The Risks of Rewriting History: A Theoretical and Empirical Study of the Real Interest Rate under the Current Monetary Policy Stance

Introduction: Monetary Policy at a Crossroads

At a time when the global macroeconomy is facing a turning point, the decisions of central banks are under the spotlight. After experiencing the most severe inflationary shock in decades, monetary authorities around the world have successfully brought inflation down from its highs through aggressive tightening policies. However, as inflation, though having receded, remains stubbornly above the policy target (typically 2%), a core and highly contentious question emerges: When, and at what speed, should monetary policy pivot toward easing? This decision not only pertains to whether the economy can achieve a soft landing in the short term but, more profoundly, it touches the very cornerstone of monetary policy credibility and could reshape inflation expectations and macroeconomic stability for years to come.

This paper aims to, through a clear analytical framework, delve into the historical relationship between the policy rate and core inflation. Using this history as a guide, it will assess the profound risks embedded in any policy proposal that advocates for "premature" or "excessive" interest rate cuts in the current environment. We will use the year-over-year growth rate of the Core Consumer Price Index (Core CPI) as a proxy for persistent inflationary pressures and compare it with the Effective Federal Funds Rate. The relative positioning of these two curves reveals a crucial, yet sometimes overlooked, macroeconomic variable: the Real Policy Rate.

Our central thesis is that the sign (positive or negative) and magnitude of the real interest rate are key to understanding the post-war history of U.S. inflation. Historical experience repeatedly warns that in a context where inflationary pressures have not been fully extinguished, lowering the policy rate to a level significantly below core inflation—that is, re-entering a deep "negative real interest rate" territory—is a policy gamble of extreme risk. Such an action is tantamount to "rewriting history," as it directly contravenes the hard-won monetary policy orthodoxy established over the past half-century, especially since the "Volcker Moment." This paper will first build the theoretical foundation, then conduct an in-depth analysis of the lessons from key historical periods, and finally, apply these insights to the current policy debate to reveal the substantial potential risks.

Part I: Theoretical Foundations—Understanding Interest Rates, Inflation, and Policy Rules

Before delving into history, we must establish a solid theoretical framework to scientifically deconstruct the complex relationship between the policy rate and inflation. This requires mastering three core concepts: the Fisher Equation, the Taylor Rule, and the natural rate of interest (r*).

1.1 The Fisher Equation: Unveiling the Essence of the Real Interest Rate

The nominal interest rate (i) is the rate we see quoted for bank deposits or loans, unadjusted for inflation. For savers and investors, however, what truly matters is how their purchasing power changes over time, which is measured by the real interest rate (r). American economist Irving Fisher was the first to systematically articulate the relationship between these two variables and inflation (π), in what is known as the famous Fisher Equation.

Its precise formula is:

(1+i)=(1+r)(1+π)

This formula shows that the return from the nominal interest rate (left side) must cover both the return from the real interest rate and the erosion of purchasing power due to inflation. When inflation and interest rates are not excessively high, we can use a widely known approximation:

r≈i−π

This simplified formula intuitively tells us: the real interest rate is approximately equal to the nominal interest rate minus the inflation rate.

In policy analysis, it is crucial to distinguish between the ex-post and ex-ante real interest rate:

• Ex-post real interest rate: Calculated using realized inflation, it is a true measure of the return on past investments.

• Ex-ante real interest rate: Calculated using expected future inflation (πe), i.e., re≈i−πe. This is more critical for decision-makers (whether central banks or market participants) because it reflects the expectation of future changes in purchasing power at the time a decision is made, thereby influencing current consumption and investment behavior.

The nominal policy rate set by a central bank regulates the economy by influencing the ex-ante real interest rate. When a central bank raises the nominal rate faster than inflation expectations, the ex-ante real rate rises, which incentivizes saving, discourages borrowing and investment, and thus cools the economy and curbs inflation. Conversely, when a central bank maintains a nominal rate below expected inflation, the ex-ante real rate is negative, which penalizes saving, encourages borrowing and consumption, and thus stimulates economic activity. Therefore, a negative real interest rate is often considered an expansionary monetary policy stance. However, a persistent and deeply negative real interest rate, especially when inflation is already high, can lead to the "de-anchoring" of inflation expectations—an extremely dangerous signal.

