Fed Rate vs. Real Interest Rates

Recent economic events have left many wondering about the relationship between the Federal Reserve’s actions and real interest rates. For instance, despite the Federal Reserve’s recent decision to cut interest rates by 50 basis points, real interest rates in markets like mortgages and bonds spiked, driven by strong economic data. While the Fed’s rate cuts often get the headlines, it’s important to understand that real interest rates are determined by a more complex set of factors. What are the key differences between the Fed rate vs. real interest rates, how they interact, and why they don’t always move in tandem.

What is the Fed Rate?

The Federal Funds Rate, often referred to simply as the “Fed rate,” is the interest rate at which banks lend to one another overnight. This rate serves as a primary tool for the Federal Reserve to influence the economy. By raising or lowering the Fed rate, the Federal Reserve aims to control economic growth and inflation.

Lowering the Fed Rate

When the economy slows, the Fed lowers rates to encourage borrowing and spending. Cheaper loans mean more investment in businesses, homes, and consumer purchases.

Raising the Fed Rate

Conversely, when inflation rises too fast or the economy overheats, the Fed raises rates to make borrowing more expensive. This helps cool down excessive spending and curb inflation.

While the Fed rate is a tool for influencing short-term borrowing between banks, its ripple effects are far-reaching. It can affect everything from mortgage rates to car loans, but there’s more at play than just this one lever of monetary policy.

What Are Real Interest Rates?

Real interest rates are the rates that individuals and businesses experience in the real world on loans, mortgages, and bonds, adjusted for inflation. They are determined by a variety of factors, including economic growth, inflation expectations, and market demand for credit.

How Real Rates Are Calculated

Real interest rates can be thought of as nominal interest rates (the ones we see advertised) minus inflation. For example, if a loan has a nominal interest rate of 5% and inflation is running at 2%, the real interest rate on that loan is 3%.

Factors Influencing Real Rates

Real rates are shaped by supply and demand in credit markets, investor sentiment, inflation expectations, and the broader economic outlook. Even when the Federal Reserve lowers the Fed rate, real interest rates can rise if there is strong demand for loans or if inflation expectations increase.

Why Real Rates Can Rise Despite Fed Rate Cuts

This brings us to the recent situation where, despite a 50 basis-point cut by the Federal Reserve, real interest rates on things like mortgages and bonds rose significantly. Why does this happen?

Good Economic Data

When the economy performs well, investors expect growth to continue. If strong economic data, such as positive job numbers or higher-than-expected GDP growth, signals that future inflation might rise, real interest rates can increase. Investors demand higher returns to compensate for this inflation risk.

Inflation Expectations

Inflation erodes the value of money over time, so when inflation expectations rise, lenders and investors want a higher return. This causes real interest rates to rise, even if the Fed is cutting its own rates in an attempt to boost economic activity.

Market Confidence in Growth

Strong economic growth signals that demand for credit will remain robust. If businesses and consumers feel optimistic, they’ll continue borrowing, pushing real interest rates higher even when the Fed is trying to make borrowing cheaper.

A Historical Perspective on Fed Rate and Real Interest Rate Cycles

Let’s take a look at some past economic cycles to understand how the Fed rate and real interest rates have interacted and diverged.

1970s Inflation and Interest Rates

In the 1970s, the U.S. faced high inflation driven by oil price shocks and loose monetary policy. To combat this, the Fed raised interest rates sharply. However, real interest rates remained low or even negative at times, as inflation outpaced the Fed’s ability to control it. This period illustrates that real rates can stay disconnected from the Fed rate when inflation expectations spiral out of control.

The 2008 Financial Crisis

During the Great Recession, the Fed slashed rates to near zero in an effort to stabilize the economy. Yet, real interest rates fluctuated as the markets dealt with fears of deflation, uncertainty in the banking sector, and overall economic instability. Despite low Fed rates, real rates in certain sectors remained elevated due to risk aversion and a lack of confidence in the broader economy.

2015-2018 Fed Rate Hikes

After nearly a decade of near-zero interest rates, the Fed began raising rates in 2015. However, real interest rates didn’t always follow the Fed’s trajectory. In 2018, strong economic data, such as low unemployment and rising wages, led real rates to rise faster than the Fed’s rate hikes as investors expected higher inflation.

Post-COVID Recovery (2021-Present)

In the wake of the COVID-19 pandemic, the Federal Reserve kept interest rates extremely low to support the economy’s recovery. However, as the economy rebounded in 2021, real rates began to rise sharply due to concerns over inflation and supply chain disruptions. This created a situation where the Fed was still holding rates low while real interest rates increased rapidly in response to market conditions.

The Fed Rate vs. Real Interest Rates Today

In today’s economic landscape, the Federal Reserve recently cut its rate by 50 basis points, but real interest rates in the bond market and mortgage sector spiked. This divergence is driven by strong economic data showing robust growth, despite efforts by the Fed to ease monetary policy.

Good Economic Data’s Role

Positive economic data such as a stronger-than-expected jobs report or consumer spending growth can lead investors to expect future inflation, pushing up real interest rates.

Rising Real Rates Impact Borrowers and Investors

For consumers, this can be frustrating. You may see the Fed lowering rates, but mortgage rates climb higher due to real interest rate increases. Investors, on the other hand, may benefit as higher real interest rates offer better returns in bond markets.

Implications for Consumers and Investors

Borrowing Costs

The real interest rate is more impactful for most borrowers than the Fed rate. If you’re planning to buy a house or refinance a loan, rising real rates can mean higher monthly payments, even if the Fed is lowering its rate.

Investing in Bonds

For bond investors, real interest rates play a significant role in determining returns. When real rates rise, bond prices tend to fall, but yields increase, providing an opportunity for higher returns on new bond purchases.

Protecting Against Inflation

Investors worried about rising inflation can look to inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), which adjust their payouts based on inflation.

Understanding the Fed Rate and Real Interest Rates

By looking at past cycles and current trends, we can see that real interest rates can rise even when the Fed is cutting rates. As a result, both consumers and investors need to monitor both the Fed rate and real interest rates to make informed decisions. Keeping an eye on economic data, inflation expectations, and broader market sentiment will give you a more complete picture of the financial landscape.

The key takeaway is that while the Fed rate is a powerful tool, it doesn’t tell the whole story. Real interest rates, which reflect inflation expectations, economic growth, and market conditions, are often a better gauge of the true cost of borrowing and the returns on investments.