Do real interest rates matter?

Back in late 2008, I argued that tight money was driving the economy into a deep recession. One counterargument was that interest rates had declined over the past year. I pointed out that interest rates are a misleading indicator of the stance of monetary policy. The response would be something like, “Yes, nominal interest rates can be misleading, but surely real interest rates are indicative.”

Even real interest rates are unreliable, albeit less so than nominal rates. But here’s what’s interesting—real interest rates were soaring in late 2008, exactly when the Fed’s tight money policy drove the US into a deep slump. So why did almost all economists miss that fact? When I raised the issue, I was told that real interest rates are also misleading, due to various factors. I agree! But then how do we measure the stance of monetary policy? I prefer to look at NGDP growth (and levels.)

This tweet caught my eye:

Fortunately, Kathy Jones doesn’t make any claims about the stance of monetary policy. But you can be sure that lots of people will look at this graph and argue that the high real interest rates show that money is tight. So was money also tight in late 2008?

PS. Jones makes a minor error when suggesting that real rates are at the highest level since 2007. Actually, the spike you see (blue line) was in late 2008. But it’s an understandable error, as who would have imagined that the Fed would drive real interest rates up to 6% just as the US was sliding into a deep recession?

PPS. Q2 NGDP figures will be released in a few days. Let’s see what they show before concluding that money is tight.



14 Responses to “Do real interest rates matter?”

  1. Gravatar of spencer spencer
    25. July 2023 at 13:21

    Real interest rates generally increase with a tighter money policy:

    And saver-holders want high real rates of interest.

    re: “what’s interesting—real interest rates were soaring in late 2008”

    Because of #1 the distributed lag effect of money flows, #2 the disintermediation of the nonbanks, #3 the contraction of the E-$ market, real rates of interest went up temporarily.

  2. Gravatar of John Hall John Hall
    25. July 2023 at 14:36

    As you’re probably well aware, that 2008 spike in TIPs yield was due to a liquidity event.

  3. Gravatar of Siddharth Siddharth
    25. July 2023 at 16:15

    I agree with you that NGDP is the measure that provides the best picture of how tight monetary policy is. But it’s hard for me to understand why real interest rates are also not a good indicator.

    Yes businesses are considering nominal spending levels in their decisions surrounding employment and future investment, but they’re most definitely also considering medium to long term real interest rates on marginally profitable investments/loans. How would higher real interest rates not lead to less business investments, and slower economic activity?

  4. Gravatar of David S David S
    25. July 2023 at 16:37

    I’m happy to buy a time machine for anyone who says that money wasn’t tight from 2006 to 2011. They can try getting a mortgage or a construction loan without cutting off their arm and sacrificing their first born.

    Also, why doesn’t Jones show 2 year yields going back to the 90’s. Did our monetary history start in 2001?

    NGDP figures will probably show that we’re at low boil. A gentle simmer would be better–i.e. around 4%–which is what it will be in time for Trump’s inauguration. Will he invite Jay Powell?

  5. Gravatar of spencer spencer
    26. July 2023 at 05:30

    The sudden drop in velocity was responsible for the spike.

  6. Gravatar of ssumner ssumner
    26. July 2023 at 10:05

    John, Yes, that’s just one of 100s of reasons why real interest rates are worthless as an indicator of the stance of monetary policy.

    Siddharth, Don’t reason from a price change. High real rates can be an effect of a booming economy. Or an effect of big budget deficits. Or lots of other factors.

    David, Money was very tight from 2008-11, but in 2006 and 2007 I don’t think it was very tight. Money isn’t credit.

  7. Gravatar of TF TF
    26. July 2023 at 14:26

    I think investors and by extension the financial press are looking for real time forward looking indicators of monetary policy. No one will care much about 2q NGDP tomorrow, markets are now looking past that. NGDP futures of course would be great but do not exist.

  8. Gravatar of Michael Sandifer Michael Sandifer
    26. July 2023 at 17:43

    You seem to focus less on forward indicators since you concluded the Fed overstimulated the economy.

  9. Gravatar of Ray Lopez Ray Lopez
    27. July 2023 at 07:17

    Were real interest rates high in the 1980s? I say this because a book I am reading by Niskanen, “Reagonomics” (he was on the CEA for Reagan) says that during this time the Fed effectively was doing NGDPLT (or a variant thereof, in his words, and yes, I alerted our host and hope he does a column on this historical curiosity). If true, then we can know if in fact “easy” or “hard” NGDPLT monetary policy had a hand in either taming inflation and/or increasing GDP growth rates from 1980-1988 or so.

    OK I found the data on my hard drive. Clearly NGDPLT in the 1980s “beat inflation”, but real growth rates were lower compared to the 1970s. Data (real gdp % avg): 1960’s: 4.2%/yr (avg), 1970s: 3.3%/yr, 1980s: 3.2%/yr 1990s: 3.3%/yr, 2000s: 1.8%/yr, 2010s: 2.1%/yr.

    So NGDPLT does not raise real GDP in the 1980s compared to previous decades when it was not practiced. Perhaps it has other benefits like promoting stable prices or smoothing GDP/yr, but it does not have “real” effects for growth.

  10. Gravatar of ssumner ssumner
    27. July 2023 at 10:24

    TF, You said:

    “No one will care much about 2q NGDP tomorrow”

    I suspect it was one factor in the stock market’s initial rise.

    Michael, You said:

    “since you concluded the Fed overstimulated the economy”

    Well, NGDP is up 23.6% since late 2019. So it’s more than my “conclusion”. It’s a fact.

    During the 2010s, I didn’t just focus on future expected NGDP, I also talked about the recent undershoot.

  11. Gravatar of Michael Sandifer Michael Sandifer
    27. July 2023 at 17:31


    I agree that there was overstimulation, but that’s due to forward-looking indicators. Comparing the current path of NGDP to a long-term trend doesn’t work so well if the baseline didn’t represent macro equilibrium. And there’s some pretty good evidence that the US economy never reached macro equilibrium between the last two recessions.

    Also, you’ve said that you think current inflation is 100% due to monetary policy, which really seems hard to support. There’s also ample evidence that we’re still in the midst of negative supply shocks, though those factors continue to ease.

    I thought your approach is called “market monetarism”, because the emphasis is on forward, market-based indicators. You want to have the Fed use an NGDP futures market for NGDP level targeting for a reason. Hence, you implicitly admit, and used to explicitly say, that you cannot reliably judge the stance of monetary policy without forward indicators.

  12. Gravatar of ssumner ssumner
    27. July 2023 at 21:15

    “Hence, you implicitly admit, and used to explicitly say, that you cannot reliably judge the stance of monetary policy without forward indicators.”

    That’s still my view.

  13. Gravatar of Michael Sandifer Michael Sandifer
    27. July 2023 at 21:37

    There seems to be a disconnect between putting such an emphasis on forward indicators and your confidence in your opinions sans forward indicators.

  14. Gravatar of ssumner ssumner
    28. July 2023 at 12:49

    Michael, I don’t recall having a high confidence about whether or not current policy is appropriate, I’ve had a high confidence that past policy (2021-22) was too expansionary.

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