The most important word for the Fed is ‘real’
As interest rates have risen, most investor and public attention has been on the absolute level of rates.
And with good reason.
The fed funds rate is at a 22-year high. Mortgage rates are north of 7% for the first time since 2002. And interest rates on credit card debt are at 38-year highs.
But the Federal Reserve isn’t just looking at these eye-popping headlines in thinking about its next steps, but also at where these rates stand when adjusted for inflation.
Referred to as “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 minus the annual change in core PCE — the Fed’s preferred inflation measure — we can see that real rates haven’t been positive for an extended period since the mid-2000s.
What we think this chart also gets across is that by saying things like “higher for longer,” what the Powell Fed is really trying to do is prepare investors for a future that looks more like the Fed’s past.
Throughout the 1980s and 1990s, for instance, real rates were almost always positive. The initial push to bring real rates into positive territory over these decades was the Paul Volcker-backed moved to crush persistent inflation, it was ultimately a long period of economic growth that kept real rates positive.
And strong economic growth is exactly what Fed Chair Jerome Powell pointed to on Wednesday as the catalyst for the Fed raising its interest rate forecasts for the coming years.
And though it is somewhat obvious to note that higher interest rates can only be sustained by a strong economy, recall that what began the current regime of rising interest rates was inflation that surged coming out of the pandemic. Inflation that was driven in part by supply chain problems, in part by strong economic growth coming out of the pandemic, and in part by consumers having excess cash in the wake of a highly unique fiscal response to the pandemic.
But as the economy transitions away from pandemic-era trends, so too does economic and monetary policy move off these benchmarks.
For investors, the renewed focus on real rates from the Fed means the central bank can get policy tighter by two paths — either rates rise, or inflation falls while rates stay steady. On this count, the Powell Fed now has more flexibility.