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The Federal Reserve increases and decreases interest rates so that it can turn financial conditions into either restrictive or accommodative regimes. This idea of what is considered restrictive is nebulous, however, and difficult to quantify. 

One method is R*, or the natural interest rate of the economy. This natural interest rate is an aggregate interest rate where if borrowing costs are around that number, the economy would be considered in equilibrium and neither restrictive nor loose. 

The Federal Reserve has two methods of calculating R* and are as followed:

The Laubach-Williams (2003) model uses data on real GDP, inflation, and the federal funds rate to extract trends in U.S. economic growth and other factors influencing the natural rate of interest. 

The Holston-Laubach-Williams (2023) model accounts for time-varying volatility and incorporates a persistent supply shock during the COVID‑19 pandemic. 

Based on these two models, we get this chart of R*

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What we see is that the R* has been in decline for decades now. There are many theories as to why, but mine are primarily attributed to a decline in demographics and an increase in debt, which both create drags in GDP growth.

As of Q3 2023, R* according to this model is at 1.19%. Meanwhile, the Federal Funds Rate is at 5.5%, significantly above it. What this implies is that current policy is extremely restrictive when compared to R*. 

In July, the Dallas fed published research comparing policy rates compared to R* and how restrictive that implies monetary policy is. As we can see, we have been in restrictive territory for a long time now.

On top of R*, the natural interest rate of the economy, the other major driver of the cost of money is inflation and inflation expectations. Variance in CPI can create major swings in the real cost money that often does not show up effectively in R* since it attempts to smoothen out fluctuations in inflation. 

Understanding where FFR sits in relation to R* provides us a framework for understanding where policy lies in NOMINAL TERMS. However, what’s more important is where policy lies in real terms, i.e inflation-adjusted terms.

To do that, we must understand the relationship between nominal rates and inflation expectations.

Real Rates

Real interest rates can be calculated in a few ways:

One way is (Yield on US treasury - breakeven rate on a similar maturity duration)

E.g 10 yr - 10 yr breakeven rate

This formula gives us the following:

This combination is useful since the two inputs are forward looking and of similar maturities, which provides the “cleanest” profile of real interest rates. 

Another common method is to use US Treasuries - CPI:

The issue with this calculation, however, is that it is comparing lagging data (CPI) with forward looking information - the yield on the 10y. That said, it is still a somewhat useful indicator to look at as forward looking inflation expectations can change on a dime whilst this is using data that has already occurred and is set in stone.

The third common method is comparing Nominal rates - inflation expectations as calculated by the Fed, as followed:

The primary downside to this approach is that the expectation number is primarily survey driven and is therefore more qualitative than quantitative in terms of its data.

Finally, a novel approach that I am finding useful is using PPI y/y as the Producer Price Index generally is a leading indicator of CPI since purchases prices trickle into consumer prices, as we see here:

Therefore, by comparing Federal Funds Rate - PPI YoY, it can provide us an idea of where policy stands on a real basis using somewhat leading data that is more quantitative in nature than more qualitative survey data.

Putting it all together, we get this chart:

Astute readers will notice that in the previous charts where the 10yr treasury bond was used, real rates have been coming lower. However, since the FFR was used here is dictated by the FOMC, it can only decrease if the Fed decides to cut rates.

Here lies the crux of the theme of this article: if inflation continues to decrease, as widely anticipated by the majority of forecasters in the next 12 months, real rates will actually increase, which would mean additional restricting of financial conditions without the Fed even hiking rates.

Now, remember in this chart we used PPI, which leads CPI. 

When comparing FFR - PPI and FFR - CPI, we see that real FFR is set to increase over the medium term:

What does this all mean?

Simply put, if the Fed does not begin to actually cut the Federal Funds Rate in tandem with the continued decrease in inflation, monetary policy will actually tighten further despite no hikes occurring during that time. This would occur in a regime where interest rates are already significantly above R* as mentioned above, and in a realm where most FOMC members have signalled that policy is plenty restrictive and does not need to be more restrictive. Reading between the lines, what that means is that to avoid becoming even more restrictive, the FOMC needs to begin cutting rates soon to do so.

Indeed, in a recent interview in August, NY Fed president Williams described exactly this dynamic coming to light:

"I think of monetary policy primarily in terms of real interest rates, and we set nominal rates. We're setting the Fed funds target. And, assuming inflation continues to come down next year, as many forecasts, including the economic projections show, then if we don't cut rates at some point next year, real interest rates will go up, and up, and up...So, I do think that from my perspective, to keep maintaining a restrictive stance may very well involve cutting the FFR next year."

Putting this all together begins to paint a logical picture of why the market is pricing in cuts to begin in March 2024:

It’s not because of psychological froth or frontrunning an unfounded Fed pivot, it is actually logically founded in the Fed maintaining a consistent stance on how restrictive they want policy to be moving forward. 

In conclusion, any more rate hikes at this point are nothing but a dream. In fact, rate cuts are extremely likely in the near future just so that monetary policy can REMAIN at the same level of restrictive, let alone loosen to accommodate any sort of potential recession on the horizon.

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Disclaimer: This research report is exactly that — a research report. It is not intended to serve as financial advice, nor should you blindly assume that any of the information is accurate without confirming through your own research. Bitcoin, cryptocurrencies, and other digital assets are incredibly risky and nothing in this report should be considered an endorsement to buy or sell any asset. Never invest more than you are willing to lose and understand the risk that you are taking. Do your own research. All information in this report is for educational purposes only and should not be the basis for any investment decisions that you make.

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