After spending the past year raising the fed funds repeatedly to try to control inflation, the Federal Reserve has finally brought the REAL fed funds rate fractionally above zero. Except for short periods of time, the Fed has suppressed the real fed funds rate to negative, paying banks to borrow money which they then invest in assets. The malinvestments during the give-away phase form bubbles which quickly pop when the Fed allows the real yield to rise above zero – which it was all the time before 2000.
Anyone who feels oh-so-clever at their investing success should be aware that their assets floated on the Fed’s giveaways of fiat money. All the asset markets are addicted to the crack cocaine of negative real yield money.
If the Fed goes back to the pre-2000 normal the markets will have to struggle to grow by real productivity growth rather than money-pumping growth.
The Fed funds rate is a current, overnight, or 1-day, rate. The change in CPI you are using is a trailing 12 month, or 365-day, year-over-year rate.
Why does it make sense to subtract a lagging, backward-looking 12-month inflation measure from a current, present-day 1-day rate?
I’ve never understood this: Lagging and 12-month compared with current and 1-day, different term lengths, different epochs
Why does it make sense to do this?
If you are saying banks borrowed at the Fed funds and then invested in some asset over some future term, should not the appropriate measures be:
(expected rate of return of asset of over future term)
(expected forward inflation rate over same future term)
Similar to how a forward inflation rate is implied by TIPS and Treasury prices?
you keep posting about the real Fed funds rate calculated in this way and I keep asking about it, like an infinite loop, lol
real > what real > real > what real > … >
@mostlylong there are many different ways to look at data. In an economy where inflation is fairly stable (which has mostly been the case since 1990 except for the recent inflationary spike) the market uses the expected inflation rate as the comparison.
With rare exceptions, the inflation rate and also inflation expectations have been between 1.0% and 2.5%. Maintaining a fed funds rate of 0% is clearly below both the current and also the expected inflation rate.
Daily Treasury Par Real Yield Curve Rates were negative at all durations from April 2020 and throughout 2021. This was abnormal on a historical basis since the normal REAL yield for the 10 year Treasury was over 2%.
Because the underlying assumption is that inflation is stable - that the lagging 12 month inflation and the instant one day inflation and the forward looking inflation for the next 12 months are all the same.
Since the mid 1990s, that has been a reasonable assumption most of the time. The best estimate for inflation over the next 12 months is usually the historical inflation of the past 12 months. With a couple of exceptions, inflation from 1993 through 2019 has varied only slightly between 2% and 4%, with my eyballed figure being about 2.5% as an average.
Of course, there have been brief exceptions - 2007 - 2010, and the current 2020 to present.
So I agree with Wendy. The real rate for most - if not all - of the time since 2000 (as in stated interest rate less inflation) has been less than zero. It’s been a very long time since we have had rational interest rates in this country.
Here I lean towards the Fed’s judgment and use and interpretation of their own internal data (and small army of economists), rather than a metric that only applies when everything is stable, which is not now.
I would say, based on Fed commentary, real rates as experienced by businesses and consumers did not just turn positive, instead, these rates have most likely been positive since at least 6 months ago.
No, not exactly. Powell said it might be restrictive - as you correctly quoted him saying at the end of the September 2022 Fed meeting.
But guess what. It wasn’t restrictive. Since that meeting, inflation has run at about a 3.5% annual rate. The target rate of 3% - 3.25% wasn’t restrictive.
Using hindsight, it wasn’t until the November meeting that the rate finally crossed into restrictive territory, going to 3.75% - 4%. That put it only a fraction of a percent above the actual inflation that we saw over the next few months.
The Fed’s longer term target is a rate 1% - 2% over the inflation rate. We’re now at a 5% - 5.25% target, which is comfortably over the actual inflation of the last few months.
But that’s comparing to history again. What is inflation expected to be for the next few months? I have no magical insights, so the best I can do is resort to the default - that inflation for the next few months will be about the same as inflation for the last few months. Or we can try to get closer to the present, and look at just the April 2023 inflation.
The headline, or all-items, PCE price index rose an annualized 3.0 percent in April after increasing an annualized 11.3 percent in March. The price index for PCE excluding food and energy rose at a 4.2 percent annualized rate after increasing an annualized 4.0 percent a month earlier.
So it looks like current inflation is closer to 4% than 3.5%. That puts the Fed’s target just 1% over inflation. Technically restrictive, but just barely. And it appears that the Fed has been in that just barely restrictive position since November.
Some data sources in case I need to defend some of this down the road:
First, my original question has been answered: it makes little sense to me (as far as anyone has explained as best I can tell), in a time period of large changes in Fed funds rate and inflation rate, to use
(Fed funds rate) - (trailing yoy % inflation change)
as a measure of a “current” real interest rate if the underlying assumption is that these measures are stable.
