What is the real federal funds rate?

The real federal funds rate is calculated by subtracting a measure of inflation (typically core PCE or CPI) from the nominal federal funds rate. This adjustment reveals the true cost of borrowing in inflation-adjusted terms and is the most important single number for assessing whether monetary policy is actually restrictive, neutral, or accommodative.

The distinction between nominal and real rates matters enormously. When the fed funds rate is 5.25% but inflation is running at 3.5%, the real rate is approximately 1.75%. When the fed funds rate is 0.25% but inflation is negative 1%, the real rate is 1.25% and still restrictive. Conversely, when the nominal rate is 3% but inflation is 5%, the real rate is negative 2%, meaning monetary policy is effectively loose despite seemingly meaningful nominal rates.

During the 2022-2024 hiking cycle, the real federal funds rate became the key metric for determining how much further the Fed needed to go. When the Fed raised the nominal rate to 5.25-5.50% and core PCE inflation was running near 2.8%, the real rate was approximately 2.5%, the most restrictive stance since before the 2008 financial crisis. This level of real restriction eventually cooled demand and brought inflation closer to target.

Economists debate which inflation measure to subtract. Using trailing 12-month core PCE gives a backward-looking real rate. Using market-based inflation expectations (breakevens or inflation swaps) gives a forward-looking real rate. Using the Cleveland Fed's nowcast gives a real-time estimate. Each approach has merit, but the key insight is the same: the real rate, not the nominal rate, determines whether policy is actually squeezing the economy. A nominal rate of 5% is not inherently restrictive; it depends entirely on where inflation sits relative to that rate.