ROI-Central banks have a real rate problem: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, May 18 (Reuters) - Accelerating inflation in the U.S. and beyond is leaving the Federal Reserve and other central banks with an acute problem - negative real interest rates. Policymakers may wish to remain patient, but the ongoing rout in bonds is sending a clear message: raise rates now.

Unexpectedly strong U.S. inflation data last week pushed the real, inflation-adjusted fed funds rate below zero for the first time in three years. If the Fed doesn't act, rising inflation will push real rates even further into negative territory. A closely watched Philadelphia Fed survey of professional forecasters on Friday forecast average headline CPI inflation this quarter of a whopping 6%.

Negative real rates are highly stimulative, so keeping inflation-adjusted policy rates below zero amidst one of the world's biggest-ever energy shocks seems counterintuitive, especially when stock markets are at record highs and overall financial conditions are extremely loose.

Of course, the drop below zero in real terms reflects the unexpected nature of this crisis and how quickly inflation has taken off, but nevertheless it has left policymakers in an invidious position.

While the Reserve Bank of Australia and Norges Bank have pulled the trigger already on rate hikes, most central bankers are still sitting on their hands. They may want to wait a few more weeks or even months to assess the impact of the energy squeeze on growth and employment before considering rate hikes, while hoping that the bond market can do some of the heavy lifting and that the inflation spike will prove transitory.

But that plan did not work very well in 2022. And with consumer prices accelerating, inflation expectations breaking higher, and bond markets cracking, time is not on their side.

UK SHOE NEXT TO DROP?

The Fed is certainly not alone.

Among other Group of Four central banks, only the Bank of England's Base Rate is positive in real terms right now, but that will no longer be the case if, or when, UK inflation reaches 3.75%. It is currently 3.3%.

The European Central Bank's inflation-adjusted policy rate is negative 1%, the most negative since 2023.

In Japan, the real policy rate has been negative since 2021 as the Bank of Japan has sought to slay the dragon of deflation. Rates looked like they might turn positive earlier this year, but the Iran war has scuttled that. Japan imports 90% of its energy, meaning inflation will likely be moving north as a result.

Japan's CPI inflation report for April will be released on May 21, a day after the UK's April CPI data.

Importantly, bond yields aren't rising solely in response to Iran-related supply shocks. Inflation is also being fueled by the artificial intelligence spending boom, which has unleashed a global wave of demand for chips and related technology.

U.S. hyperscalers collectively could spend more than $800 billion in AI-related capex this year, with cumulative AI infrastructure investment reaching $7.6 trillion by 2031, according to some estimates.

These huge outlays are reflected in the market caps of the major chip suppliers. U.S. AI darling Nvidia (NVDA) only needs its shares to rise another 9% to become a $6 trillion company, while South Korean chipmaker SK Hynix - whose market cap was only $100 billion a year ago - is poised to become a $1 trillion company.

NEGATIVE FEEDBACK LOOP

The AI mania has lifted the Nasdaq and S&P 500 to record highs this year despite punchy Treasury yields and a resilient dollar. Financial conditions in the U.S. are the loosest in four years, according to Goldman Sachs (GS).

Indeed, a self-fulfilling loop has emerged in much of the developed world. Falling real interest rates help boost stock prices, which loosen financial conditions, helping to fuel more investment and spending.

In the U.S., add to that rising inflation that has been above-target for five years, and the Fed's reluctance to raise rates becomes increasingly questionable. The current bond rout suggests investors are rapidly losing patience.

"I don't think we are quite at the point of dangerous Fed denial, but we are getting there," economist Phil Suttle says.

This backdrop is a baptism of fire for incoming Fed Chair Kevin Warsh, not least because he has previously indicated a preference for lower interest rates. The president who appointed him most certainly wants lower rates.

That will be a tough sell when real rates - the "true" price of money - are already below zero.

(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters)

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(By Jamie McGeever; Editing by Marguerita Choy)