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By Byron Gangnes
The Federal Reserve has raised interest rates sharply over the past fifteen months, and Fed officials have signaled that perhaps two more quarter point hikes are coming. How high are interest rates compared with past Fed tightening episodes? Are they high considering the state of the US economy?
First, a little about interest rates. (You can skip this if you are econ savvy.) The interest rate you pay or earn is called a nominal interest rate, that is, an interest rate measured in plain old dollars. Interest rates that are relevant for decision making are real interest rates: interest rates adjusted for inflation. To see why this is so, consider the following example:
I am deciding whether to make a one-year loan to my daughter at an interest rate of 5%. Ignoring the (almost certain?) risk that she will fail to repay me, whether 5% is a good deal depends in part on what I think inflation will be over the coming year. Suppose I think that inflation will be 2%, then a one-year loan will net me a 3% real rate of return after adjusting for inflation—not the full 5%, because the purchasing power of the repaid dollars will be less than when I made the loan. But if inflation turns out to be 6%, then I will have lost money on the deal, since I will get repaid (it could happen) less purchasing power than I gave her up front. Of course it’s tricky, because when I consider making the loan, I have to form an expectation of what inflation will be, and that could turn out to be wrong.
So expected real interest rates are what decision makers should care about. This is true for my loan to my daughter, and for any other lending, borrowing, or investing decision. And to evaluate whether prevailing interest rates are high or low, we need to consider not just nominal, but also real interest rates.
OK, back to the Fed.
The Federal Open Market Committee has raised its policy interest rate, known as the federal funds rate, 10 times since the beginning of last year. The fed funds rate is important because interest rates on many loans and bonds are directly or indirectly linked to this interest rate. (Long-term rates like mortgages are less closely linked.) The Fed is currently maintaining the fed funds rate within a range of 5% to 5.25%. Here is a graph of the fed funds rate going back to 1990:
A few things to note:
- The Fed has moved the nominal federal funds interest rate up and down over time as it has sought to moderate the ups and down of the US business cycle. They have cut rates when they wanted to provide economic support during recessions and their aftermath, and they have raised interest rates late in expansions when they wanted to discourage spending and prevent the economy from growing unsustainably fast.
- Often (but not always), real interest rates have gone negative during periods of Fed interest rate cuts. Note that they were particularly low in the period following the 2000s housing boom/bust, and they were exceptionally low during the COVID-19 pandemic and early recovery period.
- The Fed does not directly control the real interest rate, since this depends importantly on what people expect inflation to be. When the Fed held nominal rates near zero during much of the stagnant 2010s and during the recent pandemic, real rates were negative because of expected inflation. The recent period saw such exceptionally low real rates because inflation and inflationary expectations soared during the pandemic and its aftermath.
Substantially negative real interest rates are just what you want if you are trying to stimulate a very weak economy—they make it cheap for consumers to borrow to buy cars, and for businesses to invest in new factories, for example. But if the economy is in danger of overheating, that is, growing unsustainably fast and driving inflation, the Fed needs to raise interest rates enough to get real rates out of that super-stimulative negative rate territory.
I mentioned that changes by the Fed in the fed funds rate also affect market interest rates, especially other relatively short-term rates. We can see that here in the path of nominal and real interest rates for three-year US Treasury bonds. Real rates on these bonds also fell precipitously during the pandemic and its aftermath, and they have risen since the beginning of 2022.
Notice that for both the fed funds and the three-year T-bond, because of persistently high expected inflation real interest rates remained negative well into this tightening cycle. Only now with rates above 4-5% and inflation cooling (albeit slowly) has the fed funds rate turned positive.
How high are current real rates compared to past tightening episodes? As you can see from the first graph, the real fed funds interest rate is now about 2% based on consumers’ expectations of inflation over the next twelve months. That’s roughly on par with many past rate hike periods.
Whether that’s high enough to meet the Fed’s goals depends on the current economic environment. If you look at labor market indicators, conditions are not excessively tight by some measures (for example, the unemployment rate is similar to its level at the end of the Fed’s last contractionary cycle), but job and wage growth are more buoyant. The big difference is that inflation, while trending lower, remains well above the Fed’s long-run goal of 2%. So it is understandable that rates may go a bit higher and remain high longer than in many past tightening cycles.
