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Monetary policy, real interest rates and economic growth
When real interest rates are positive and exceed the rate of growth of real GDP, there is generally a tendency for a gradual and significant economic slowdown, which can culminate in a recession. When real yields on instruments such as time deposits, US money market funds (overnight SOFR, Secured Overnight Financing Rate, currently at 4.82%) or government bonds at the beginning of the yield curve (2-year US sovereign yield, currently at 4.25%) exceed real economic growth, the propensity to withdraw investments from the real economy increases. Under these conditions, it is preferable to opt for the security of a deposit with similar returns (real interest rate identical to or even higher than real GDP growth), but with much lower risk, instead of allocating resources to productive investments, in the production of goods and services.
The 2-year treasury yield, currently at 4.30%, is a robust indicator for predicting the future evolution of the Fed Funds Rate (FFR), acting as a reliable proxy for future FFRs. Discounting this yield by the most recent inflation rate of 2.4% in September gives a real interest rate of 1.9%, an interesting return, but at an almost restrictive level and close to real US GDP growth, which was 2.8% in the third quarter. If we consider the upper limit of the FFR, currently at 5%, the real interest rate would rise to 2.6%, even closer to economic growth of 2.8%, which would mean a monetary policy even closer to the restrictive level. The use of an interest rate that reflects expectations for the evolution of the FFR, such as the 2-year sovereign yield, offers a more accurate view of investors' outlook for future monetary policy. Meanwhile, the victory of the Republican Party in the US presidential elections and in the Senate, which is also close to winning the House of Representatives, has boosted US treasury yields. This move is justified by the possibility that full Republican control will promote the protectionism advocated in the electoral program - generally inflationary - and cut taxes, worsening the already high US budget deficit, which reached 6.3% in fiscal year 2024. The increase in the 2-year treasury yield intensifies the risk of monetary policy becoming effectively restrictive, prolonging the higher-for-longer scenario, jeopardizing the current positive economic environment (goldilocks) and potentially reversing the soft landing into a hard landing.
It is important for a central bank to understand the impact of monetary policy on economic growth, assessing the likelihood of rapid economic slowdowns or even future recessions based on historical patterns. Periods of positive values, i.e. real interest rates higher than economic growth, tend to precede or coincide with sharper economic slowdowns or even recessions, suggesting that when the real federal funds rate exceeds real GDP growth, the economy may be at greater risk of going into recession. Currently, real interest rates in the US when subtracted from real GDP are approaching zero again, suggesting that current economic conditions are potentially approaching another turning point. If monetary policy remains restrictive, the risk of an economic slowdown or recession in 2025 increases. However, this is an analysis based on historical patterns, but other economic factors, such as consumer behavior, business investment and global conditions (developments in geopolitical tensions and the economies of other major economic blocs, such as the European Union and China), also influence the US economic outlook.
When real interest rates are positive - that is, the return exceeds inflation - there is a natural incentive to save, with gains without additional risks. There is an incentive to save rather than invest. With a positive real interest rate, such as the current 4.82% return on money market funds (paid at the SOFR rate) compared to inflation of 2.4%, investors and consumers are encouraged to save money rather than spend it or invest it in riskier assets, such as shares or business projects. This can reduce the flow of money into the real economy - investments in companies, new businesses, innovation and other productive assets that are key to economic growth. This crucial insight highlights how central bank policy and interest rates structurally affect the economy. The dilemma lies in finding the neutral point, where rates are not excessively restrictive to the point of stifling growth, but also not too low to the point of boosting inflation again. It's an exercise in precision and mastery where a "misstep” can have a high cost for the economy.
PAULO MONTEIRO ROSA
Senior Economist at Banco Carregosa