Federal Funds Rate
The Federal Funds Rate is the target interest rate set by the Federal Reserve’s Federal Open Market Committee (FOMC) . This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. It is important as a policy tool because it can affect monetary and financial conditions in the economy including employment, growth, and inflation. It can also, influence short-term rates on consumer loans and credit cards.
Real Rate of Interest
The real rate of interest is the nominal rate of interest, minus the rate of inflation. For example, if the Federal Funds rate is 4%, but inflation is running at 8%, then the “real” rate of interest is -4%. Below is a graph of the “real” Federal Funds rate. When the real rate is negative, it is an indication of loose, or expansionary, monetary policy.
Interest Rates vs. Federal Debt (% of GDP)
2-Year vs. 10-Year Treasury
Typically, longer term debt carries a higher interest rate as there is more risk associated with a longer time horizon. However, occasionally, the yield curve becomes “inverted” which means that short term rates are higher than long term rates. This indicates that the near term is riskier than the long term. In the graph below, this inversion is indicated by the red line being above the green line. This inversion is one of the most reliable leading indicators of a recession. In fact, it has preceded every recession since 1956 with only one false signal.