On countless occasions over the past 12 or so months, Fed critics insisted that despite aggressive rate hikes, the real funds rate was still far too forgiving to be effective at countering inflation.

To the extent that argument relied on a funds rate adjusted for contemporaneous (i.e., realized) inflation, it was spurious to the point of being either disingenuous or ignorant. When addressing it, I’m usually generous: I assume it’s an example of critics being mendacious, not stupid.

I have, myself, employed charts purporting to show the real funds rate utilizing realized inflation for dramatic effect. I was being disingenuous each and every time, but I wasn’t trying to mislead anyone — no reader of mine would seriously countenance the idea that the Fed might need to hike rates to, say, 15%. You’re all smarter than that. Wherever r-star is, r-double-star is lower. They’d never make it anywhere near 10%, let alone higher, without triggering a financial crisis. Or at least not if they tried to get there over some compressed time frame. Markets would need years to adjust.

For whatever reason, this simple point (i.e., that you have to use some measure of forward looking inflation when you endeavor to show the real funds rate) gets very little attention, perhaps because it’s so obvious to serious market observers that they assume it isn’t worth harping on. But it bears mentioning.  It matters immensely for the 2024 rate cut debate, and no less than John Williams seems prepared to give it short shrift.

In an August interview with The New York Times‘s Jeanna Smialek, Williams mused that, “Assuming inflation continues to come down… if we don’t cut interest rates at some point next year then real interest rates will go up, and up, and up. And that won’t be consistent with our goals.”

Forgive me, but no. You can’t think about it that way if you’re a policymaker. Goldman’s David Mericle was kind enough to explain why. “We have repeatedly expressed skepticism of this argument since early last year,” he said, commenting specifically on Williams’s remarks to Smialek. “Real interest rates should be calculated by subtracting off forward-looking inflation expectations rather than backward-looking realized inflation,” Mericle emphasized.

Regular readers know I typically use the year-ahead University of Michigan series to compute the real funds rate. I then compare that rate to various measures (academic models and market-based proxies) of the real neutral rate to determine whether and to what extent policy is restrictive. I do it that way because… well, because how else would you do it?

In case the point wasn’t clear enough, Mericle continued. “This is important because while YoY core inflation still has about two percentage points to fall, inflation expectations — even year-ahead expectations — have already normalized to within at most a few tenths of target-consistent levels,” he said. You can see that in the left pane above.

Although Goldman does expect the Fed to commence quarterly rate cuts beginning in Q2 of next year, the implication from the above is that they (the Fed) won’t be compelled to do so by additional inflation normalization. As Mericle wrote, concluding, “nearly all of the decline in inflation expectations that would raise real interest rates for a given nominal rate is behind us.”

On Monday, the latest installment of the New York Fed’s consumer survey showed year-ahead inflation expectations fell to 3.5% in July, the lowest since April of 2021.