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Rallying markets weighed on by dovish fantasies

TonHis “Money Illusion” It is one of the more lyrical-sounding concepts in economics. It refers to the mistake people make when focusing on nominal value instead of actual value. Anyone ecstatic about getting a big raise without considering whether they could actually buy more after inflation has fallen prey to fantasy over the past year. Financial investors should be more savvy, but they might also be drawn to a cute titular story. The Fed’s cut to a smaller rate hike is a good example. This may look like a step away from hawkish monetary policy; but in reality, the central bank’s stance is tighter than it appears.

On February 1, the Fed raised interest rates by 0.25 percentage points, taking short-term borrowing rates to a ceiling of 4.75%, as widely expected. That was half of its previous increase of 0.5 percentage points in December, which was down from three-quarters of the previous increase. The immediate question for investors is when the Fed will call it fully exited. A narrow majority sees the central bank raising interest rates by another 25 basis points next month before stopping hikes as evidence of cooling inflation. Even those who are more worried about high inflation will raise rates by at most 0.5 percentage points before the Fed stops. It’s the light at the end of the monetary tightening tunnel that has helped fuel the stock market rally in recent weeks.

However, for companies and households that need to borrow money, it is the real interest rate, not the nominal interest rate, that ultimately matters. Here, the outlook is a bit mixed — and almost certainly less rosy. Traditionally, many observers have simply subtracted inflation from interest to obtain the real interest rate. For example, if annual consumer price inflation was 6.5% in December and the federal funds rate cap was 4.5% that month, that would calculate to a real rate of -2%, which would still be highly stimulative.

However, this reflects a fundamental error. Since interest is a forward-looking variable (ie, how much will be owed at some future date), the relative comparison with inflation is also forward-looking (ie, how much prices will change by the same future date). Of course, no one can perfectly predict how the economy will develop, but bond pricing and survey data can be used to provide a composite measure of inflation expectations. Subtracting one such measure — the Cleveland Fed’s one-year expected inflation rate — from U.S. Treasury yields yields a steeper rate trajectory. In fact, they have soared 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. The one-year expected inflation rate before covid-19 was about 1.7%. It is now 2.7%. If inflation expectations return to pre-pandemic levels, real interest rates will rise another percentage point — to pre-recession heights of the past few decades.

None of this is preordained. If inflation proves persistent this year, expectations for future inflation could rise, which would lead to lower real interest rates. The Fed could end up cutting nominal interest rates sooner than expected, as many investors have predicted. Some economists also believe that the level of the natural, or non-inflationary, rate of interest may have risen since the pandemic, meaning the economy can maintain high real interest rates without falling into recession. Regardless, one conclusion is clear. It’s always better to keep your feet on the ground.

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