Real Rates Projections: Federal Reserve vs Market

In the realm of economic steering, the Federal Reserve is no stranger to manipulating short-term interest rates. It’s like their trusty old toolbox–they’ve used it for ages to influence the economic engine. But since not long ago, the Fed started to embrace other tools, among them “forward guidance.” Former Fed chair Ben Bernanke once quipped, “monetary policy is 98 percent talk and only two percent action.” The carefully crafted public statements released after the meetings work like a rudder, steering market expectations.

If the market and the Fed are singing in harmony about the economy’s future, it’s only natural to assume that their economic forecasts will be in sync. As an example, one would expect the market’s predictions for the federal funds rate and inflation should at least be in the same ballpark as the Federal Reserve Board’s forecast. However, it seems that this assumption comes with a few asterisks attached.

In the chart above, the red line is the average market yield on long-term TIPS. And the blue line is the difference between the median projected federal funds rate and the median projected inflation–both from the Summary of Economic Projections (SEP). At first glance, these two lines are peas in the same pod, as they both reflect the long-run real interest rate in our economy. (They don’t necessarily match exactly though since TIPS is based on CPI while SEP is projecting PCE).

It is easy to see that these two measures began to diverge around the COVID pandemic.

On the other hand, the inflation expectation seems well-anchored as the 10-year breakeven inflation rate continues to hover near 2%. In this case, the high yields on TIPS may indicate that the market expects the Fed to keep rates high for an extended period of time (perhaps even longer than those at the FOMC meetings expect).