Now, you are raising another specific question: “When did Fed policy become restrictive? (if at all)”
Here, looks to me like we agree, although with different reasoning:
I would disagree with your focus on the word might in Powell’s September press conference, but many people disagree about what the Fed says because they use so many hedge words. To me, and I think 95 or more out of 100 economists would say “Powell is indicating his best guess at that moment is that the Fed policy just entered, or is near the edge, (caveat however you’d like) between accommodative and restrictive policy.”
Further, at the next meeting, in November, Powell said: “I think as we move now into restrictive territory,…”
(maybe you prefer to emphasize the word think, whatever, I’d say they are always thinking)
But I still have a question on this:
With hindsight, you are doing something like this calculation (I think this is your intent):
(Fed funds rate in November) - (actual % inflation change November to May)
Why do you think that this calculation being positive/negative indicates that policy was restrictive/accommodative in November?
First, businesses and consumers don’t borrow at the Fed funds rate.
Second, when borrowing/lending/investment decisions are made, we never have the benefit of hindsight. We can only have expectations about future or forward rates. It could be argued that what mattered more back in November, are market expectations for forward rates (over some future term). Now, it may turn out that the actual rates over the next 6 months line up with forward expectations at the start of the 6 month period, or maybe not.
I think we’re in violent agreement here. Might, just entered, near the edge - all are fine interpretations to me. At that point, Powell believed they were near the crossover between restrictive and accommodative.
Yes - well Nov to March/April. We’re not done with May yet and I don’t recall if I was eyeballing monthly inflation figures through March or April. But that is my methodology.
How else would you define it? Let me answer that. I’ve thought about it a bit and decided I wasn’t quite right. And I’ll conclude that we were still in accommodative territory back when Powell said we might be crossing over to restrictive, and have been so until at least the latest rate increase.
Let’s go back to the definition of a neutral Fed rate - a rate that is neither accommodative nor restrictive. Here’s how Janet Yellen defined it back in 2005 when she was President of the San Francisco Fed:
“Research suggests that the neutral real rate is probably somewhere in a 1.5 percent to 3.5 percent range. To get to a neutral nominal rate, we have to add in expected inflation. That probably takes us to a neutral nominal range of around 3.5 percent to 5.5 percent at this point.”
To your point, she is adding the neutral real rate to the expected inflation, not historical inflation. But let’s address that bit in a moment.
What I want to note is that she says the neutral real rate is something between 1.5% and 3.5%. I’m not one to argue with her, but others have said its more like 1% - 2%. Either way, there’s some positive rate above inflation that is in the neutral range. Get below that neutral range and monetary policy is accommodative.
Let’s go back to your question: Why do I think that monetary policy was accommodative in November? Well, that’s simple math. The Fed target rate was 3%-3.25%. Future inflation over the next few months at that time - and using hindsight - was about 3.5%. The minimum neutral rate would have been 1% over inflation, or about 4.5%. And potentially higher. Since the target rate was significantly less than this, monetary policy was accommodative.
Continuing to use hindsight, monetary policy remained accommodative because the target rate remained less than the inflation rate plus a margin to get to neutral.
So my error was doing the subtraction and looking at the sign of the result. But that’s not right. There needs to be some margin over inflation to get to neutral. Negative answers are always going to be accommodative. But even small positive answers (certainly less than 1%, and potentially more) are also accommodative.
Now, some other points you made that need some kind of answer.
Correct, but irrelevant. These calculations are traditionally done using short term risk-free rates.
Yep. We all get to make our own projection of future inflation. I’ve described my method already. What’s yours? But we also get to test our projections against actual results. So looking back is an important part of the process to refine our projections. All those different opinions about future inflation are what makes markets. In this instant case, I was comparing Powell’s projection (we are somewhere close to what I have subsequently defined as neutral) with the actual results. And his projection was off a bit.
I could ramble on a while about why, but that should probably be in a different thread, so I won’t for now.
There was some recent commentary on the neutral rate, noted by @wendybgFederal Reserve’s “neutral rate” (that thread drifted off to @qazulight retirement planning - let’s keep qaz happy and stimulated - and then Amazon return policy - much less interesting)
Two interesting points from the WSJ article referenced in the above post:
Fed research suggests we are still in an era of low interest rates. Specifically,
“There is no evidence that the era of very low natural rates of interest has ended,” says New York Fed President John Williams
And from their research, they try to estimate the neutral rate,
The model shows the inflation-adjusted neutral rate stood around 0.7% at the end of last year and has declined over the past year, though the degree of uncertainty over those estimates is large.
So, ballpark guesstimate, take 0.7% real, add 2% expected forward inflation, get about 3% neutral Fed policy rate as a long-run, forward-looking average.
My current thought is: we were in a low-rate era pre-pandemic, the world is different now, but not that different, so my default case is the U.S. reverts back to near the trend of low rates.
And for this item, I still think it is important.
And, Powell thinks it is important, he said in the November 2022 Press Conference
“Very few people borrow at the short end—at the federal funds rate, for example. So households and businesses, if they’re [borrowing]—[there are] very meaningfully positive interest rates all across the curve for them, credit spreads are larger, so borrowing rates are significantly higher, and I think financial conditions have tightened quite a bit.”
