The “illusion of money” It ranks among the most lyrical concepts in economics. This refers to the mistake people make when they focus on nominal rather than real values. Anyone who’s had a pay rise over the past year, regardless of whether or not they can actually buy more after inflation, is delusional. Financial investors should be wiser, but they too can be seduced by a lovely name story. The downward movement of the Federal Reserve towards lower interest rate hikes is an example of this. It may seem like a step away from belligerent monetary policy. However, in reality, the position of the central bank is tougher than it seems at first.
On February 1, the Federal Reserve raised rates by a quarter of a percentage point, bringing the short-term borrowing rate to a record high of 4.75 percent, as expected. That was half the size of its last gain, a half point in December, which in turn was down from the previous string of three-quarter gains. The immediate question for investors is when the Fed will leave it altogether. A narrow majority sees the central bank delivering another quarterly rate hike next month and then holding off, as evidence of deflation mounts. Even those most concerned about high inflation will see at most an additional half point rate hike before the Fed stops. This is the light at the end of the monetary tightening tunnel that has helped boost the stock market in recent weeks.
However, what ultimately matters to firms and households that need to borrow is the real interest rate, not the nominal one. Here, the outlook is a bit more complicated and almost certainly less rosy. Conventionally, many observers simply subtract inflation from interest to arrive at the real rate. For example, with annual consumer price inflation at 6.5% in December and the federal funds rate at 4.5% that month, the calculation implies a real interest rate of -2%, which would still be very stimulative.
But this represents a fundamental mistake. Since interest is a forward-looking variable (ie, how much will be owed at some future date), the inflation-related comparison is also forward-looking (ie, how much prices will change at the same future date). Of course, no one can fully predict how the economy will evolve, but there are comprehensive gauges of inflation expectations that use both bond pricing and survey data. Subtracting one such measure—the Cleveland Fed’s expected inflation rate—from Treasury yields creates a much steeper path for rates. In real terms, they have risen to 2%, the highest level since 2007 (see chart).
Even after the Fed stops raising nominal rates, real rates are likely to rise for some time. Before Covid-19, expected one-year inflation was around 1.7%. Now it is 2.7 percent. If inflation expectations fall back to pre-pandemic levels, real interest rates will rise by another percentage point — as high as they have always been before recessions in decades.
None of this is predetermined. If inflation proves to be stable this year, expectations for future inflation may rise, leading to lower real rates. As many investors predict, the Federal Reserve may cut nominal rates sooner than expected. Some economists also believe that the natural or non-inflationary level of interest rates may have risen after the pandemic, meaning the economy could sustain higher real rates without suffering a recession. Anyway, one conclusion is clear. It is always better to be grounded in reality. ■