1.2 The Taylor Rule: Providing a Benchmark for the Policy Rate

If the Fisher Equation is a diagnostic tool, then the Taylor Rule is a blueprint for a "prescription." Proposed by Stanford economist John Taylor in 1993, it provides a simple yet powerful guiding framework for how a central bank should systematically set its policy rate. Its classic form is as follows:

it​=r∗+πt​+α(πt​−π∗)+β(yt​−y∗)

Where:

• it​ is the target nominal policy rate the central bank should set.

• r∗ (r-star) is the neutral or natural real rate of interest, which is the long-run equilibrium real interest rate that neither stimulates nor restricts the economy when it is at full employment and inflation is stable. It is a theoretical and unobservable concept.

• πt​ is the current inflation rate.

• π∗ is the central bank's inflation target (e.g., 2%).

• (πt​−π∗) is the inflation gap.

• yt​ is the logarithm of real output (e.g., real GDP).

• y∗ is the logarithm of potential output.

• (yt​−y∗) is the output gap, which measures the degree to which the economy is overheating or underperforming.

• α and β are policy response coefficients, reflecting the central bank's weighting of the inflation and output gaps. Taylor originally suggested setting both to 0.5.

The most important insight of the Taylor Rule is the "Taylor Principle," which states that the inflation response coefficient α must be greater than zero, or more strictly, that the coefficient on inflation in the equation (1+α) must be greater than 1. In Taylor's original formula, the response of the nominal rate to inflation is 1+α=1.5. This means that when the inflation rate rises by 1 percentage point, the central bank should raise the nominal interest rate by more than 1 percentage point (e.g., 1.5 percentage points). Why is this necessary?

Returning to the Fisher Equation r≈i−π, if the increase in i is the same as the increase in π, the real interest rate r remains unchanged, and the stance of monetary policy has not tightened. Only when the increase in iexceeds the increase in π (i.e., Δi>Δπ) will the real interest rate r rise, thereby playing a genuine role in curbing inflation. The Taylor Principle is the mathematical expression that ensures monetary policy can effectively stabilize inflation and is the bedrock of a central bank's credibility. Violating the Taylor Principle means that in the face of rising inflation, the central bank effectively lowers the real interest rate, which is akin to pouring fuel on the fire.

1.3 The Natural Rate of Interest (r): A Moving Target*

The r∗ in the Taylor Rule serves as an anchor, but this anchor itself is drifting. The natural rate of interest is determined by deep, structural economic factors, such as population growth, productivity growth, public saving preferences, and global capital flows. Over the past few decades, it is widely believed that r∗ has declined globally due to factors like aging populations, slowing productivity growth, and increased demand for safe assets from emerging markets.

The uncertainty surrounding r∗ poses a significant challenge for monetary policy. If a central bank misestimates r∗, it could lead to a policy that is persistently too tight or too loose. For example, if r∗ is actually lower than the central bank believes, a seemingly neutral policy rate could in fact be contractionary, and vice versa. Despite the difficulty in estimation, the concept of r∗ reminds us that we cannot mechanically apply historical interest rate levels to today's economy. When assessing the monetary policy stance, these long-term structural changes must be taken into account.

Part II: Lessons from History—An Empirical Analysis of Post-War U.S. Inflation and Interest Rates

Theory provides us with a map, while history shows us the actual path. We now return to the core visual discussed in the introduction—the chart plotting the Effective Federal Funds Rate (black line) against year-over-year Core CPI (blue line)—to examine several key phases of post-war U.S. monetary history.

2.1 The Great Inflation (1965-1979): The Painful Lesson of Negative Real Rates

The chart clearly shows that from the mid-1960s through the entire 1970s, the black line (Fed Funds Rate) was frequently and persistently below the blue line (Core CPI). This means that for a period of fifteen years, the U.S. real policy rate was in negative territory for most of the time. This is the defining characteristic of the "Great Inflation" era and the root of its tragedy.

