Soaring inflation pushes US real interest rates into deeper negative territory


This year’s surge in inflation has had a sometimes overlooked side effect: it means that the Federal Reserve’s interest rate policy is providing even more fuel to a booming economy.

The Fed influences borrowing costs by controlling a short-term borrowing rate, called the fed funds rate. To stimulate the economy, it has kept the rate close to zero since March 2020, when the coronavirus pandemic hit.


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But in business models, it’s the inflation-adjusted – or “real” – interest rate that matters most, because inflation reduces the value of future repayments. The real rate “is arguably the most fundamental indicator of the direction of monetary policy,” economists Christina Romer and David Romer wrote in a 2004 article.

With inflation of 5% in October compared to the previous year, according to the Fed’s preferred gauge, real short-term rates are at their lowest levels in four decades and deeply negative.

The federal funds rate influences many other borrowing costs in the economy, and often the most important are long-term mortgage and business loan rates, which have not changed much over the year. elapsed. If long-term rates do not rise with rising inflation, real long-term rates could fall even more, providing more incentive for debt-fueled spending.

When unemployment drops as much as it has this year and underlying inflationary pressures intensify, “you could normally say that policy should tighten a bit or maybe stay the same. Instead, the policy has actually relaxed, ”said Jason Furman, who chaired the Council of Economic Advisers under the Obama administration. “This indicates that the policy is above the mark more than the Fed expected, and that a larger correction may be needed.”

A measure of borrowing costs and financial conditions tracked by Goldman Sachs has fallen this year at a rate equal to the Fed’s interest rate cut by one percentage point, Furman said.

This helps explain why more and more Fed officials are laying the groundwork to hike rates to ease price pressures much sooner than what seemed likely just a few months ago.

Fed officials, at their two-day meeting ending Wednesday, are set to speed up the winding-up of their bond-buying stimulus program as they want to wrap it up before raising rates.

For the slow moving Fed, this counts as a drastic change, as officials just approved plans in November to cut bond purchases by $ 15 billion a month, which would end it all. here June. Reducing purchases by $ 30 billion per month would close it by March, paving the way for tariff increases.

This change surprised some investors as the Fed unveiled a new framework in August 2020 in which it would not hike rates simply on the basis of forecasting inflation above its 2% target. Instead, he wanted to see real evidence of an increase, and he would look for an average inflation of 2% over time.

Fed Chairman Jerome Powell last month. Fed officials are expected to meet on policy from Tuesday.


Michael Brochstein / Zuma Press

The change in framework meant that the Fed would keep rates lower for longer than in the past. “It was a promise not to raise rates prematurely. It was not a promise to make financial conditions easier and easier as the economy begins to take off. And that’s what they did, ”said Steven Blitz, chief US economist at research firm TS Lombard.

Mr. Blitz is one of the few analysts who now expect the central bank to raise rates next March. He still expects inflation to slow next year, as Fed Chairman Jerome Powell and most private forecasters predict. But even if the recent impressive inflation figures subside, the growth in rents and wages could keep inflation high enough to prompt the Fed to raise rates.

“Forget the price spikes due to shortages. These will go away next year, ”Mr. Blitz said. “But the underlying economy is growing and by whatever measure the real fed funds rate is too low.”

For some analysts, a rate hike by March looks unlikely to be near. There are a number of external events that could spoil the strength of the U.S. economy, including new variants of the coronavirus, a stock market slump, and China’s slowdown.

The US unemployment rate fell to 4.2% in November.


Joe Raedle / Getty Images

The past three months, however, have shown how quickly the economy can produce stronger-than-expected growth. The US unemployment rate fell one percentage point from August to 4.2% in November.

Fed officials have pledged to keep borrowing costs close to zero until two tests are met. First, they want to ensure that inflation does not drop below their 2% target, a condition many of them believe has been met.

Second, they want labor market conditions to be compatible with maximum employment, a condition they have not defined numerically. But the rapid drop in the unemployment rate and shrinking workforce during the pandemic suggest to some officials that they have reached or are on the verge of reaching that goal.

Mr Furman said the central bank must move to a default position in which it will hike rates several times next year, unless inflation slows significantly or the labor market deteriorates.

Such measures could help prevent policy easing further.

While the cost of groceries, clothing, and electronics rose in the United States, prices in Japan remained low. Peter Landers of the WSJ is shopping in Tokyo to explain why fixed prices, while good for your wallet, can be a sign of a slow growing economy. Photo: Richard B. Levine / Zuma Press; Kim Kyung Hoon / Reuters

Write to Nick Timiraos at [email protected]

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