Over the past four years, the rate of inflation measured by the CPI-U has remained persistently low. As a result, with the nominal Fed Funds rate near zero over this period of time, the effective Fed Funds rate adjusted for the rate of inflation was actually negative.
Is there some level of real rate of interest that the Federal Reserve is targeting? We believe the answer is yes.
Typically, the real Fed Funds rate is declining sharply as economic activity is slowing. The exception was the recession in 1981-1982 where inflation was increasing as the economy slowed. Through the first half of 2019, we expect that the Fed will continue to push short-term interest rates higher. However, in the second half, we expect the economy to show signs of slowing, which will force the Fed to begin a narrative of “pausing” its tightening program.
Historically, the Fed has targeted a real Fed Funds rate near 2 percent. In this new monetary regime, however, we expect the Fed will only be able to push rates high enough to achieve a 1 percent real Fed Funds rate. As they attempt to shrink their bond portfolio during a time where the capital markets are adjusting to higher rates, we expect the potential negative impact on economic growth will cause the Fed to err on the side of a lower targeted nominal Fed Funds rate. With inflation near 2.0 percent today, this would imply a nominal Fed Funds rate closer to 3.0 percent, which leads us to believe that the Fed has roughly three more moves higher, including an increase of 25 bps in December.
Greg Hahn is president and chief investment officer of Winthrop Capital Management.