Behind the headlines on real interest rates
By Tyler Mondres
HInitial inflation in the United States climbed to 6.2% in October, but the federal funds rate, set by the Federal Open Market Committee, remained targeted between 0% and 0.25%. As a result, the real interest rate in the United States, negative 5.97%, is at its lowest level in decades.
Real interest rates are the difference between the inflation rate (U.S. consumer price index) and nominal rates (federal funds rate or any savings deposit rate) and reflect purchasing power nominal rates. If prices rise at a rate higher than the cost of borrowing, then individuals and businesses see that goods and materials would be cheaper if they borrowed to buy now; the global incentive stimulates the economy. On the other hand, if interest rates exceed inflation, many will feel that borrowing is too expensive and will wait to spend, which will weigh on growth. For these reasons, economists focus on the real inflation rate. In the United States, the focus is on the federal funds rate minus inflation as measured by the Consumer Price Index.
The United States is not the only country with negative real rates, according to Bloomberg data. Real interest rates are in the red for many developed economies around the world, including Canada (negative 4.15%), the euro area (negative 4.1%) and the UK (negative 3%) .
While real rates have trended downward over the past decades, the last time they were this low in the United States was in 1975, when real rates hit 5.23% in due to rising energy prices. Real rates also fell in the United States after the Great Recession, reaching a low of minus 3.62% in 2011.
Some believe that falling real rates are driving the 40-year rise in the stock market as investors seek higher returns. If real rates rise, they could trigger portfolio reallocations, which in turn could cause stocks and other assets to revalue. But until then, negative rates are likely to depress the purchasing power of families and households that depend on interest income as a source of finance.
Despite growing concerns about the path of inflation, monetary policy in developed countries remains very accommodative and central banks have been reluctant to raise rates too quickly. Over the past two months, the European Central Bank and the Bank of England have pushed back market expectations for rate hikes. In October, investors widely expected the BoE to raise rates, but chose to keep them at 0.1%. In November, the ECB said it considered “the current market price of a rate hike [in 2022]as excessive. At home, the Fed announced that it would start reducing its asset purchases in November. However, the FOMC remained divided 9-9 when it met in September on whether to raise rates next year.
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