It is impossible to know whether rates have now gone high enough, simply because interest rate hikes to date will take a while longer to feed through fully to lower demand and lower inflationary pressure. And the recent period, with its pandemic-related supply-side constraints, differs from other expansionary periods. But we do know that real rates will rise further in coming months even without additional Fed nominal interest rate hikes. That’s because inflation expectations will ease further as experienced inflation continues to trend downward. The Fed may well have already done enough to cool the economy.
4 thoughts on “How high are interest rates really?”
Fed signals of two rate hikes are not widely believed. Austan Goolsbee and a couple of other committee members would like to stop hiking now. Jerome Powell may push for two more hikes on the grounds of high core inflation and continued job market strength. The market “expects” one rate hike but not two.
I think this is impossible to know. We are pretty sure we will get one more. After that will depend on labor market indicators.
“The big difference is that inflation, while trending lower, remains *well* above the Fed’s long-run goal of 2%.” [original emphasis]
Really?
I think that’s a lot less clear now, isn’t it? Obviously this can be cut a lot of different ways, and everyone is cherry picking data, but when you look at the broad array of measures that try to account in different ways for lagging factors (housing) and temporary volatile swings not related to monetary policy (food, energy, and used cars) it looks like underlying inflation has come down to between 2.5 and 3.5%. In other words, the inflation spike is mostly over, and today it sits well below what inflation was when Paul Volcker took his foot off the break and Ronald Reagan declared “morning in America” back in 1984.
Personally, I have a hard time understanding why the benefits of pushing inflation down to 2% (even if it’s not on its way already from past tightening) outweigh the costs of pushing many of the most vulnerable people in society into unemployment. We are seeing remarkable increases in wages at the lower end of the spectrum, which has reduced inequality notably. Wages among the more well-to-do haven’t quite kept pace with inflation. I gather that’s one reason people are crying. But undeniable reality is that we’re finally seeing a refreshing break from rapidly growing inequality, a remarkably strong economy, and rapidly moderating inflation. It’s a Goldilocks recovery so far — the best in my lifetime. Adjusting for demographic changes, a greater share of working-age people are working today than have been in 50+ years.
The only weird thing is that nobody in the media wants to admit it. Neither do most economists. (Those dismal beasts!) Everyone is predicting a recession that just never comes.
Stepping back, the Fed seems to have lexicographic preferences with regard to their double mandate: inflation first, employment second. This seems to be born of a culture that evolved from few sample points in modern macroeconomic history, with just one business cycle looming large in the minds of folks like Jerome Powell — the 1981-83 recession created by Volcker’s storied taming of inflation. But does that shoe really fit? That was a different economy long ago, itself a complex situation that was also a bit more than simply money printing and government spending. We may have read history wrong, and even if we didn’t, well, it’s just one point.
To me this lexicographic ordering is backward. People ought to come first. To sacrifice the livelihoods of millions to so we can push inflation down from 3% to an arbitrary (and arguable too low) inflation target of 2% strikes me as absurd.
Economists are clearly divided on inflation the issue. This column by Paul Krugman today is interesting and informative as it is entertaining.
https://www.nytimes.com/2023/07/14/opinion/inflation-economists-soft-landing.html
Anyhow, I realize this wasn’t the main thrust of your post. With regard to real interest rates: might a better measure be the real 10-year T-bill rate? Often the Fed has difficulty influencing it like they can short-term rates, but they influenced it big time on this cycle. The 10-year rate is also the rate that’s most germane to all manner of investment. The FRED graph is here:
https://fred.stlouisfed.org/series/REAINTRATREARAT10Y
This tightening cycle saw a real increase of over 2%. I don’t see anything that large over the last 40 years. In *relative* terms this change is considerably greater, too, since present values are more sensitive to changes when the level of rates is lower. For example, the present value of a flow of future benefits typically decreases by a larger percentage when the rate increases from 0 to 2% than from 4 to 6%. So, this is a big tightening.
Clearly tightening was needed. But there are risks from tightening too much, aren’t there? I sure wish more economists thought so.
Thanks Robert. A couple things: yes, inflation is receding more rapidly than many feared. The area where rates remain well above the target are ex-housing services as measured by the PCE, which haven’t really come down at all on a year on year basis. As for the 2% target, first the Fed can’t give it up without a substantial hit to their credibility. And I guess I still see value in trying to anchor long term inflation comfortably close to zero. That’s where 2% comes from. Having said all that, clearly what the Fed needs to see is evidence that we are headed toward that long run goal, not actually there. I have suggested elsewhere that we can argue that this job is done. Ten-year rates? Not sure that is really as important as short-term rates—which anchor the prime rate—except for housing. Anyway thanks for the comments