with the fed’s rate hike announcement naturally there’s been a lot of discussion about what this means for our investments going forward but there may be a more fundamental question we should be asking what should interest rates be after all if there’s some natural rate where interest rates should be that would provide some insight as to where they may end up let’s take a closer look first let’s define our terms when we talk about interest rates we are usually talking about something we see in the market whether a mortgage rate or the yield on a bond those however are nominal rates—they reflect a combination of the current real interest rates and inflation as inflation changes so do the nominal rates real rates however should at least in theory be less variable as they reflect the underlying real economic factors such as demographics and capital demand to get an idea of what interest rates should be this is the layer we need to concentrate on one way to get real rates is to look at the yield on 10year us treasuries and subtract inflation from the late 1980s through about 2000 real rates were around 3 percent to 4 percent in the 2000s prefinancial crisis real rates were roughly between 1 percent and 3 percent in the 2010s real rates were between 0 percent and 2 percent but mostly between 0 percent and 1 percent in the years before the pandemic currently real rates are at almost –6 percent well below the previous bottom of –2 percent this gives us the context for most of the interest rate discussion over the past decade it explains why economists me included widely expected rates to go back to “normal” levels of 3 percent to 4 percent after 2000 it explains why economists expected rates to go back to “normal” levels of between 2 percent and 3 percent in the 2010s and it explains why economists expect rates to go back up now given this history you would expect those expectations to once more go unfulfilled there are good reasons both economic and historical to expect rates to rise this time potentially significantly real rates only dropped below zero two times in the past 40 years in 2008 and 2011 both times of systemic crisis in both cases real rates then bounced back above zero within a year based on that we should expect real rates to rise above zero again sometime in the next year or so rates have to increase by much more this time to get above zero as mentioned earlier real rates are now at almost –6 percent well below the previous bottom of –2 percent not only is the gap greater but so is the economic urgency to move back to a more normal level of real rates this in turn explains why the fed is being very clear that it expects to keep raising rates over at least the rest of this year but the fed has a problem here yes it is raising rates and will keep doing so but the plan as announced will not solve the problem if we get seven more rate hikes as markets seem to be expecting plus the one we just had that is two of the six percentage points we need to get back to zero more has to be done which leaves three possibilities one is that the fed hikes faster and longer than markets now expect this is certainly a possibility but based on what it has announced so far and on market expectations this is not what the fed is looking for the second possibility is that it takes other policy action that will drive rates higher—and this is the quantitative tightening ie the reduction in fed purchases of bonds that was also teased in the most recent meeting statement this could contribute another point or two of higher rates and will help close the gap the rest of the solution is likely to come from a decline in inflation or so both the fed and markets hope if inflation closes the year down a couple of points from where it is now which is quite possible then that combined with fed rate hikes and tightening would get us back to or close to zero we can get there but the exact path remains uncertain the path back to zero this is what both the fed and markets will be watching over the rest of the year rate hikes are certain quantitative tightening almost so and lower inflation likely exact policy changes and outcomes will be datadependent as the more inflation declines the less the fed has to tighten policy and vice versa when you read the headlines this is what you need to watch as for the end state zero real interest rates are of course not where we want to be real rates should be and from an economic perspective have to be positive by how much is up in the air but looking at the 2010s around 1 percent seems to be a reasonable minimum so the progress back to zero is just a start it is however a necessary start and will define policy for the next several quarters for the rest of the year we can reasonably conclude that we will have interest rate hikes of at least two points quantitative tighten should get started in the next meeting or two and if inflation doesn’t start to roll over expect the fed to signal an even more restrictive policy ahead big picture the fed meant what it said at the last meeting look to see six or seven more rate hikes by yearend