According to my calculations, the real (inflation-adjusted) interest rate is around 1.5%, which is one percentage point higher than the Fed’s estimate of the neutral real policy rate (which neither stimulates nor reduces economic activity). Prior to previous recessions, the real rate has been higher. While current market pricing suggests that the Fed will increase the federal funds rate once more this cycle, I think that is optimistic. Between stubborn and high underlying inflation, financial conditions that aren’t tightening, and real interest rates that are lower than is typical before a significant economic slowdown, there are ample reasons for the Fed to raise rates more than economists and investors currently seem to expect. If that happens, the risk of recession will increase. Related: Furman On CPI Report and A Default Cycle Has Started
- Date Posted:
- July 25, 2023
Markets are not taking the ongoing rise in default rates for HY and loans seriously. The reality is that more and more companies are defaulting because the cost of capital is higher, and Fed Chair Powell says that interest rates will stay at these levels “for a couple of years,” so tight monetary policy will continue to have a greater negative effect on the economy and capital markets. In fact, higher costs of capital is precisely how monetary policy works: By making it more difficult to get financing. Once there is a default by some household name in credit, we will likely see an overnight change in market sentiment from bullish to bearish.