In response to rising inflation, the Fed has raised the effective federal funds rate from 0.08% in January 2022 to 5.3% today. This is higher than the historical average over the past 60+ years relative to the current inflation rate. In contrast, market interest rates relative to the inflation rate are lower than historically suggested. The latter is consistent with the market view that the inflation since 2020 is transitory. If the market view is correct, the Fed will begin to lower interest rates, but the reduction in market interest rates is likely to be smaller than the federal funds rate. If the market view is wrong and inflation remains at or exceeds current levels, market interest rates will need to rise. Data for this article are taken from the Federal Reserve Economic Data File (FRED) maintained by the Federal Reserve Bank of St. Louis.
Price Inflation:
There are several measures of price inflation. The most commonly looked at is the Consumer Price Index (CPI). However, economists consider the GDP (Gross Domestic Product) implicit price deflator index to be the most complete price indicator in the economy. Since 1962, the annual consumer price inflation rate has typically exceeded the GDP deflator, a more complete inflation indicator (see Figure 1). Since 1962, the annual CPI inflation rate and the GDP deflator inflation rate have averaged 3.8% and 3.4%, respectively. In the first quarter of 2024, the annual CPI inflation rate was 3.3%, and the GDP deflator inflation rate was 3.1%. The two measures move closely together; the correlation is +0.96 (+1.0 is a perfect positive correlation).
Inflation and interest rates:
The Federal Reserve has the most control over the federal funds rate. The key relationship is the difference with the inflation rate. The federal funds rate has averaged 1.5 percentage points higher than the GDP deflator inflation rate since 1962 (4.9% vs. 3.4%) (see Figure 2). The difference in Q1 2024 is 2.2 percentage points (5.3% vs. 3.1%), 0.7 percentage points higher than the historical average difference.
The difference between market interest rates and the inflation rate is also interesting. Two market interest rates that are widely followed are the 10-year Treasury note and the Moody's Aaa Corporate Bond Index. Since 1962, when FRED first reported the 10-year Treasury note rate, these two market interest rates have averaged 2.5 and 3.5 percentage points higher than the GDP deflator inflation rate, respectively (5.8% and 6.9% vs. 3.4%) (see Figure 2). In 2024Q1, the difference has narrowed significantly to 1.1 and 1.9 percentage points, respectively.
Market Inflation Expectations:
FRED publishes market forecasts of the expected average inflation rate over the next 10 years, calculated from 10-Year Treasury Fixed Interest Rate Notes and 10-Year Treasury Inflation-Indexed Fixed Interest Rate Notes. The forecasts were first available in 2003. From 2003 to 2023, expected inflation over this decade averaged 2.1% (see Figure 3). In 1Q24, it rose slightly to 2.3%, indicating that the market likely views the inflation rate beyond 2020 as transitory.
Discussion
The current relationship of the federal funds rate and market interest rates to inflation is different from their historical relationship.
10-year Treasury and Moody's Aaa-rated corporate interest rates have a narrower than normal premium over inflation. Thus, market rates are currently lower than would be historically expected given recent U.S. inflation rates. This relationship is consistent with the current market assessment that inflationary events beyond 2020 will be largely, if not entirely, temporary.
In contrast, the federal funds rate, the rate over which the Federal Reserve has most direct control, is now trading at a higher premium to inflation than its historical average premium. This relationship is consistent with comments by the Fed that it is concerned about the extent to which inflation beyond 2020 will be permanent.
These two divergent views are likely to converge in the future. If the market’s view of transitory inflation after 2020 is wrong, market interest rates will need to rise. If the market’s view is correct, the Fed will begin to cut interest rates, but the reduction in market interest rates will likely be smaller than the federal funds rate.
In considering future timelines, it is interesting to compare current inflationary events to those of the 1970s so far. After the 1973 oil price shock (Corbett), the Fed Funds rate was below inflation for three years (1975, 1976, 1977) (see Figure 2). After the COVID lockdown, the Fed Funds rate was below inflation for three years (2020, 2021, 2022). In the 1970s, the Fed Funds rate gradually exceeded inflation for four years (1978, 1979, 1980, 1981), but then it began to fall, both in the level of interest rates and in its relative relationship to inflation, as inflation also began to fall. While it would be inappropriate at this point to claim that these two inflationary events will follow similar paths, the inflation path of the 1970s is a warning signal that the federal funds rate may remain elevated for years to come, both in terms of its level and relative to the rate of inflation.