Below is a chart of the real federal funds rate in the U.S., which is the overnight interbank lending rate minus inflation. It is now at the lowest it has been in as long as data has been available (since 1954).

Rate

The Fed is going to tighten the monetary policy – to raise the target range of just this very federal funds rate. Now it is at the minimum level: from 0% to 0.25%. For the first time they want to raise the rate by 25-50 basis points. Will this help curb inflation in the U.S.?

The 0% to 0.25% target range set during the pandemic ensures low rates throughout the U.S. economy and, as a result, economic growth, strong demand and inflation. Which is actually what we are seeing in the US. GDP grew by 6.9% (y/y) in Q4. Let’s not talk about inflation at all, it is at its highest level in 40 years.

The US economy is clearly overheated from such low interest rates. Especially if you look at real rates (i.e. rates net of inflation). The real federal funds rate is now around -7.5%. Again, this is the minimum in the time that data has been available. Would raising the rate by 25-50 basis points at the next meeting help in this situation? Very doubtful. Unless inflation starts to fall on its own, the real rate will still be deep at the lows – around -7%.

Conclusions?

1. Deeply negative real rates on interbank lending and other transactions in the U.S. lead to adverse selection. Investors in the stock market at negative real rates tend to seek higher returns and take more risk. This makes the financial market less stable.

2- What the Fed is doing now is not a tightening of policy, but a shift from an extremely loose policy to a soft policy. And this in the face of record inflation.

3. If the Fed really planned to fight inflation, it would have raised rates by a few percentage points a long time ago and started shrinking its balance sheet a long time ago. So the Fed is actually demonstrating by its cautious actions that it is abdicating responsibility for current inflation.

4. So far, everyone expects inflation in the US and globally to slow down only “by itself” when supply chains get back on track. Well, or thanks to high interest rates in developing countries. The Fed is not taking any effective steps in this direction yet.