The Federal Reserve of that time was influenced by several flawed schools of thought. First was the short-run Keynesian "Phillips Curve" thinking, which held that a stable trade-off existed between inflation and unemployment, allowing for slightly higher inflation in pursuit of lower unemployment. Second, the Fed had an unclear understanding of the causes of inflation, often attributing it to "cost-push" factors like oil shocks and union power rather than its own overly accommodative monetary policy. Finally, immense political pressure also made it difficult to implement necessary tightening measures.

The result was catastrophic. Whenever the economy showed signs of a downturn, the Fed would quickly cut rates, pushing the real interest rate deeper into negative territory in an attempt to stimulate growth. This did indeed boost growth in the short term, but the embers of inflation were never truly extinguished. As the public and markets gradually realized the Fed lacked the resolve to fight inflation, inflation expectations began to "de-anchor." People expected higher prices in the future and thus demanded larger wage and price increases, which in turn validated and exacerbated inflation, creating a vicious cycle. This "stop-go" policy pattern not only failed to achieve stable low unemployment (ultimately leading to "stagflation") but also allowed the inflation rate to run wild, soaring from under 2% in 1965 to nearly 15% by 1980.

The historical lesson of this period is profound: persistent negative real interest rates are a breeding ground for high inflation and unstable expectations. A central bank that adopts a policy of appeasement toward inflation will ultimately lose on both of its goals—price stability and maximum employment—and severely damage its own credibility.

2.2 The "Volcker Moment" (1979-1982): The Iron Fist of Positive Real Rates

In 1979, with the appointment of Paul Volcker as Chairman of the Federal Reserve, U.S. monetary policy reached a watershed. Facing runaway inflation, Volcker adopted a strategy dramatically different from his predecessors. He publicly declared that the Fed's primary mission was to restore price stability—at any cost.

On the chart, this shift is represented by the dramatic spike in the black line. Starting in 1979, the Fed Funds Rate was raised to a level far exceeding Core CPI, reaching a peak of 20% in 1981. This meant the Fed forcibly pushed the U.S. economy into a realm of deeply positive real interest rates. The theoretical basis for this policy was that only when the real cost of borrowing became prohibitively high could aggregate demand be effectively restrained and the inflationary spiral be broken.

The cost was immense. The sharp rise in interest rates triggered two severe and closely linked recessions in 1980 and 1981-82. The unemployment rate climbed into the double digits, interest-rate-sensitive sectors like agriculture and manufacturing were devastated, and the political pressure was overwhelming. Yet, Volcker withstood the pressure and held firm on his tightening policy.

The effect was decisive. By 1983, the inflation rate had fallen from double digits to below 4%. More importantly, Volcker rebuilt the Fed's credibility through action. The market and the public came to believe that the Fed had both the ability and the will to control inflation. Inflation expectations were re-anchored at a low level. This "Volcker shock," though painful, successfully ended the Great Inflation and paved the way for the two-decade-long "Great Moderation" that followed.

The lesson of the "Volcker Moment" stands in stark contrast to that of the Great Inflation: to tame entrenched high inflation, the real policy rate must be raised to a sufficiently high positive level and maintained for a sufficient period to send an unambiguous signal to all economic agents. Short-term economic pain is the necessary price for rebuilding long-term credibility and price stability.

2.3 The Great Moderation (c. 1985-2007): The Fruits of Maintained Discipline

After Volcker, the Fed, led by Alan Greenspan, largely inherited this policy legacy. During the "Great Moderation," as the chart shows, the black line (policy rate) generally maintained a more prudent relationship with the blue line (core inflation)—it was either slightly above the blue line or roughly equal to it, rarely allowing the real rate to be negative for a prolonged or significant period.

The Fed's policy framework during this era can be seen as an implicit adherence to the Taylor Rule. In the face of signs of rising inflation, the Fed would preemptively raise rates to ensure the real interest rate remained positive or at least neutral, thereby preventing inflation expectations from running out of control. This predictable, rules-based policy framework greatly reduced macroeconomic volatility.

Of course, the success of this period was also aided by favorable "tailwinds," including cheap goods from globalization, productivity gains from the information technology revolution, and a relatively stable fiscal environment. These positive supply-side factors helped suppress inflation, making the Fed's job easier. The core lesson, however, is that the Fed maintained a baseline of discipline during this period and did not repeat the mistakes of the 1970s.

