Screen Shot 2015-11-18 at 4.55.47 PM

For all the talk about how the Federal Reserve has finally decided to pick up the pace of interest-rate increases, the fact is that real rates — or those after taking into account inflation — are not only still negative, but getting even more negative.

Normally, that’s not such a bad thing if the goal of a central bank is to spur growth and the price of assets. But the problem now is that negative rates have weighed on the dollar, which is helping to push asset prices to or close to record highs. Although global economic growth is picking up, it’s nowhere near levels that would justify such valuations. If history is any lesson, then investors might want to study the 1970s, when the Fed responded to similar conditions by stepping up the pace of rate hikes in an effort to cause real rates to turn positive. The period from mid-1976 through March 1978 wasn’t a very good time for stocks and riskier assets in general.

According to Irving Fisher, the early 20th-century economist who is credited with creating the “monetarism” school, when inflation expectations are stable, nominal rates approximate real interest rates. Lately, though, inflation expectations have crept lower, as shown by short-maturity inflation break-even rates falling by 40 basis points after the Fed boosted rates for the second time in three months on March 15.

Japan is an example where inflation expectations became unstable and the Fisher relationship broke down. More recently, Europe and the U.S. have seen volatility in inflation expectations to the extent that Fisher relationships are on the cusp of breaking down for them, too. The consequence is that U.S. and European real interest rates could stay negative, and that may loosen financial conditions even more, cause the dollar to weaken, and spark capital outflows.

Advertisements