Real (Inflation-Adjusted) Fed Funds Rate Rises To 17-Year High
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The market consensus is expecting the Federal Reserve will soon start cutting interest rates. Fed funds futures, for instance, are estimating a 90%-plus probability that the central bank will start lowering its target rate at the September 18 monetary policy meeting. Another market-based indicator also points to a rate cut in the near future via the policy-sensitive 2-year U.S. Treasury yield, which is trading at roughly 4.5% -- well below the Fed’s current 5.25%-to-5.50% target range. History suggests that the 2-year yield summarizes the market’s expectations for the policy outlook, and on that basis a rate cut appears to be approaching.
Skeptics might wonder if the rate-cut forecasts find support in the inflation data? One way to approximate an answer is by comparing the real (inflation-adjusted) Fed funds rate to the actual inflation numbers. As shown in the analysis below, the case on this front supports the market’s expectation that a new rate-cutting cycle may be near.
For the analysis, we’ll use core inflation, which is considered a more robust measure of pricing pressure. The “core” label is a reference to removing the high-volatility components – typically energy and food – to calculate a clearer measure of the trend. Note, too, that the Fed has publicly stated that it uses the core reading of Personal Consumption Expenditures Price Index as its primary inflation benchmark.
To further reinforce the analysis, we’ll use the median of five measures of core inflation – a technique that minimizes the noise that can arise by relying on any one measure of core inflation. (For a list of the five inflation indicators for the analytics see the table below.)
The key takeaway from this review is that the effective Fed funds rate – roughly 5.33% at the moment – has recently risen well above the year-over-year change in core inflation (see chart below). As of June, core inflation rose 3.1%, or more than 2 percentage points below the median Fed funds target rate. In other words, monetary policy is restrictive – more restrictive than at any time in the past 17 years.
Deflating the Fed funds rate by the median core inflation rate translates to a real Fed funds rate of 2.25% – the highest since 2007. As shown in the next chart below, relatively sharp increases in the real Fed funds rate tend to be associated with the start of rate-cutting cycles. That’s no guarantee that a rate cut is near, but it tips the scale in that direction by more than a trivial degree.
