3 Things to Know About the Fed and Rate Hikes

All eyes are on the Fed this week as it decides whether to lift rates for the first time in nine years. Should interest rates rise, what can we expect? This paper looks at three aspects of future rate hikes: How high will rates go? What signals are the markets sending now? And what are the repercussions of a rate hike?

Let’s start with the basics. When the Fed “raises rates,” it is really raising the target for the Fed Funds rate—the rate at which large banks lend excess reserves to each other on a nightly basis. Raising rates is like tapping the brakes on the economy. Higher rates increase the cost of borrowing and typically slow down lending for everything from mortgages, to business loans, to credit card purchases. When the cost of borrowing rises, banks raise the rate it pays depositors, lending becomes more expensive, money gets tighter and this adds a drag to the economy. Likewise, when the Fed lowers rates, it is stepping on the accelerator by making borrowing cheaper and money looser.

Since the onset of the recession in 2007, the Fed has put the pedal to the metal, lowering rates to historic lows in 2008, and keeping them there for seven years. Thus, interest rates have been at unprecedented lows for an unprecedented length of time. No one knows how exactly the economy will behave when the Fed touches the brakes, but here are three things to watch for:

1. The New Normal for Rates Could Be Lower than the Old Normal

Since the end of 2008, the Fed Funds rate has averaged 0.13% and that is simply abnormal. So what is normal, and will the future normal be different from the past?

The graph below shows that as the time horizon for the loan gets longer the rate gets higher. This is what’s known as a “yield curve.” In this graph, the gray line represents the past and shows average interest rates from 1954 to 2008 for the Fed Funds rate, plus the 1-year Treasury, 10-year Treasury, and 30-year fixed-rate mortgage, as far back as public data is available.¹ The blue line represents the present and shows rates for the same four instruments from the end of 2008 until today. The orange line is a prediction of rates in 2018 and beyond.²

Second, interest rates were typically much higher than they are today. The Fed Funds rate averaged 5.63% between 1954 and 2008.³ Even if one excludes periods of very high rates (the inflation years from 1975 to 1982), rates still average a little over 5%. This shows just how unusual the post-recession average of 0.13% is when compared to rates historically.

Third, economists generally agree that we are in a “new normal” of below-average interest rates due to slower future economic growth.⁴ According to a survey from June, Fed officials expect the Fed Funds rate to plateau at 3.5% to 3.75% sometime after 2017.⁵ This serves as an anchor for the “new normal” and associated predictions, although the future performance of these indicators could be different from the way they have behaved in the past, particularly if inflation expectations drift upwards.⁶

2. The market sends its own signals on rates

The last series of Fed rate hikes occurred from 2004 to 2006. Earlier in the decade, after the dot.com bubble burst and in the aftermath of 9/11, the Fed lowered rates to get the economy moving. By 2004, the Fed was concerned that the economy was moving too fast, so it “tightened” the money supply with a series of rate hikes.

The behavior of bond rates during that period provides clues about two important features of this tightening: timing and trajectory.

Timing: The graph below depicts interest rates from 2004 through the summer of 2006 for the same four financial instruments as the earlier graph showed plus an average of standard, well-rated corporate bonds (the dark blue line).

From March to May in 2004, interest rates jumped about 0.75% for every instrument except the Fed Funds rate—which stayed at 1%.⁷ This is known as “pricing in” a rate hike. Investors anticipated that the Fed would bump up rates based on Fed statements. Today, the market has reacted somewhat, but it is unclear the extent to which it will react further when the rate hike begins.

Trajectory: When the Fed raises rates, expect more of them. In June 2004, the Fed raised the Fed Funds target rate 25 basis points (0.25%) and kept raising it by the same amount each time the Fed met until the middle of 2006. The coming rate hike is expected to take a similar, albeit slower, path—depending on how the economy holds up. That’s why markets participants are so focused on the initial rate hike—one rate hike implies more to come.

Also, the graph shows that the longer-maturity bonds and mortgage rates didn’t have the same trajectory as shorter-lived bonds like the Fed Funds rate and 1-year Treasury. These longer-term debt instruments are influenced less by the Fed Funds rate and more by inflation and long-term growth expectations. By August 2006, the interest rate for a 10-year Treasury bill was lower than both the rate for a 1-year Treasury and the Fed Funds rate (which is essentially an overnight loan). When a 1-year loan pays a higher yield than a 10-year loan, the market is saying that it expects a downturn and believes the Fed will soon reverse course and bring rates lower. And of course, a year later it did. The “inverted yield curve” in the summer of 2006 was a harbinger of the recession a year away.

3. Rate hikes have repercussions across the globe

Over the last two decades, a 25-basis point move in the Fed Funds rate corresponded with a 13-basis point change in average mortgage rates.⁸ Thus, a rise of 3.5 points in the Fed Funds rate suggests a 2-point jump in mortgage rates. But outside of the mortgage holder the impact of the rate increase gets more interesting.

First, because super safe investments like Treasury bonds will pay a higher rate of return, some cash that is now going into more aggressive, higher yield investments will flow back toward less risky assets like Treasuries. This has an impact on high yield products like subprime mortgages, but also debt from emerging markets like Brazil.

Second, raising rates puts the U.S. and Europe at cross-purposes. As the graph above indicates, when the U.S. reverses monetary policy, much of the world follows suit.⁹ But the European Central Bank (ECB) wants to keep its rates as low as possible to stimulate the moribund EU economies.¹⁰ The ECB is expected to not only keep its rate near zero, but also to continue stimulating Europe’s economy with quantitative easing for at least another year. However, higher U.S. interest rates mean investors can purchase U.S. treasuries that are both safer than ECB bonds and have higher yields. This could force the ECB into the uncomfortable position of raising rates in a slowing economy.

Third, interest rates affect foreign currency exchange rates. For other economies this can be a good news, bad news scenario. Higher interest rates strengthen the Dollar, which has already hit 10-year highs in relation to the Euro and the Yen. A stronger Dollar makes exports from Europe, Brazil, and elsewhere cheaper, which generates economic growth in these struggling economies. But for foreign borrowers, any rise in the Dollar makes Dollar-denominated debt more expensive to pay. It is this flight to safer capital and impact on exchange rates that is behind the World Bank’s warning that a rate hike would “affect countries quite badly.”¹¹ In the end, raising rates increases the cost of money for every borrower including emerging market countries and companies.

What will happen in other leading economies? Unlike the Eurozone, the UK is poised to kick off its own tightening cycle in 2016.¹² Meanwhile, Japan’s central bank has held interest rates at the miniscule level of 0% to .50% for an incredible 20 years, as they try to fight deflation.¹³

So why raise rates?

The alternative could be worse. When interest rates are this low, money becomes so inexpensive to borrow that it is tempting to take on more debt. Mortgage rates are so low that it is tempting to build more homes. And yields on bonds so stingy that it is tempting for investors to search for riskier options that can give them a higher rate of return. Without meaningful returns from relatively safe assets like treasuries, investors may be overeager to purchase emerging market bonds, subprime auto loans, and high-growth stocks. This phenomenon has been dubbed the “reach for yield.” Some fear that it will lead to the next bubble, and some believe it has already arrived. Higher rates on safer investments temper the search for yield.