Written by: Meera Pandit
During the September Federal Open Market Committee (FOMC) press conference, Chairman Jerome Powell noted that the Committee would like to see positive real rates across the entire yield curve as one indication that they have reached an appropriate policy stance. A real rate of interest is a nominal rate that an investor or lender receives or expects to receive adjusted for inflation. Yet, calculating real rates based on actual inflation (CPI, PCE) or inflation expectations signals different levels of appropriate policy stance.
The FOMC’s latest economic projections show a terminal Federal Funds Rate (FFR) at 4.6% in 2023. That implies the Federal Reserve (Fed) could hike 75 bps in November, 50 bps in December, and 25 bps on February 1 to reach a target range of 4.50-4.75%.
At that point, the Fed will have a December print for the PCE deflator and CPI. With core PCE already at 4.6% year over year through July and lower commodity prices weighing on headline inflation, it is plausible that the real FFR will be positive at that point based on both measures of PCE, allowing the Fed to take its foot off the gas. However, the Fed has never stopped hiking rates while the FFR is below CPI. It would take monthly prints closer to 0.1% month over month on core CPI and outright monthly deflation on headline CPI to bring inflation below the FFR by the February meeting. Inflation is slowing, but may not be slowing quickly enough, creating a potential timing issue for the Fed.
Yet, real rates are already positive across the curve today when looking at TIPS yields, which are essentially nominal yields minus inflation expectations, highlighted in the chart below. By this measure, another 150bps of tightening could go well beyond what is necessary to bring down inflation and meaningfully raise the likelihood of recession.
Different measures of real rates signal different paths for Fed hikes. Not only does this risk a policy error, but also continues to generate uncertainty for investors trying to assess the end of the hiking cycle, which is contingent upon some combination of positive real rates, a softening labor market, and disinflation. This is likely to prolong interest rate and equity volatility in the near-term, warranting a cautious and diversified approach from investors.
U.S. Treasury Inflation-Indexed Curve
Source: Bloomberg, J.P. Morgan Asset Management. Data are as of September 26, 2022.