A real interest rate is the interest rate when we subtract inflation from a nominal interest rate. Real rates are important because they tell us where the real economy is.
I will be looking at 3 types of real rates in this post from the perspective of the effective demand research at this blog. All 3 real rates are seen in this graph (quarterly data).
Natural real rate (2.5%)
The blue line is the real rate projected for the natural level of production. That is when the economy reaches the Long-run full employment level. The natural real rate is estimated from the growth rate of potential GDP. So potential GDP is rising as it has through previous biz cycles. This means that the nominal Fed funds rate would be higher when full employment is reached. With an inflation target of 2% upon a natural rate of 2.5%, the Fed funds rate would reach 4.5% at the natural level of the economy.
Actual Short-term real rate (-1.9%)
The green line shows the actual short-term real rate by subtracting existing core CPI inflation from the Fed funds rate. The line is dipping downward recently basically from the rise in core inflation.
Calculated Short-term real rate (0.6%)
The orange line shows the short-term real rate according to the monetary rule of effective demand. This peaked at 1.8% at the end of 2014 when the economy reached the effective demand limit. This calculated rate was equal to the natural real rate which reflects the effective demand limit.
Since 2014 it has been falling, which in past business cycles is an indication of the economy falling toward a contraction. In past cycles, once this calculated short-term real rate starts downward, it keeps trending downward toward a contraction.