The real fed funds rate has sat below zero since the Financial Crisis. What does this mean for the U.S. economy?

Since the nadir of the Great Recession, the economy of the United States has added more than 16 million jobs. The jobless rate sits under 5%. Home prices finally surpassed its 2007 peak, meaning many households have recouped all losses from the housing crash.

While there is a strong churn to the U.S. economy – especially considering the lasting effects of a financial crisis like the one experienced in 2008 and 2009 – one key indicator still shows that there is a long way to go.

Except for one minor spike in 2010, the real federal funds rate has sat in negative territory for the entire recovery. Through March 2017, the real fed funds rate sits at -1.07% .

What does the real fed funds rate tell us?

The real fed funds rate is calculated as the fed funds rate minus the median consumer price index in the United States. The Federal Reserve sets the fed funds rate as the interest rate given for on overnight deposits between financial institutions.

It is designed as monetary policy tool to manage the balance of the U.S. economy. If the fed funds rate is low, banks are incentivized to not hold cash because the return on that cash is low. Instead banks would want to lend it out to where it can earn a higher return. If the fed funds rate is high, banks then want to hold cash, because they can earn a higher return relative to the risk taken by lending for mortgages or to small business owners.

With the real fed funds rate in negative territory, banks are effectively taking small losses on deposits in real (inflation-adjusted) terms. In recent years, banks have been happy to bleed slowly. The return on lending isn’t high enough to justify the risk, so you might as well lose 1% a year than risk losing 100%.

Unless the real fed funds rate turns back into positive territory, this amounts to death by a thousand paper cuts.

With the real fed funds rate still below zero, the Fed is still very much in accomodative monetary policy mode. The Fed may hike rates a few more times this year, but unless inflation picks up, the real fed funds rate will still be negative.

What does the real fed funds rate indicate moving forward?

In the past, the real fed funds rate tracked the market cycles. The rate t would rise as the markets continued to rise, then fall below zero at market corrections. The fed funds rate has bounced between -3.0% and -1.0% over the past five years, but hasn’t necessarily trended upward over time. In fact, the trendline shows the real fed funds rate falling over this period.

Compared to past cycles, there is a substantial divergence between the real fed funds rate and market performance. But what does that mean? Does that mean that the market still has room to run? Or does that mean we are in a new paradigm of permanently low interest rates?

If anything, this is a reminder that the stock market is not the U.S. economy.

Photo: International Monetary Fund, Flickr Commons