The “money illusion” is one of the most lyrical terms in economics. It refers to the mistake people make when they focus on nominal rather than real values. Anyone who was happy about a hefty salary increase last year without considering whether they can actually buy more after inflation has succumbed to the illusion. Financial investors should be wiser, but even they can be seduced by a nice nominal story. The Federal Reserve’s downgrade for smaller rate hikes is a case in point. It may seem like a step away from tight monetary policy; In real terms, however, the central bank’s stance is stricter than it first appears.
On February 1, the Fed hiked interest rates by a quarter of a point, bringing short-term lending rates to a widely expected 4.75% ceiling. This was half the last rise, a half point in December, which in turn was down three quarter points from its previous series of gains. The immediate question for investors is when will the Fed give up altogether. A slim majority expect the central bank to deliver another quarter-point hike next month and then back off as evidence of a slowdown in inflation mounts. Even those more worried about high inflation are pricing in at most an additional half-point of rate hikes before the Fed stops. This is the light at the end of the monetary tightening tunnel that has helped fuel a stock market rally in recent weeks.
But what matters for companies and households that need to borrow money is the real rather than the nominal interest rate. Here the outlook is a bit more complicated – and almost certainly less rosy. Traditionally, many observers simply subtract inflation from interest rates to get the real interest rate. For example, assuming annual consumer price inflation of 6.5% in December and an overnight interest rate of 4.5% this month, the calculation would imply a real interest rate of -2%, which would still be very stimulative.
However, this reflects a fundamental flaw. Because interest rates are a forward-looking variable (ie how much is owed at a future date), the relevant comparison to inflation is also forward-looking (ie how much prices will change by the same future date). Of course, nobody can predict exactly how the economy will develop, but there are comprehensive indicators of inflation expectations based on both bond prices and survey data. Subtracting one such indicator — the Cleveland Fed’s expected one-year inflation rate — from Treasury yields yields a much steeper yield path. In real terms, they have risen to 2%, the highest level since 2007 (see chart).
Even after the Fed stops raising nominal interest rates, real interest rates are likely to continue to rise for some time. Before Covid-19, expected inflation for one year was around 1.7%. Now it is 2.7%. If inflation expectations return to pre-pandemic levels, real interest rates would rise by as much as another percentage point – to levels that have always preceded a recession in recent decades.
None of this is predetermined. If inflation proves to be persistent this year, expectations for future inflation could rise, leading to a fall in real interest rates. The Fed could cut nominal rates sooner than forecast, many investors are predicting. Some economists also believe that natural, or non-inflationary, interest rate levels may have risen since the pandemic, meaning the economy can absorb higher real interest rates without suffering a recession. Whatever the case, one conclusion is clear. It’s always better to stay grounded in reality. ■
