. A model built with data from 1987-2006 indicates that the 10-year T-note's yield "should" be 4.7-6.4% in 2007-2008. If that model is at all relevant, the 10-year T-note's yield is unlikely to decline much further and could rise as mortgage- and recession-related fears diminish.
The chance that longer-term interest rates could rise implies that investors should keep their fixed income (bond) portfolio maturities somewhat shorter than normal. The likelihood that risk spreads could widen further implies that investors should continue to favor higher-quality bonds.
What is the outlook for the stock market? Skepticism about common stocks continues to be reflected in the estimation that the stock market is undervalued relative to interest rates. Interest rates would have to soar — the BAA corporate bond yield would have to rise from around 6.4% to more than 8.5% — or corporate profits would have to drop 15% — in order to eliminate the undervaluation at current market price levels.
Interest rates could rise but should not soar. Profits could increase more slowly than in the recent past but the level will not collapse unless a deep economic recession occurs — and recession seems improbable for the reasons discussed above. And note that bull markets in common stocks do not end just because "undervaluation" has been eliminated. The usual pattern is that the stock market rises until it becomes overvalued in the extreme — usually by more than 40%. (Figure 13.)
The current targeted real federal funds interest rate level is 270 basis points — well below the 450 basis point level that induced both recessions and bear markets in the 
past. This plus its estimated undervaluation should limit the market's downside risk to a "correction" and support its further advance on balance in future months and quarters. (Figure 14).
What is the "bottom line" for asset allocation? What does all this mean for investors?
Based on fundamental relationships that have been dependable over the decades, economic stock market prospects remain better than the consensus fears. If so, then expectations that the Federal Reserve will slash interest rates much further will be disappointed. This warrants some caution on bonds, because long-term yields and quality spreads could both well rise in those circumstances.
The low real federal funds rate and the stock market's undervaluation relative to interest rates seem to make the stock market vulnerable to no worse than occasional corrections. Such relative optimism seems all the more warranted now because investor "bullishness" is nowhere near "irrationally exuberant" levels.
Investors with well-considered asset allocation plans should check on the need to rebalance their portfolios but should otherwise adhere to their plans. Those without such plans should develop and implement some as soon as possible. Remain focused on fundamental forces and not near-hysterical headlines.
The most important and reliable fundamental forces that have warned us about recessions and bear markets in the past are still not in evidence. The most important fundamental forces and reliable indicators remain positive.