While the agency’s July rate increase was expected, the hawkish tone that dominated the minutes of its meeting came as a brutal shock that sent share prices reeling and the 10-year Treasury to its highest yield in over two decades.

The reason: The markets believed that the widely expected, 25 basis point rise in July to a 5.25% to 5.50% range, would be the last. Not only did the pause in June encourage that view, but it appeared that by and large, the Fed officials agreed. The “dot plot” that captures the FOMC members’ average forecast of where Fed Funds would finish 2023 put the number at 5.6%. So the July hike reached what looked like the final target.

Not so, the Fed’s now signaling. Its July minutes, released on August 16, strongly suggest more to come. “Most participants continued to see significant upside risks to inflation, which could further require tightening of monetary policy,” stated text from the colloquy. The minutes also reveal much sharper divisions among Fed officials than prevailed at previous meetings. The document disclosed that “a couple of participants” advocated leaving rates unchanged, and that some officials cited the potential damage to the economy and jobs of further increases.

A leading economist says a lofty “real fed funds rate” means the Fed’s already gone too far

Put simply, the Fed’s doves are right. That’s the take from a distinguished monetary economist, Will Luther, professor at Florida Atlantic University. “I would have expected that the Fed’s language around rate hikes would have softened as we got closer to the its goal, but that hasn’t happened,” says Luther. “Their position is that even though we’ve had a string of good inflation reports, continued strong GDP growth and low unemployment suggest that inflation could rebound. The Fed wants to whip it now. If they go too far, the thinking goes, they can quickly loosen policy and minimize the damage.”

Luther maintains that the “real,” or inflation-adjusted Fed Funds rate is a good measure of how restrictive the Central Bank is making monetary policy. If what it costs businesses to borrow for building new plants or finance working capital takes too large a share of the projected revenues they’ll garner from expanding, those enterprises will curb fresh investments and hire fewer people. The same principal applies to consumers on their mortgages and car loans. Put simply, the strongest lever for curbing credit, and hence slamming growth, is fostering and maintaining high real interest rates.

And that’s just what the Fed’s done. Luther explains that the real Fed Funds rate is simply the difference between the current “nominal” number of 5.25% to 5.50%, and the latest month-over-month CPI reading that indicates the current run-rate in prices. The most widely-reported CPI data for July showed prices up 3.2%, and 4.1% excluding food and energy. But that’s a year-over-year reading versus July of 2022. The increase from June to July was much lower, indicating where the trend is moving. The month-over-month gauge showed an annualized increase of 2.0% in the overall price level, and a core rise of just 1.9%.

The real rate is now twice as high as what’s necessary to keep inflation heading downwards

To simplify, Luther uses the 2.0% figure. “That means the current real Fed Funds rate is between 3.25% and 3.50%, the difference between the 2.0% month over month inflation reading and the nominal rate of 5.25% to 5.50%.” Where would the real rate stand if it were set not by the Fed, but by the market? In other words, where would the number settle if determined simply by today’s supply and demand for credit? As Luther points out, the Fed furnishes its own answer. The New York Fed produces of estimates the “natural” real rate of interest. The most recent are 0.58% and 1.14%. “That’s the range where monetary policy is neither too tight nor too loose,” says Luther. If the real Fed Funds rate were in that vicinity, inflation would stay where it is now.

Of course, the Fed wants keep taming year-over-year price increases, so a real rate higher than, say, 1.14% is necessary to get there. But how much higher? “Anything above 1.14% is restrictive,” says Luther. “But a real rate of 3.25% to 3.5% is severely restrictive, and far too high. My estimate is that a real Fed Funds rate of 1.5% to 2.0% would be sufficient to get the Fed to its 2% year over year goal.” In effect, Luther maintains that the today’s number is as much as twice as high as is needed to win the battle.

The Fed’s mistake: They keep raising rates when falling inflation is already doing the job

For Luther, the Fed has misfired in continuing to tighten when falling inflation was swelling the number that matters most in curbing credit and slaying the beast: the real Fed Funds rate. “If the Fed hadn’t raised in July, the real rate would have risen because the CPI was trending downwards,” he says. “But instead, the Fed’s been doubling down by ratcheting up even as inflation keeps falling. So two forces are pushing up the real rate. That accounts for why it’s risen so fast and to such excessive heights.”

As the July minutes showed, the Fed is now prepared to keep hiking. “That’s a mistake,” says Luther. “If they just left rates where they are now, the real rate will continue rising as inflation falls. But if the Fed raises another 25 basis points in September, the real rate would go 3.5% to 3.75% or even higher.”

Luther reckons that at the current levels, the 3%-plus real rates are bound to put the brakes on capital investment and consumer spending. The Fed Funds trajectory exerts a powerful influence on the longer-term yields that in turn, encourage or discourage new investment. In mid-August, the real rate on the 10-year Treasury hit 2%, the highest level by far since the Great Financial Crisis, and more than double the average over the past 15 years. If the Fed keeps hiking, borrowing costs on both near-in essentials such as lines of credit and big-ticket, multi-year investments for the likes of factories or fabs with get even costlier.

“The Fed’s actions that have swelled real rates make it much more likely we’ll have a credit squeeze that causes a recession,” declares Luther. He recalls a comment where Austan Goolsbee, president of the Chicago Fed, compared achieving a soft landing for the economy to safely landing an airplane. “The idea was that when you come in for the final stretch, you need to keep up the nose cone up and in the right position to avoid diving into the ground,” he says. “The Fed did a good job getting this close to the destination. Now, they’re risking an unnecessary crash landing.”

In the July minutes, the Fed’s staff raised the odds of a soft landing, and issued a new forecast predicting no recession for this year. Those tidings come just when the Fed’s taking its eye off the real-interest rate altimeter that’s flashing red. The markets may see the dangers of the Fed’s flight plan better than the Fed itself. And that’s why you hear those clicks as they fasten their seatbelts.