Just How Low Are Interest Rates?

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Legend has it someone once asked Winston Churchill how his wife was? The answer, dripping Churchillian wit:

“Compared to what?”

Even after December’s little bump the nominal Fed funds target rate is still just about 0.50%. Rates are low. But the question arises… low compared to what?

Look back to, say, 1979. Nominal interest rates averaged about 12.5% in 1979. So the same nominal interest rate that’s 0.50% today was 12.5% in 1979 — 24 times higher.

But could it be that today’s puny 0.50% rate… is actually not much different from 1979’s 12.5%?

Consider…

The real interest rate is the nominal interest rate minus the inflation rate. There’s a reason why it’s called the real interest rate. It penetrates numerical mists. It scatters statistical fogs.

So if nominal interest rates averaged 12.5% in 1979 and inflation ran to 13.3%, let us apply some grade-school math to arrive at the real interest rate in 1979…

When we take 1979’s average nominal interest rate (12.5%) and subtract the inflation rate (13.3%), we come to the startling conclusion that the real interest rate was not 12.5%… but negative 0.8% (12.5 – 13.3 = -0.8).

Negative rates? There you have it. In the words of Jim Rickards:

Negative real rates exist when the rate of inflation is higher than the nominal interest rate. This condition can exist at any level of nominal rates. For example, inflation of 3% with nominal rates of 2.5% produces a negative real rate of 0.5%.

Likewise, inflation of 4% with nominal rates of 3.5% produces the same negative real rate of 0.5%.

Again, the nominal rate was 12.5%. But the real interest rate was -0.8%. Roll the film forward to today…

Today’s nominal rate is about 0.50%. And the Bureau of Labor Statistics says consumer price inflation ran about 2.1% last year. Ignore what you think inflation might be and take the number at face value for now. If we want the real rate, we subtract inflation from the nominal rate and discover that today’s real rate of interest is somewhere in the range of -1.6%.

So despite the nominal difference, today’s -1.6% real interest rate is in the same neighborhood as 1979’s -0.8%.

Conclusion: The nominal interest rate has no meaning absent the inflation rate.

Yet the difference between nominal rates and real rates draws nowhere near the attention it rates. Because as Jim Rickards notes, “Real rates are what determine investment decisions.”

Now the Fed has essentially cracked its blessed 2% inflation target. And it’s planning at least “a few” rate hikes a year until it reaches 3% by late 2019.

We have our doubts it’ll get there. But go ahead and assume a nominal 3% rate at the end of 2019. Assume further — as the Fed currently does — that inflation will average 2% in 2019.

The math says the real rate would still be just 1%. For the nation’s average long-term real interest rate is about 3%.

So… even if nominal interest rates rise, real interest rates will remain a good amount below normal. And it could be a long time before they return to normal.

That is, if they ever return to normal.

Below, Jim Rickards shows you why the foregoing matters to the all-important bond market. What are the implications for Trump’s economic agenda? Read on.

Regards,

Brian Maher
Managing Editor, The Daily Reckoning

The post Just How Low Are Interest Rates? appeared first on Daily Reckoning.

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