Real Fed Funds Rate at Lowest Level Since October

The real Fed Funds rate was -1.44% in May 2014. This is the lowest the real rate has been since October 2013. This is the second month in a row that the real rate has fallen. However, the real rate has fluctuated in a very narrow band since October 2013 and has not changed significantly since April 2013.

The year-over-year change in the Fed funds rate has been falling since April 2013. In May 2014, the real rate was just 10 basis points higher than it was one year ago. This is the smallest year-over-year increase in the real Fed funds rate since August 2013, which was the last time the real Fed funds rate fell from the previous year. This decelerating growth in the real rate should provide a temporary boost to spending on goods purchased with debt (housing and consumer durable goods in particular). Real interest rates tend to lead housing by about 12 months and consumer durable goods spending by about 15 months.

The real Fed funds rate is likely to provide only a temporary boost for a couple of reasons. First, the nominal rate set by the Federal Reserve is virtually zero and cannot go any lower. And, the Federal Reserve has begun to hint that rates are going to rise sooner than many expect. An increase in the nominal rate would cause the year-over-year change in the real rate to rise (everything else being equal).

Second, the annual rate of inflation, according to the CPI, has remained lower than what the Federal Reserve would like. While the inflation rate has remained relatively low, it is increasing. In May 2014, the annual rate of inflation was 2.13%, which is the highest rate of inflation since October 2012. The inflation rate has increased each of the last three months. The increasing rate of inflation is what is driving the real Fed funds rate lower. Unless the inflation rate continues to rise, the year-over-year change in the real Fed funds rate will being to flatten out. If the Fed raises nominal rates, the inflation rate will have to increase even faster to keep real rates from rising (rising real interest rates are negative for housing and consumer spending).

The real Fed funds rate is an important leading indicator for the following industries: appliances; automotive; custom processors; furniture manufacturing; hardware; HVAC; metalcutting job shops; off-road and construction machinery; petrochemical processors; plastics and rubber; pumps, valves, and plumbing products; textiles, clothing, and leather goods; and wood and paper.