Adjusting to a New Reality: Higher, Potentially Positive, Real Fed Funds

The Core Consumer Price Index (CPI) moved higher with the November print from 1.91% year-over-year to 2.02% year-over-year, jumping 0.11% in one month. For reference, core inflation is most often calculated by taking the CPI and excluding certain items from the index, usually energy and food products.  From a significance perspective, it has been three years since core CPI was in excess of 2%. With that in mind, let’s pause for a moment and consider notable macroeconomic drivers during the past three years:  falling oil prices, the rising U.S. dollar, and global economic volatility. Throughout all these macroeconomic events core CPI has been resilient, moving up from a low of 1.57% in February 2014. Domestic demand, led by tighter labor markets and a robust housing market, have acted as the key drivers for increasing core CPI. And as we move forward, tighter labor markets will likely sustain inflation at a higher level over the next few years.

As I’ve written about for the past couple of months, inflation on a year-over-year basis is now shedding the very low inflation from a year ago. Headline CPI moved higher from 0.17% year-over-year to 0.50% year-over-year. This astounding one month volatility will likely continue over the next couple of months moving overall CPI an additional 1.0% higher to around 1.50% year-over-year. I view this three month volatility to be a catch-up phase bringing headline CPI more in line with a longer term trend. With any move higher in oil prices over the course of 2016, headline inflation, which does include energy and food products, could end the year over 2%.

Regarding the Federal Reserve’s (Fed) preferred measure of inflation,  the core Personal Consumption Expenditures (PCE) price index has been on a lower track but will likely move up to its 10-month trend rate of 1.5% annualized from the current 1.3% year-over-year rate in the near future. One way to look at The Fed’s monetary policy conditions is to examine the so called “real fed funds rate”, which is fed funds minus inflation. Over the past seven years the Fed has kept fed funds well below core PCE, providing substantial stimulus for the economy. During this time period, real fed funds has averaged -1.36% providing very attractive borrowing rates for companies, consumers, and governments. Using November inflation, real fed funds is currently -0.98% today.

If the Fed were to move fed funds higher, only to match inflation, actual monetary policy would not be any tighter at all. So, if as I anticipate, core PCE moves higher by about 0.5% in 2016, the Fed in an effort to normalize real fed funds higher, and less negative, will need to raise fed funds in excess of 0.5%. Indeed the median of Fed member expectations is four 0.25% hikes throughout 2016, totaling a 1% increase.

As real fed funds moves higher, expect market interest rates to move higher. Unfortunately, asset prices supported by exceedingly low real fed funds will now need to adjust to a new reality of higher, and maybe at some point positive, real fed funds.

Follow Principal Global Investors on LinkedIn


The information in this article has been derived from sources believed to be accurate as of January 2016. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments.  Principal Global Investors does not endorse, authorize, or sponsor any third party content.  Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

Investing involves risk, including possible loss of principal. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.