Despite recent hikes, interest rates are still near zero in real terms

Key Points
  • President Trump is worried that the Federal Reserve is pushing interest rates too high, and so are some investors on Wall Street.
  • But, by historical standards, the real level of short term rates - adjusted for inflation – is still relatively low.
  • Here are four charts showing how the current level of interest rates compares with cycles of boom and bust in past decades.

President Trump is worried that the Federal Reserve is pushing interest rates too high, and so are some investors on Wall Street.

But, the real level of short term rates — adjusted for inflation — is still low by historical standards.

The Federal Reserve Wednesday raised its benchmark interest rate a quarter-point. But amid signs of a slowing economy, policy makers lowered their projections for future hikes.

As was widely expected, the central bank moved the target for its federal funds rate to a range of 2.25 percent to 2.5 percent. The move marked the fourth increase this year and the ninth since central bankers began moving rates higher in December 2015.

But officials now project only two hikes next year, less than indicated earlier this year but more than the financial markets are expecting, based on the bond futures prices.

The short term federal funds rate set by the Federal Open Market Committee matters because it used as the starting price for the cost of borrowing. When the Fed lowers rates, lending gets cheaper and money flows through the economy more easily, spurring growth. As rates rise, the pace of borrowing tends to slow down, along with overall economic growth.

That's what has happened recently as rates have moved higher, especially for industries like housing and autos that are especially sensitive to changes in interest rates.

The Fed's job is to keep the economy growing. But it is also focused on keeping inflation in check. That's because inflation eats away at the value of money over time. If you borrow when inflation is high, the lender has to charge higher interest rates to make up for that lost value. When inflation is low, borrowers can still make money when rates are relatively low.

With inflation currently running at about 2.2 percent, the FOMC's latest move has restored the real federal funds rate to just about zero.

By historical standards, that's fairly low. During much of the 1980s and 1990s, when the economy was strong, real rates were much higher than today. That was also true in during the housing boom of the early 2000s.

But despite real borrowing rates of near zero, "a relatively modest amount of monetary tightening is having a disproportionate impact on the economy than in the past," according to Joseph Lavorgna, chief economist of the Americas at Natixis.

Why? In a note to clients, Levorgna said one reason may be the lasting effect of the Fed's response to the financial crisis of 2008, which included a massive purchase of Treasury debt. That policy of so-called "quantitative easing" pumped trillions of dollars into the credit system.. But it more than quadrupled the pile of debt held by the Fed.

Now, as the Fed slowly pares back that debt, the impact may be weighing on the credit markets.

"If so, this quantitative tightening would have the effect of lowering the natural rate of interest," said Levorgna.

In many ways, the FOMC is navigating uncharted monetary territory. The Fed's response to the financial crisis introduced policies never before deployed by U.S. central bankers. Those policies come in marked contrast to Fed actions in decades past.

For much of the 1980s and 90s, the U.S. economy and stock market enjoyed a long tailwind of gradually declining rates after the Fed's historic move to kill the inflation of the 1970s with double digit interest rates. The growth in gross domestic product and stock prices wasn't without setbacks, including a shallow recession in the early 1990s and an Asian financial crisis in the late 1990s, among others.

But the long-term trend of falling rates gave the Fed plenty of room to cut rates to head off economic or financial downturns.

Those double-digit rates followed a ruinous bout of inflation that lingered through much of the 1970s. Beginning in 1973, policy makers were confronted with both rising inflation and a contracting economy, a condition dubbed stagflation. Even with real rates below zero, high rates of inflation continued to erode consumer spending power and the value of financial assets.

The ultimate solution involved a sharp rise in real rates that ushered in a painful set of back-to-back recessions at the start of the 1980s and set the stage for the recovery later in the decade.