"Real" Interest Rates

We are diving right into this one, no words to start, just a graph! 

Red line = Federal Funds rate, blue line = Federal funds rate minus 5 year expected inflation.

From July 2003 to June 2004 the Effective Funds rate is essentially flat at 1%, during this time inflation expectations increase by about 1 percentage point.  This represents roughly a 67% increase in the expected inflation rate, from around 1.5% to 2.5%.

What is the Fed to do?  Well, start raising rates of course.  The Fed raises rates over 4 percentage points from June 2004 to July 2006 while 5 year inflation expectations move up another 15-20% to their peak at just under 3% in early 2005.  Meanwhile at the 10 year break even rate

So 10 year inflation expectations peaks right before the Fed starts raising the funds rate, and then is in the 2.2 to 2.8 range right up until August 2008 (not shown here).  Another look

The spreads here are small, but functionally doubled.  Early in the graph 10 year inflation expectations are basically 0.35% per year more than 5 year at the widest points, given that 10 year inflation includes the next 5 years as well this implies that years 6-10 should have around 0.70% higher inflation than years 1-5.  That isn't a huge deal but it is notable when rates are in the 1.5-2% range.

What is a huge deal is that the Federal Reserve raise interest rates by 4 percentage points and inflation expectations are virtually identical after the last increase to what they were at the first increase and were slightly higher for good portions of the rate increases.

If you are of the opinion that the Federal Reserve can control inflation (expectations) with the funds rate then you are looking at a 400% increase over 2 years to stop inflation expectations from rising.  And don't give me "long and variable lags", these rates include the 10 year break even rate which stops rising BEFORE the 5 year rate does.

There is a sentiment to be found that the Fed was to tight during this period, that they either raised rates to far or held them up there for to long.  This is awkward to argue as the lower of the 5 and 10 year break even rates stays above 2.15% and they were both right around 2.35% when the Fed starts easing in 2007.  Then the Fed lowers rates by 3+ percentage points from July 2007 to May 2008 and inflation expectations stay in the range the Fed wants them to.

All of this is just a set up for

This is about as close to a smoking gun as you can have against monetarism or Keynesian economics, both of which rely on using real interest rates as a mechanism for driving down the savings rate and driving up the consumption rate to combat a recession.  First I will zoom out as far as the Fed data goes to show how poorly correlated real interest rates are with the savings rate

Now a zoomed in section from the financial crisis

The savings rate fell and held steady while real interest rates climbed.  There are multiple measures here of what a "real" interest rate should be, the 10 year bond rate minus 10 year expected inflation, the same for 5 and 5, 2 year bond minus 5 year inflation, 2 year treasury minus the current inflation rate, the federal funds rate minus 5 year inflation and they all show the same pattern.  Real interest rates climbed and the savings rate ignored them, then rates fell and the savings rate ignore them and then the early stages of the financial crisis started and the savings rate moved higher and quickly.  I'm not going to discuss the spikes here, just the trend, the savings rate went from around 4% in the early stages of the recession to above 5% in about 6 months and up to the 6-7% range with peaks above 7.5%. 

If you read my previous posts on the yield curve you would note that the stock markets started rising more rapidly right around the same time that real interest rates started rising during the above period, and not long before housing starts fell off a cliff.

I am going to return to my explanation of a bifurcated market, that there exists two (or several) different sets of participants with little cross venturing.  Low, and especially negative, real interest rates should benefit borrowers at a cost to lenders.  Higher rates should benefit lenders at a cost to borrowers, and lower rates vice versa but how many would be borrowers can benefit by switching to being lenders?  If you have a cash reserve and are thinking of borrowing because real rates are low then your cash reserves are going to suffer poor growth roughly equal to the gains you get by borrowing the money for a project rather than using your own.  Moving towards equilibrium is difficult in this way, which is why the channel of rising real rates encouraging savings and decreasing real rates reducing them is central to modern macro theories and why the above graphs are so devastating to them.