Few would find fault with the steady, gradual decline in U.S. inflation, but it has recently come with an unwelcome side effect: rising 'real' borrowing costs.
With the Federal Reserve's official policy rate on hold and the benchmark 10-year Treasury yield edging higher, inflation-adjusted interest rates – so-called real rates – are rising, effectively tightening monetary policy and financial conditions.
The real yield on the 10-year Treasury note is now approaching 2.20%, the highest in a decade, based on the April headline annual CPI inflation rate of 2.3%. And the real fed funds rate has risen from a low of 1.50% in January to eclipse 2.00%, the highest in more than six months.
While real borrowing costs are not at levels that will trigger alarm bells with Fed officials, CEOs or CIOs, the direction of travel is pretty clear, and is one more factor that could weigh on the activity of consumers, businesses, and investors in an environment already shrouded in a thick fog of uncertainty. Additionally, for policymakers, it shines a light on the constant struggle to determine the optimal interest rate at any given time.
In Fed Chair Jerome Powell's press conference earlier this month after the central bank left its fed funds target range on hold at 4.25-4.50%, he said no fewer than eight times that rates are "in a good place". Current policy is "somewhat" and "modestly or moderately" restrictive, he added.
The higher real rates grind, however, the tighter policy gets, unless the Fed resumes its easing cycle, which has been on pause following cuts of 100 basis points between last August and December. The tariff-fueled uncertainty and volatility of recent months has helped to extend that pause and, thus, enabled real rates to rise.
Real borrowing costs can send vastly different signals from their nominal equivalents. For example, Japan's official policy rate and long-dated bond yields are the highest in years, but the real policy rate is deeply negative and by far the lowest among the G4 central banks.
In the U.S., the signaling behind today's rate moves is far from clear. If real yields are rising because investors are demanding a risk premium to hold dollars and Treasuries, then it's a cause for concern. If the upward shift reflects strong growth expectations, then that's much more positive.
But, regardless, one thing is evident. The higher U.S. real rates grind, the further away they move from 'R-Star', the amorphous real rate of interest that neither stimulates nor crimps economic activity when the economy is at full employment.
Two closely watched R-Star models partly constructed by current New York Fed President John Williams suggest the optimum real interest rate at the end of December was 0.8% or 1.3%, both the lowest in years. These figures will be updated for the January-March quarter at the end of this month. Fed rate-setters' median projection for the natural real interest rate is around 1.0%, and this view will be updated next month.
These projections assume inflation at the Fed's 2% target, which it hasn't been for years. The R-Star concept has come under heavy criticism since the pandemic. Williams defended it in July last year, saying it is a fundamental part of all macroeconomic models and frameworks. "Pretending it doesn't exist or wishing it away does not change that."
But he also cautioned that R-Star should not be "overly" relied upon when setting appropriate monetary policy "at a given point in time" given the uncertainty surrounding it.
Right now, financial conditions are loosening as markets calm after the market turmoil wrought by the 'Liberation Day' tariff tantrum last month. But if you exclude that uniquely volatile episode, conditions have been steadily tightening since September last year, Goldman Sachs's U.S. financial conditions index shows.
Further upside for real yields from here may be limited if inflation ticks higher in the coming months as Trump's tariffs kick in. But worries over U.S. debt and deficits are beginning to weigh on the long end of the bond market again.
As investors continue to monitor countless economic variables to determine where the U.S. economy is heading, elevated real yields are one they should watch closely.
