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Home Economy

Behind the Headlines on Real Interest Rates

November 16, 2021
Reading Time: 2 mins read
Risk Across the Enterprise
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By Tyler Mondres
ABA Data Bank

Headline inflation in the United States surged to 6.2 percent in October, yet the federal funds rate—set by the Federal Open Market Committee—remained targeted between 0 percent and 0.25 percent. As a result, the real interest rate in the U.S., negative 5.97 percent, is at its lowest level in decades.

Real interest rates are derived as the difference between the rate of inflation (U.S. Consumer Price Index) and the nominal rates (fed funds rate, or any savings deposit rate), and reflect the purchasing power of the nominal rates. If prices are rising at a higher rate than the cost of borrowing, then people and businesses see that goods and materials would be cheaper if they borrow to buy now; the overall incentive stimulates the economy. On the other hand, if interest rates exceed inflation then many will feel that it costs too much to borrow and will wait to spend, depressing growth. For these reasons, economists focus on the real rate of inflation. In the U.S., a common focus is on the federal funds rate less inflation measured by the Consumer Price Index.

The U.S. isn’t the only country with negative real rates, according to data from Bloomberg. Real interest rates are in the red for many of the world’s developed economies, including Canada (negative 4.15 percent), the Eurozone (negative 4.1), and the U.K. (negative 3 percent).

While real rates have been trending down over the past few decades, the last time they were this low in the U.S. was in 1975, when real rates hit negative 5.23 percent amid rising energy prices. Real rates also fell in the U.S. following the Great Recession, hitting a low of negative 3.62 percent in 2011.

(Click graph to enlarge.)

Some believe that declining real rates are behind the 40-year rise in the stock market as investors look for higher returns. If real rates rise, they could trigger portfolio reallocations, which in turn could cause stocks and other assets to re-price. But until that time, negative rates are likely to depress the purchasing power of families and households relying on interest income as a source of funding.

Despite rising concerns about the trajectory of inflation, the monetary policy of developed nations remains very dovish in posture, and central banks have been hesitant to raise rates too quickly. Over the past two months, the European Central Bank and Bank of England pushed back on market expectations of rate hikes. In October, investors largely expected the BoE to hike rates, but it elected to hold them at 0.1 percent. In November, the ECB said it considered “current market pricing of a rate hike [in 2022] as excessive.” Here at home, the Fed announced it would start tapering its asset purchases in November. However, the FOMC remained split 9-9 when it met in September on whether to hike rates next year.

Tags: ABA Data BankConsumer Price IndexFOMC
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Author

Tyler Mondres

Tyler Mondres

Tyler Mondres is senior director of economic research at ABA and a frequent contributor on economic and fintech topics to the ABA Banking Journal.

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