Last time I wrote how the last 6 months of CPI inflation at rates in the 3% range made shot the real interest rate up to over 2% for the entire period. Why? Because after almost a quarter of a century of the Fed pushing the real interest rate below zero (with 2006-2007, and a year over 2018-19 as the 3 years of exceptions), now the Fed is by declaration (of its “interest rate on reserve balances IORB”) causing a too high real interest rate designed in markets only for the best of times.
Inflation in December 2024 was 3.3%, making the average over the 7 months from June 2023-December 2023 exactly 3.3%. In contrast, the “IORB” has averaged 5.37%, set at 5.4% for the last 6 months to December. Well, the real interest rate is the market rate discounted for inflation, which means that you subtract the inflation rate from the market rate. This is an “implied” rate, while the market rate and inflation rate are known variables. We attribute this as the Fisher equation of interest rates from his 1896 PhD thesis, deriving the “real” rate of interest after accounting for inflation.
So 5.37% minus 3.3% is a real rate of 2.4%. Quite above 2%. Throughout postwar US history, we have had such high rates only during boom periods of the 1960s, 1980s, 1990s. The inflation rate averaged 6.6% from April 2021 to May 2023, not a good time for the economy, and not a time when we would want to follow up with suddenly high real interest rates. Now, do not mistake me for saying that a “normal” 2% real rate is bad; no, it can be good in good times and is expected in good times. But a Fed-enforced period of MINUS 1.9% (-1.9%) on average from the month after the 9/11 terrorist attacks to May 2023 (Oct 2001-May 2023) means the Fed has “prohibited usury” or a positive return on capital of the most liquid asset in the world: the 3-month Treasury bill yield, since the Fed set rates determine almost exactly the T-bill rate (see graph below).
Suddenly going from a regime of 22 years of an average -2% real rate to 7 months now through the end of 2023 at +2% is a shock to capital markets that endangers global financial markets. The Fed started the negative interest rate policy to “safeguard” global finance. Prolonging it for a quarter of a century, almost, gravely endangers global financial markets.
The Fed should immediately lower their dictated IORB market rate so that the T-bill rate will fall and real interest rates will realign a bit more towards normalcy.
Once cannot pretend that after -2% real rates for decades, it is “normal” to suddenly dictate +2% real rates for more than half a year. Shock therapy went out with lobotomies.
The Graph shows the real rate in the thin grey line, the inflation rate in the black line, and the IORB rate in the red line along with the Tbill rate in the blue line
(for more, see my book The Spectre of Price Inflation on Amazon; https://www.amazon.com/Spectre-Price-Inflation-Max-Gillman/dp/1788212371 )
Max Gillman 