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Getting back to normal? Part 2 Are real interest rates trending down to "normal"?


In our previous post, we mentioned that the Federal Open Market Committee (FOMC) is trying to normalize interest rates by gradually increasing the target for the federal funds rate. But what is the “normal” interest rate? Some people are arguing that it’s actually lower than what it has been before. One way to try to identify this normal state is by looking at long-term trends in interest rates: Presumably, long-term forces are what move the normal level of interest rates. (In contrast, interest rates respond in the short term to economic fluctuations rather than trends.) So we’ve graphed three popular interest rates that have a longer time series: the 1-year Treasury bond rate, Moody’s Aaa corporate bond rate, and the federal funds rate.

Can you see a trend? Of course, you can. There’s a trend increase until the end of the 1970s and then a trend decrease. And, of course, this has to do with the history of inflation. This is why people tend to discuss trends in real interest rates without the inflation component. But it’s not perfectly clear how to determine that inflation component: Indeed, interest rates are driven by markets and what they think inflation will be over the life of the bond or the period of credit. The data we have cover past inflation. While past and future inflation may be correlated, they’re not the same thing. Over the longer run, however, using realized inflation as a proxy for expected inflation works reasonably well, with exceptions. So we move to the second graph, where we’ve taken the same three interest rates and subtracted the CPI inflation rate from each. Do we see a downward trend? It looks like there’s one from 1980 to the Great Recession. After that, it’s subject to debate.

How these graphs were created: For the first graph, search for “1- year treasury rate” and take the monthly, constant maturity series. Then from the “Edit Graph” section, use the “Add Line” option and search for and add “aaa” and then also “fed funds rate,” each time taking the monthly rate. Finally, start the graph in 1955. For the second graph, repeat this process for each line: search for and add “CPI,” modify its units to “Percent Change from Year Ago,” and apply formula a-b.

Suggested by Christian Zimmermann.

View on FRED, series used in this post: AAA, CPIAUCSL, FEDFUNDS, GS1


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