I think I go back to my initial post in this thread, I wrote,
while still recognizing that the Fed funds rate is a very important reference rate for lending.
I think you are correct. Two things come to mind and I believe influence the absolute rates. One old people. Old people generally have money that they need to work, thus it is available for investment.
Second and it hasn’t changed yet but will, the demand for business investment. For the last 20 years, businesses have become more and more asset light needing less and less capital. Having just watched the Tesla annual meeting, I am guessing that there will be a large demand for capital over the next 10 to 20 years. If I remember correctly , it was estimated that 10 percent of the world GDP will be needed to build the battery plants needed to fully transition the electric cars. (I don’t know if this is one year GDP spread over 10 years or 10 percent of 1 year spread over 20 years, so big difference. Still a significant demand for asset heavy businesses.
Again, we’re agreeing on the methodology, if not the exact numbers. There is some positive rate above inflation that is neutral. Whether that difference between the nominal interest rate and the inflation rate is 3.5% or 1.5% or 0.7% or something else, it exists and it is greater than zero.
(And for the record, I did note that Yellen’s comment was pretty old and that there was an argument for a real rate more like 1%. So even on that, we’re not very far apart. The main reason for mentioning it was to demonstrate that there is some real interest rate that is positive, and therefore an interest rate that is equal to or only slightly larger than inflation is not restrictive.)
That brings up an interesting thought. I don’t disagree that we have been in a low rate environment since 2009 or so. The Fed target rate has been approximately zero for much of that time, with a bit of an exception in the 2015 - 2017 time frame, and again over the last two years. But during that time inflation has been averaging about 2% - 2.25%. Is that normal? I’m not sure. If I can find the time and the data, it would be interesting to compare the Fed rate with the Prime rate over time - and possibly compare that to inflation as well. I think you’d agree that the Prime rate is a better benchmark for real world borrowing by actual businesses. A comparison to something like 1 year Treasuries might be interesting as well, to benchmark something that is generally considered to be the risk-free rate for that time period.
And one nit to pick:
Well, that’s not exactly a projection of inflation rates. That’s a projection of the real interest rate. My question was: How do you get your expected forward inflation rate?
Being a rather simple guy, I generally estimate next month’s inflation to be the same as last month’s inflation, with a potential adjustment up or down based on something akin to reading tea leaves in the bottom of the cup. I do the same thing for next quarter and next year, with the tea leaves potentially playing a larger role in the longer term projections. So how do you estimate your forward inflation rate?
@ptheland the Federal Reserve calculates the expected and forward inflation rates by comparing TIPS with Treasury yields of the same duration.
These are hard data which fluctuate daily based on the bond market’s actual pricing. The bond market is currently saying that inflation will not rise above 2.5% for the next 10 years. If future inflation actually is higher than that (remember how the Fed was blindsided in the 1970s by intractable inflation for years) trillions of dollars of bonds will lose value. The entire bond market would have to reprice to higher yields.
Yes, it is hard data and something for investors (and apparently Fed governors) to monitor. But is the 5 and 10 year inflation rate all that useful for projecting inflation over much shorter time frames - say the next 1 to 6 months?
I’d also point out that the market is just saying that any current inflation is expected to be well controlled and not get out of hand. It would be up to the Fed to take steps to control inflation in the shorter term.
Further, markets can be wrong. These derivations from market prices are just the collective gut feeling of market participants. In the late 1990s, the markets were saying that dot com companies were very valuable, yet many crashed and burned in just the next couple of years. In 2005 and 2006, the markets were saying that banks were rock solid and had no problems. Again, they were wrong.
While bond traders are different critters from stock traders, it’s still just a market. Markets have been wrong going back centuries to the price of tulip bulbs and even before. They will be wrong again.
In some sense, then, its the job of Fed governors to decide when the market for TIPS and Treasuries is getting it wrong for future inflation. That’s not going to happen often, but when it does, the Fed needs to take action. For ordinary bond investors, it’s also important to decide when markets are wrong and adjust their investment decisions.
Lastly, I’d note that my question was very pointedly directed at Mostlylong, as he has disagreed with my projection of short term future inflation without providing his alternative. Without an alternative, it’s hard to consider whether I’m making a mistake in my thinking.
I think I would estimate forward inflation using the TIPS and Treasury markets (crowdsource it), as mentioned in my initial post in this thread. The market consensus, while it certainly can be incorrect in hindsight, is a forecast aggregating decisions from all market participants.
Even though 5 years is the smallest new issue TIPS, yields for TIPS from a range of maturities are quoted in the secondary market. I think (someone correct me otherwise, please) the calc is
expected forward inflation = (nominal Treasury yield) - (TIPS yield)
for a given maturity.
Between now and Jan 15, 2024, about 6 months out,
expected forward inflation = 5.362 - 3.007 = 2.355