For all the hoopla over each Federal Reserve meeting, the thing that matters to the economy, funnily enough, isn't the level they set interest rates to exactly, but rather where rates are compared with inflation and the economy's "neutral" level of policy.
The first comparison is one that we can make directly. The whole reason the economy got out of whack during Covid wasn't just because the Fed took rates to zero; it was because they took rates to zero while inflation soared to 9%. That meant in "real" terms, interest rates weren't zero; they were sharply negative, extremely stimulative to the economy.
Think about it: if you can borrow money at zero, and your sales are growing 9-10% thanks to high inflation and a bit of real growth, that's a pretty juicy opportunity--a no-brainer, really. It's why we saw tons of new business formations during the pandemic, and a start-up boom as capital flooded into companies that seemingly had "sure-thing" growth and business models.
The exact opposite is happening now. The Fed has jacked rates up to nearly 5.5%, but inflation has collapsed to just 3.2%. Now, as a business owner, if you have to borrow at let's say 6% but your top-line is only growing 3-4%, you're in a pickle. So the start-up boom is sharply reversing. U.S. bankruptcy filings this year have hit their highest since 2010. And that's just for the largest corporations, which have the most financing options, so you can imagine its worse for smaller businesses.
So the Fed isn't just raising rates; it's raising rates on steroids right now, because each successive month that the inflation rate stays as far below their target rate as it is right now--more than two points, meaning the "real" interest rate is currently about 2%--that's actually a super restrictive monetary policy. This is why analysts like MKM's Michael Darda continue to expect a hard landing, as the lagged effects of all of this tightening come home to roost.
Now, the next piece of this is to look at where these real rates are relative to where they "should" be, but this is a bit of economic artistry that is hotly contested, and very difficult to know for sure in real time. The reason it's come up again is that analysts are confused as to why the economy hasn't been weaker yet in the face of all of this Fed tightening. So they posit that perhaps the "neutral" level of real rates has become much higher than it used to be. (The supposed "neutral" level is known as r* in the profession, in case you hear that term thrown around this week.)
In other words, the experts are debating not whether real rates are upwards of 2% right now--that's a pretty observable fact--but whether that level is restrictive enough. It certainly was back in the 2010s, when real rates were rarely higher than 0.5% and yet the economy struggled to remain growing post-financial-crisis. But is it restrictive enough now? If you take the message of leading indicators (which remain negative) and the inverted yield curve, yes. If you ignore those and focus on current data, like jobs and GDP, you think the answer is no.
And in a sense, the stock market has become a kind of unofficial referee on all of this. The last time real rates were in the 2% range was in the mid-2000s expansion before the financial crisis hit. Stocks at the time traded at just 15 times forward earnings, on average. Fast-forward to now, and stocks are completely shrugging these higher real rates off. The S&P 500 hit almost a 20 times multiple earlier this year, and is now trading around 18.5, as Darda notes.
Maybe that's warranted, as the bulls argue, because new innovations like AI are so profound and productive that the biggest stocks trading at high valuations deserve the premium they have been awarded. If so, it certainly gives the impression that the economy may need more restrictive real rates now than it used to, in order to really cool things off.
Or maybe a year from now we'll be holding our heads as the S&P returns to a more "normal" valuation, and the days of 5.8% GDP prints (if we even get that this quarter) are a distant memory. Only by then will we know if these 2% "real" rates were really high enough.
See you at 1 p.m!
Kelly
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