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Real Interest Rates Hit Minus 12.55% As Inflation Explodes!

Economics / Articles Apr 18, 2008 - 10:41 AM GMT

By: Money_and_Markets

Economics Best Financial Markets Analysis ArticleMike Larson writes: If you've been following the news, you know the Federal Reserve has been cutting interest rates. The benchmark federal funds rate was 5.25% last summer. It's all the way down to 2.25% now, and chances are the Fed will cut that rate again when it concludes its next policy meeting on April 30. The only question is whether we'll get a quarter-point or half-point cut at this time.

Now, here's something to consider: 2.25% sounds low, and it is. But what if I told you that interest rates, by at least one measure, are really -4.65%? Or that by another measure, they've hit a stunning -12.55%? You'd probably think I need to have my head examined!

And yet, those numbers are accurate. Here's why ...

The Riddle of REAL Interest Rates And Where We Stand Today

Let's say you're holding a corporate bond that pays you 5.5% in interest per year. That rate seems decent and roughly in line with the typical interest rate on long-term, AAA industrial company debt over the past few years (using Moody's data).

But what if inflation is running at 5.5%? Then you're not really earning anything. The interest you earn matches the decline in the purchasing power of your dollars. Or in other words, you're simply running in place.

And if inflation is 10%? In this unhappy scenario, you're actually losing money — to the tune of 4.5 percentage points, or 450 basis points, if you prefer.

That's the concept of "REAL" interest rates versus "nominal" ones. You have to not only look at the current, nominal level of rates, but also what inflation is doing, to get an idea of whether monetary policy is easy or tight.

When real rates are negative, it's a sign that policy is easy. That can drive inflation pressures and inflation expectations higher. When real rates are positive, it means that monetary policy is restrictive. That, in turn, tends to keep a lid on inflation.

Now, let's circle back to today. The nominal federal funds rate may be 2.25%. But we just got some key inflation data over the past several days that showed ...

  • Import prices skyrocketed 14.8% from a year ago in the month of March. That was up from 13.4% a month earlier and the highest rate of import inflation since the government started tracking it in 1982.
  • Producer prices jumped 6.9% from March 2007. That year-over-year gain in the Producer Price Index is just shy of the 7.4% rate in January, which in turn was the biggest rise since 1981.
  • The Consumer Price Index, for its part, rose 4% from last March.

So if you compute the REAL funds rate using import prices, you get an eye-popping -12.55% rate (2.25% nominal funds rate - 14.8% import inflation rate). If you use the PPI, you get -4.65% (2.25% - 6.9%).

And even if you use the CPI, which many people (including me) believe doesn't accurately reflect the true inflation rate we're seeing in our everyday lives, real interest rates are still negative — to the tune of -1.75% (2.25% - 4%).

As you can see from the chart below, this is the most negative that interest rates have been in years and years.

What Negative Real Rates Mean To You and Your Portfolio

The Fed keeps shoving its head deeper into the sand, hoping this inflation problem will go away. We get a bunch of speeches about how policymakers are "watching inflation closely."

But when it comes down to doing anything about it, the policymakers fold. Actually, they do something worse than that — they keep cutting interest rates even lower, driving real rates more deeply into negative territory.

Is it any wonder, then, that crude oil hit a fresh, all-time high of $115 a barrel this week? Or that the prices of all kinds of commodities have gone through the roof? Or that the dollar has been falling like a rock?

It's not just strong demand. It's not just strong overseas economic growth. It's the fact that nominal rates are much lower here than elsewhere, and that real rates are hugely negative.

Federal Reserve Chairman Ben Bernanke has come under fire as real inflation continues to soar.
Federal Reserve Chairman Ben Bernanke has come under fire as real inflation continues to soar.

Investors are piling into commodities and fleeing dollar investments because they are desperately trying to maintain their purchasing power in the face of a Fed that appears dead-set on destroying it!

In other words, there is no such thing as a free lunch, despite what Wall Street would have you believe. Fed Chairman Ben Bernanke has abandoned any semblance of caring about inflation and decided that the real concern is fighting deflation by any means necessary, including slashing interest rates to as little as -12.55%.

For a while, Treasury bond investors were willing to just sit there and take it. But that started to change this week. Long bond futures suffered a critical technical breakdown in price, a troubling development that could point to higher long-term rates over time.

So in my opinion, you should put your money in investments that can protect you. That includes hard assets like gold and other commodities ... Treasury Inflation Protected Securities, or TIPS ... and foreign bonds, which rise in dollar terms when the greenback loses value.

Until next time,


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