Two Charts to Understand Changing Interest Rates

Posted by David Widmar on May 23, 2022

These days, you don’t have to go very far to find an article or chart about the current interest rate situation. While the topic is admittedly noisy, we have two important ideas to share that haven’t gotten much attention. This week’s post reviews real (inflation-adjusted) interest rates and the magnitude of historic rate changes.

Real Interest Rates Turn Negative

A feature of the farm economy in the 1970s was very low – and sometimes negative – real interest rates. On the surface, adjusted interest rates for inflation seem complicated, but it’s simply the difference between the rate of interest paid (or nominal rate) and the annual rate of inflation.

As we discussed in Escaping 1980, low and negative real interest rates are sometimes mentioned as part of the enthusiasm in the farm debt and real estate markets in the late 1970s, which didn’t play out well during the 1980s. In short, some viewed negative real interest rates as a reason to “load up on debt,” as inflation outpacing the cost of capital made future debt obligations seem easy to satisfy.

There are many ways to measure real interest rates, and Figure 1 shows the U.S. prime interest rate adjusted by the Consumer Price Index (CPI). In 2021, the combination of a low nominal rate (the U.S Prime Rate was 3.25%) and higher-than-normal levels of inflation (CPI average of 4.7%) resulted in a real rate of -1.45%. The last time these data were negative was in 1974 (-0.26%) and 1975 (-1.29%). Real interest rates were also very low in 2011, approaching 0%.

The main idea here is that the combination of low interest rates and high inflation set the stage for low and negative real interest rates. This could have a significant effect on how some view future purchase and financing decisions.

Looking ahead, it’s hard to imagine negative real interest rates persisting – especially at the bank or individual level – for multiple years. A combination of factors – higher nominal interest rate and/or lower inflation rates – will likely push real rates higher in the future. That said, it’s hard to predict how or when this situation might evolve.

Figure 1. Real U.S. Prime Interest Rate, 1955-2021. Average annual Prime Loan Rate Less Annual Percent Change in CPI. Data Source: St. Louis FRED, aei.ag calculations.

Figure 1. Real U.S. Prime Interest Rate, 1955-2021. Average annual Prime Loan Rate Less Annual Percent Change in CPI. Data Source: St. Louis FRED, aei.ag calculations.

Small Adjustments, So Far

Attention has been hyper-focused on the Fed’s next decision and the range of possible rate hikes. So far, the Fed raised the upper limit of the Fed Funds target rate by a total of 75 basis points, and the range of future hikes has spanned from 25 to 75 basis points. This got us wondering about what historic interest rate adjustments have looked like.

Figure 2 shows the change in the effective Fed Funds rate over the previous twelve months. The data are a bit lagged for 2022, but you can clearly tell that the current 75 basis points of change are, historically speaking, rather small.

In recent memory, the Fed increased rates by 100 basis points (or 1 percentage point) for the twelve months ending in November 2018. At the end of 2005, short-term rates had increased by more than 200 basis points. In early 2000, rates had increased 175 basis points, coinciding with the Dot-com crash. Lastly, the Fed pulled rates 270 basis points higher between 1994 and early 1995.

However, it’s the interest rate volatility of the 1970s and 1980s that really captures one’s attention. While the 1980s are infamous for high interest rates (farm rates peaked at more than 18%), an overlooked feature is the frequency and magnitude of adjustments made by the Fed during this period.

At the extremes, there was a twelve-month period from 1980 to 1981 where the Fed Funds rate increased by 1,000 basis points – or 10 percentage points. Shortly after, rates fell by nearly 800 basis points within a twelve-month span.

Although not shown in the chart, there were also very large monthly changes. The largest swings occurred in 1980. In March of that year, the Fed increased the Funds Rate by 300 basis points. In April, another 40 basis points were added. Reversing course, the Fed lowered then short-term rates by more than 650 basis points in May. While those changes were extreme, they illustrate just how different today’s environment is in comparison.

Finally, Figure 2 also illustrates how stable the Fed Funds rates have been in the last decade. In addition to growing accustomed to low interest rates, the last decade has also affected our expectations around the risks and range of expectations about possible rate hikes.

Figure 2. Change in the Fed Funds Effective Rate Over the Previous 12 Months. 1955 – 2021.

Figure 2. Change in the Fed Funds Effective Rate Over the Previous 12 Months. 1955 – 2021.

Wrapping It Up

With interest rates heading higher, it will be important to monitor the relationship between the rates folks are paying and the broader inflation situation. For the first time in nearly fifty years, real interest rates turned negative in 2021. It’s unclear how long extremely low real interest rates will persist – or how they end – but it’s worth considering how the current situation might affect perception about using and repaying future debt.

Second, there were many headlines about the Fed’s recent 50 basis point hike and how large it seemed. There have been countless comparisons to the 1970s and 1980s, but, in many ways, conditions are still very tame compared to those two decades. It’s one thing to say conditions are unfamiliar to anything we’ve observed since the 1980s, but it’s completely different to conclude we’re repeating that period of history.

The above charts are part of two AEI Premium articles posted earlier this year, which you can read in entirety here and here.

Also, check out these popular and related articles:

Lastly, those looking to challenge their thinking and learn from others should check out the AFN questions related to 1) Fed rate hikes in 2022 and 2) changes in long-term rates.

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