Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Obsessed With the Real Rate
Transcript
- Lucas: So, Luna, the Fed's favorite conversation right now isn't really about the policy rate itself. It's about the real rate — the fed funds rate minus inflation expectations. And right now, that number is doing something we haven't seen in over a decade. Luna: You mean the real rate is actually high? Because the fed funds rate is sitting at 3.63 percent, and ten-year breakevens have dropped to 2.27 percent. That implies a real rate of about 1.36 percent. Lucas: Exactly. And that's not just high by recent standards — that's the highest real rate since before the global financial crisis. The last time the real rate was this elevated, we were in a completely different macro regime. And the Fed is starting to realize that this real rate is doing a lot of the tightening for them. Luna: So the Fed can just sit back and let the real rate do the work? That sounds too easy. Lucas: Well, that's the debate. Because the real rate is high, but it's not uniform across the economy. Mortgage rates are still around 7 percent, which is a very high real cost for households. But corporate borrowing costs, especially for investment-grade firms, are actually lower in real terms than they were in the early 2000s. So the transmission isn't clean. Luna: Right, and that's why the Fed is so focused on inflation expectations. If breakevens keep falling, the real rate rises even without a hike. That's basically a passive tightening. Lucas: And that's exactly what Chair Kevin Warsh has been hinting at. He's said the Fed doesn't need to move the nominal rate if inflation expectations are anchored and the real rate is already restrictive. But here's the catch — core PCE is still running at 3.3 percent. That's above target, and it's not falling fast enough. Luna: So the real rate is high, but inflation is still sticky. That's the worst combination for the Fed. Lucas: It is. And that's why the internal debate is so heated. Some FOMC members look at the real rate and say, 'We've done enough.' Others look at core inflation and say, 'We need to do more.' But the interesting thing is that the real rate argument is actually giving the doves cover to hold. Luna: How so? Lucas: Because if the real rate is already at 1.36 percent, and the Fed's own estimate of the neutral real rate is somewhere around 0.5 to 0.7 percent, then policy is meaningfully restrictive. That's a strong argument for patience. But the hawks can counter that the real rate isn't high enough to crush inflation that's been running above 3 percent for two years. Luna: So the real rate is the battleground. It's the lens through which both sides see the same data differently. Lucas: Exactly. And this isn't just an academic exercise. It has direct consequences for markets. Look at the equity rally we've seen this week — the S&P 500 is up nearly 6 percent in five days. That's partly because investors are betting the Fed won't hike again. But if the real rate keeps climbing because inflation expectations fall, that could pressure valuations. Luna: So the real rate is like the silent hand guiding everything. Lucas: It is. And it's the reason why the Fed watches breakevens so closely. A drop in inflation expectations isn't just a data point — it's an automatic tightening of financial conditions. So the Fed has to be careful about cheering for lower inflation too loudly, because it could overshoot. Luna: That's a delicate balance. You don't want to sound like you're rooting for higher inflation, but you also don't want expectations to fall too far. Lucas: Right. And that's why you see Fed speakers being so careful with their language. They're all dancing around this real rate concept without actually saying it out loud. Luna: But isn't this something the Fed has dealt with before? I mean, the real rate wasn't invented in 2026. Lucas: No, it's a classic concept. But the difference is that for the past decade, the real rate was often negative. You had near-zero fed funds and inflation above 2 percent, so the real rate was negative. That was stimulative. Now we've flipped to a positive real rate. That's a regime change, and it affects everything from housing to business investment. Luna: And it's happening at a time when the economy is already slowing — Q2 GDP came in at just 1.5 percent. So the real rate is tightening into a slowdown. Lucas: Exactly. And that's the risk. The Fed could overtighten without even moving the nominal rate. If inflation expectations fall on their own, the real rate rises, and that could push the economy into a recession. So the Fed is essentially walking a tightrope. Luna: So how do they get off the tightrope? What's the endgame? Lucas: The endgame is getting inflation back to 2 percent without breaking the economy. And the real rate is the tool that's doing most of the heavy lifting right now. But the Fed can't control it directly — they can only influence it through inflation expectations and the nominal rate. That's why the communication strategy is so critical. Luna: And that's also why we're seeing such a divided Fed. Because some members think the real rate is already too high, and others think it needs to go higher. Lucas: Exactly. And that division is playing out in public. You had some members saying the Fed should hold because the real rate is restrictive, and others saying they need to keep the option to hike because core inflation is still too high. Luna: It's a real tug of war. Lucas: It is. And you know, this kind of conversation is exactly why we love doing this show. We get to peel back the layers of what's really driving the Fed's decisions. And we do it without any ads interrupting the flow. That's a choice we've made, and it's a choice that's only possible because of listeners who support the show directly. If you find these discussions valuable, you can support us at buy me a coffee dot com slash fexingo. It's a simple way to keep this podcast ad-free and independent. Luna: Yeah, we really do believe in this model. And it's great that you're part of it. Lucas: So, back to the real rate. What does this mean for the average person? Because it's not just a Wall Street concept. Luna: It means your savings account is finally earning a positive real return. And your mortgage is expensive. And your rent is still going up because shelter inflation is sticky. Lucas: Right. And for investors, it means the era of cheap money is over. You can't just buy any stock and expect it to go up. The real rate is a filter — it separates companies that can generate real cash flow from those that were only surviving on easy money. Luna: So what should we be watching next? What's the signal that tells us the Fed's next move? Lucas: Watch the ten-year breakeven rate. If it starts to fall below 2 percent, that tells you the market is pricing in a real rate that's even more restrictive. And that might force the Fed to actually cut rates to prevent an overshoot. So paradoxically, falling inflation expectations could lead to a rate cut. Luna: But if inflation expectations rise, then the real rate falls, and the Fed might need to hike again to keep policy tight. So the Fed is really at the mercy of inflation expectations. Lucas: Exactly. And that's why the Fed spends so much time talking about expectations. They're trying to manage that number as much as they're trying to manage actual inflation. Luna: So the real rate is the silent driver, and inflation expectations are the lever. Lucas: That's a great way to put it. And I think that's the key takeaway from today's episode. The Fed's next move won't be about the nominal rate alone — it'll be about how the real rate evolves, and that depends on what happens to inflation expectations. Luna: And that's why the August jobs report and the next CPI print are going to be so crucial. They'll shape those expectations. Lucas: Absolutely. So keep an eye on those breakevens, and maybe take a look at your own savings rate. Because in this regime, it's actually working for you.