2.4 The Post-GFC Zero-Interest-Rate Era (2009-2015): A Special Case for Negative Rates

The chart shows that after the 2008 Global Financial Crisis, the Fed Funds Rate was cut to near zero and held there for seven years. As core inflation, though subdued, remained positive (typically between 1% and 2%), this resulted in a long period of negative real interest rates. However, unlike in the 1970s, negative real rates during this period did not trigger inflation. Why?

The key here lies in the fundamental difference in initial conditions and economic structure. The 2008 crisis was a classic "balance-sheet recession." Households and businesses were saddled with heavy debt, and their primary goal was to deleverage (pay down debt), not to increase borrowing and spending. This led to persistent weakness in aggregate demand and a large output gap. In this context, the natural rate of interest, r∗, had likely fallen temporarily into negative territory. Therefore, even with a nominal rate at zero, resulting in a negative real rate, the policy stance relative to the extremely low r∗ may have been merely neutral or even slightly tight. In other words, the economy was stuck in a "liquidity trap" and required extremely accommodative monetary policy to avert a deflationary spiral.

The experience of this period teaches us that the interpretation of real interest rates cannot be divorced from the broader macroeconomic context. In the face of severe demand shocks, deleveraging pressures, and deflationary risks, negative real interest rates are a necessary and appropriate policy tool. But this is a fundamentally different policy choice from actively creating negative real interest rates in an environment of high inflation and strong demand.

2.5 The Post-Pandemic Inflation Shock and Response (2021-2023)

The inflation surge that began in 2021 was the result of a combination of supply-side shocks (pandemic-induced supply chain disruptions, the Russia-Ukraine conflict) and demand-side stimulus (large-scale fiscal transfers, accommodative monetary policy). Initially, the Fed characterized the inflation as "transitory" and was slow to act. This led to a period from 2021 to early 2022 where, as the blue line (Core CPI) climbed sharply while the black line (policy rate) remained near zero, the U.S. economy once again fell into a deep negative real interest rate trap, with a depth that at times exceeded that of the 1970s. This undoubtedly fueled the rapid spread of inflation and the rise in expectations.

Realizing its mistake, the Fed in 2022 initiated its fastest hiking cycle in four decades. As the chart shows, the black line rose steeply, eventually crossing above the receding blue line in 2023, turning the real policy rate from negative to positive. This decisive action was a modern application of the lesson from the "Volcker Moment": in the face of inflation pressures that have become broad-based and persistent, the policy stance must be quickly shifted to become restrictive—that is, to achieve a positive real interest rate—to effectively cool demand and convince the public of the central bank's resolve. Ultimately, inflation began to fall significantly, proving the effectiveness of this classic strategy.

Part III: The Current Policy Dilemma—A Proposal to "Rewrite History"

Historical analysis provides a clear mirror for examining the present. After the aggressive rate hikes of 2022-2023, U.S. core inflation has fallen from its peak but, as of the time of this analysis, remains significantly above the 2% target. At this juncture, a rather influential voice has emerged in the market, advocating for the Fed to immediately and substantially cut interest rates. For instance, let's assume a view suggests cutting the Fed Funds Rate directly to a level of around 2% (as indicated by the dashed "Bessent proposed rate" line in the chart).

Let's use our preceding theoretical and historical framework to evaluate this proposal.

Assume that at the time of the rate cut, Core CPI (blue line) is still at 3.5%. If the policy rate (black line) is cut to 2%, then according to the Fisher approximation, the ex-ante real interest rate would become:

rreal​=iproposed​−πcore​=2.0%−3.5%=−1.5%

This means that a seemingly "normalizing" rate cut proposal would, in reality, plunge the U.S. economy back into a significantly negative real interest rate environment. This is the core risk of our analysis.

Why would this action constitute "rewriting history"? Because it runs contrary to every successful case of inflation control in the past.

