Is Fed Funds at restrictive levels ? The Fed Funds is at restrictive levels when it is higher than nominal r*, also referred to as the neutral rate. It begs the question to ask, are we even at restrictive levels? I've been trying to answer this question using the current 10 year treasury yield and "core" inflation rate.
The 10 year treasury yield is approximately equal to the expected inflation over the next 10 years, the growth in productivity (real r*) and the term premium. The term premium historically is around 75 bps which is the compensation investors require for taking on duration risk. According to Fred, the 10 year breakeven inflation rate is 2.37%.
10 year yields = inflation (breakeven) + real r* + term premium
The 10 year treasury as of April 5th is 4.406%. We have,
4.406% = 2.37% + real r* + .75%
Real r* = 1.286%
The nominal neutral rate is equal to r* plus the "core" inflation rate. Fed funds is at restrictive levels when it is above real r* plus core inflation.
Fed funds (neutral rate) = 3.75% + 1.286%
Fed funds (neutral rate) = 5.036%
current Fed Funds =~ 5.33%
To put all this math into context, the 10 year treasury is telling us that Fed Funds is at restrictive levels. If the 10 year rises from here then it is signalling that rates may have to go higher. Keep an eye out on the 10 year and especially if it begins to trade in the 4.5% - 5% range.