The Consumption-Interest Rate Puzzle
Have rising rates made any difference?
From March 2022 to July 2023—a span of about 16 months—the Federal Funds Rate, the Federal Reserve’s main policy lever, increased from about zero percent to 5.3 percent.
Over the 12-months running from April 2023 to March 2024, real consumer spending increased by about 3 percent year-over-year (as noted last week by Macrosight)1.
The latter increase in consumer spending was higher than the 2000 to 2019 average of 2.3 percent. Over that same twenty-year time period the Federal Funds rate averaged 1.8 percent. Yet recently, somehow, as interest rates rose, consumer spending has increased faster than in the past?
What the heck?!
Rising interest rates should slow consumer spending. Rates go up and it becomes more expensive to borrow money, and/or the opportunity cost of consuming goes up. That means consumers have more of an incentive to not buy stuff (a.k.a. save). Consumer spending in 2023 should not have increased at a higher clip than pre-2019, when rates were lower, right?
The entire point of the Federal Reserve’s 16-month rate-hike campaign was to slow the economy in order to slow inflation. While the latter has happened to an extent, the economy continues to defy the Fed’s cudgel. As the Fed noted in their March policy report, real GDP in 2023 grew at 3.1 percent and “consumer spending grew at a solid pace.”
So, what gives? One way to understand why consumer spending is thriving in spite of higher rates is through the looking glass of a good ole’ fashioned macroeconomic huckleberry known as the “Fisher Effect”—the difference between the nominal interest rate and the real interest rate.
Macrosight provided an explanation of this concept a while back. But let’s revisit the idea in light of recent data.
Nominal vs. Real
Figure 1 displays two macroeconomically-important nominal interest rates—the Federal Funds rate and the 30-year mortgage interest rate (for fixed-rate mortgages)—from January 2021 through March 2024 (at the monthly frequency).
As of March 2024, the nominal interest rate on a 30-year fixed rate mortgage equaled 6.8 percent, while the Federal Funds rate stood at 5.3 rate. As is typical between these two rates, the 30-year rate, being a long rate, is higher than the short rate (this post has a breakdown on the connection between the very long mortgage rate and the very short federal funds rate).
A nominal interest rate is what we see quoted by our financial institutions, whether it be a commercial bank offering you a savings account paying 2 percent, an auto-financing company quoting a 48-month car loan at 8 percent, or a mortgage broker advertising rates “as low as” 6.8 percent. Each of those rates represents a nominal rate.
The real interest rate is the interest rate that reveals the purchasing power of the interest you are paying as a borrower or receiving as a saver. The real interest rate takes into account the rate of inflation. The nominal rate does not. The real interest rate is written as follows:
Real Interest Rate = Nominal Interest Rate – Rate of Inflation
The real rate is what should matter to us as consumers, just as the purchasing power—or real value—of our paychecks matters to us. If the Fed is to slow down the Hungry Beast, they must raise nominal rates high enough to out-pace inflation. That is, the real interest rate must increase.
Figure 2 shows the difference between the nominal federal funds rate and the real federal funds rate since January 2021. The latter was calculated using the formula above, where the rate of inflation is based on the PCEPI index, measured as the year-over-year rate for each month.
One can readily see that from the beginning of the displayed sample period until about March or April of 2023, the real federal funds rate was negative. Its most negative point occurred about a year before that in March 2022.
Around March/April of 2023 the real federal funds interest finally made it into positive territory. By March 2024, we can see that the real rate stood at 2.6 percent (5.3 nominal rate - 2.7 PCEPI rate of inflation).
What does a negative real rate mean?
If you are saver, negative real rate means that the amount of savings you have in your account is losing its purchasing power. If you start the year with $100, and the bank pays you a nominal rate of, say, 5 percent, at the end of the year your nominal balance will read “$105.00”.
But, if the rate of inflation was 5 percent for that year, your real return for the year equals zero percent. The $105 you get at the end of the year buys the same amount of stuff you could have purchased a year ago with $100.
If instead the rate of inflation was 10 percent, you would earn a negative 5 percent real rate of interest. That means that the $105 you see on your bank statement buys less than what $100 would have gotten you a year ago.
If you are a borrower, a negative real interest rate means that the bank is essentially paying you to borrow money from them. With inflation, the real value of each monthly payment you make on a fixed-rate mortgage is worth less and less in terms of purchasing power. That is, the money the lender is receiving from you buys them less and less over time. That is because with a fixed-rate mortgage the monthly nominal payment on your mortgage will be the same for 30 years! (Unless, you decide to refinance that mortgage.)
That is one reason a fixed-rate mortgage is such a good deal for borrowers—the nominal value of your monthly payment never increases. Another reason is that, in a world with never-ending inflation, the amount of money you borrow today buys you a lot more today than that same amount of money will buy you at any point in future.
With respect to these points, Figure 3 displays the nominal mortgage rate along with the real mortgage rate since 2021 (calculated in the same way as the real federal funds rate).
For the mortgage rate, we see a similar pattern as the federal funds rate. The real mortgage rate is much lower than the nominal rate. Like the federal funds rate, for much of 2021 and half of 2022, the real mortgage rate was negative. The largest negative value for the real rate equaled - 3.1 percent in December 2021 (3.1 nominal rate - 6.2 rate of inflation). Around September of 2022, the real mortgage rate finally became positive; in March of this year the real rate equaled 4.1 percent.
What does the real rate mean for consumer spending?
Admittedly, putting a finger on how the real rate drives or dissuades consumer spending is difficult. The concept seems very academic, a far-from-real-world concept your macro-101 professor drones on about while you scroll through Instagram with your phone concealed beneath your desk.
But, the distinction between nominal and real rates of interest is just as “real-world” as the purchasing power of our paychecks. We observe daily how rising grocery or gas prices stretch those paychecks, especially so the past couple of years. In that respect, the nominal value shown on our paycheck is clearly distinct from the real value of that number.
With interest rates, however, the effect is more subtle as it plays out over time. On the savings side it is more intuitive—just like our paychecks, inflation eats away at the amount we are saving for retirement. But that reality does not really hit us until far down the road, as we get close to retirement (professional financial planners, of course, are very aware of such a reality).
As borrowers, it is more difficult to grasp the distinction. However, inflation does, in fact, provide us as consumers a rational reason to save less today, to consume more today, and to borrow more today, than in a world with no inflation. That incentive is indisputable.
As such, if the Fed wants to stimulate the economy, negative real interest rate should be more simulative than a zero or positive interest rate. Why not consume or borrow in such a world?
If the Fed, however, wants to slow the economy, they need to raise the nominal rate high enough that the real rate rises too. That means the increase in the nominal federal funds rate needs to be higher than the rate of inflation. If not, any Fed-induced increase in the nominal interest rate will not provide a disincentive for consumers to cut back on spending.
Thus, if we observe the rate of consumer spending out-pacing the historical rate of said spending, in spite of a rising nominal interest rate, it may be due to the fact that the real rate is not rising enough.