1. It Contradicts the "Volcker" Experience: Volcker's success lies precisely in his demonstration that policy normalization can only be considered after inflation is decisively crushed back to target and inflation expectations are firmly anchored. Prematurely shifting the real interest rate back to negative while inflation remains the primary threat is a dangerous return to the "stop-go" policies of the 1970s. It would send a signal to the market that the Fed's tolerance for inflation has increased, or that it is more concerned with asset prices or short-term growth. This could lead to a resurgence in inflation expectations, making the "last mile" of disinflation exceptionally difficult, and could even trigger a second wave of inflation.

2. It Ignores the "Taylor Principle": In an environment with a core inflation rate of 3.5% (an inflation gap of +1.5%), no reasonable variant of the Taylor Rule would prescribe a nominal interest rate of 2%. Such a rate level implies an extremely low, or even negative, response coefficient to the inflation gap, completely violating the fundamental logic of the Taylor Principle, which requires raising the real interest rate to stabilize inflation.

3. It Misreads the "Post-GFC" Experience: Proponents of deep rate cuts might use the 2009-2015 experience as a defense, arguing that negative real rates are not to be feared. However, as previously discussed, this is a dangerously flawed analogy. The current macroeconomic environment is starkly different from that period: the economy is not facing a balance-sheet recession, the labor market remains tight, aggregate demand is strong, fiscal deficits are high, and the natural rate of interest, r∗, has likely recovered from its post-crisis lows. Implementing a policy of deeply negative real rates in such a context would produce effects more akin to the 1970s than the 2010s.

Therefore, the essence of this proposal is to recommend that the central bank, at a moment when the threat of inflation is far from over, voluntarily abandon a policy discipline that has been proven effective, in order to conduct an experiment with a highly uncertain outcome. This is precisely "rewriting" the lessons of history that were paid for with a high economic price.

Part IV: Beyond the Chart—Limitations, Complexities, and the Path Forward

Of course, any analysis that relies on a two-dimensional chart must acknowledge its limitations. A prudent, doctoral-level analysis needs to recognize that the complexity of the real world far exceeds the relationship between two curves.

1. Shifting Structural Factors: We cannot mechanically apply lessons from the past. The world today is fundamentally different from that of previous decades in many respects. The process of globalization may be reversing toward regionalization and supply-chain restructuring, which could exert persistent upward pressure on prices. Many developed economies face high levels of government debt, raising concerns about "Fiscal Dominance," where monetary policy might be forced to remain accommodative to finance fiscal deficits. The potential impacts of demographic shifts, the energy transition, and technological revolutions like artificial intelligence on productivity make estimating the natural rate of interest, r∗, more difficult than ever. These structural changes mean that the level of the real interest rate that was able to stabilize inflation in the past may no longer be applicable in the future.

2. Choice of Inflation Metrics and Forward-Looking Policy: The chart uses Core CPI, whereas the Fed's official inflation target is based on the Personal Consumption Expenditures (PCE) Price Index. Although their long-term trends are consistent, there can be short-term divergences. More importantly, monetary policy is inherently forward-looking. Central bank decisions are based on forecasts of future inflation and employment, not just on current data. Therefore, if a central bank is highly confident that inflation will quickly return to target, it might begin cutting rates before the data actually confirms it. However, the threshold for such confidence should be very high, especially after recent forecasting errors.

3. The Dual Mandate Trade-off: The Federal Reserve must not only focus on price stability but is also committed to achieving maximum employment. In a scenario of a significant economic slowdown and a rapidly rising unemployment rate, the central bank might choose to cut rates even if inflation is still slightly above target, in order to balance its dual mandate. This is an inherent trade-off in monetary policymaking. The lesson of history, however, is that in the long run, price stability is a prerequisite for achieving sustainable maximum employment. Allowing inflation to get out of control ultimately harms both the economy and employment.

In conclusion, the core relationship revealed by this chart—the critical role of the real policy rate in combating inflation—is an extremely powerful and time-tested macroeconomic insight. It reminds us that there is no free lunch in monetary policy. Before the embers of inflation are completely extinguished, any attempt to "rewrite history" through substantial rate cuts is likely to backfire, returning us to an era of uncertainty and pain that we thought we had long since left behind. For policymakers, history may not repeat itself exactly, but to ignore its lessons is to risk a very costly rhyme.