Rallying markets suffer from a doveish illusion

THE “money illusion” ranks among the most lyrical-sounding concepts in economics. It refers to the mistake that people make when they focus on nominal rather than real values. Anyone chuffed to get a hefty pay rise over the past year without considering whether, after inflation, they can actually buy more has fallen prey to the illusion.

Financial investors ought to be savvier, but they too can be seduced by a lovely nominal story. The US Federal Reserve’s downshift to smaller interest-rate rises is a case in point. It may look like a step away from hawkish monetary policy; in real terms, though, the central bank’s stance is tighter than it first appears.

On Feb 1 the Fed raised rates by a quarter of a percentage point, taking short-term borrowing rates to a ceiling of 4.75 per cent, as widely expected. This was half the size of its last increase, a half-point in December, which in turn was down from its previous string of three-quarter-point increases.