The most important word for the federation is ‘real’
As interest rates rose, most investor and public attention was on the absolute price level.
And for good reason.
Fed funds rate is at 22-year high. For the first time since 2002, the mortgage rate is north of 7%. And interest rates on credit card debt are at a 38-year high.
But it’s not just these eye-popping headlines as the Federal Reserve ponders its next steps, but also where they stand when adjusted for inflation.
In so-called “real” interest rates, the Fed’s aggressive rate hikes earlier this year pushed real rates into positive territory for the first time since 2019.
Looking at the Fed funds rate, the annual change in core PCE – the Fed’s preferred measure of inflation – we can see that real rates have not been positive for a long time since the mid-2000s.
What this chart seems to get across is that, by saying things like “higher for longer,” what Paul Fed is really trying to do is prepare investors for a future that looks like the Fed’s past.
In the 1980s and 1990s, for example, real rates were almost always positive. The first push to bring real rates into positive territory during these decades was driven by Paul Volcker’s persistent inflationary moves, which eventually turned real rates positive into long periods of economic growth.
And strong economic growth, Fed Chairman Jerome Powell said on Wednesday, will raise interest rate forecasts for the Fed for the coming years.
Although it’s fairly obvious that high interest rates can only be sustained in a strong economy, remember that the current rate hikes started with inflation coming out of the pandemic. Inflation driven in part by supply chain problems, in part by strong economic growth coming out of the pandemic, and in part by an extraordinary fiscal response to the pandemic has left consumers with excess cash.
But as the economy moves away from pandemic-era trends, so too will economic and monetary policy.
For investors, the renewed focus on real rates from the Fed suggests the central bank could tighten policy in two ways – either rates rise, or inflation falls, while rates remain unchanged. On this count, the Powell Fed now has more flexibility.