By Haddon Libby
The financial markets are in a tizzy over anticipated interest rate increases. Rate increases are needed in order to begin eliminating the extraordinary monetary easing policies of the Federal Reserve. Since the end of 2008, the Federal Funds rate has been at 0%.
What is the Federal Funds rate? It is the rate the Federal Reserve charges or pays to banks that borrow or deposit money.
This free money means that banks can borrow at 0%, invest in bonds and create nearly risk-free earnings.
With banks buying bonds as an investment, the cost to borrow by the government and corporations is much lower. As a result, government budget deficits are not as high while corporations have cheap money to invest in their businesses. Cheap money is meant to bolster corporate financial health which is meant to cause the creation of more jobs and greater wealth for workers. With this recovery, corporate wages for new jobs has been lower than the wages paid on the jobs lost during the Great Recession. This has bolstered corporate earnings but left the US economy weaker than the typical recovery.
Seven years of 0% money has caused the market to become addicted to cheap money. Even the threat that this extraordinary financial arrangement might go away has financial markets very nervous.
Think of the markets like a person addicted to coffee – drinking all of that coffee has left the person jittery and not acting normally. While the coffee was necessary to wake them up, it’s clear that they have too much caffeine in their system. Caffeine withdrawals will cause headaches and irritability but has to be done.
This is what is happening in the markets. Businesses with an over-reliance on cheap money will see their results weaken.
How high will rates go?
It is fair to assume that rates will need to go higher than 0.25% over the next few years. A level in the 2-4% range is a reasonable expectation although there is no way to know when that might happen. Rates could go even higher if inflation takes root in the economy.
If we look at recent history, the federal funds rate reached 5.25% in 2006 as the Federal Reserve tried to cool an overheated housing market. As we all know now, the real fix should have been in removing liar loans and other fraud from the mortgage market.
Before that, the Federal Funds rate had fallen to 1% in 2003 as the Federal Reserve tried to help the economy recover from a recession caused in large part to the dot-com bubble at the turn of the century (2000). As the Fed tried to combat that stock bubble, the Federal Funds rate hit 6.6%.
In the early 1990’s, the Federal Funds rate fell to 3% from the 7-8% level as the Federal Reserve combatted a recession caused economic disruptions due to increased globalization and a rise in the use of technology.
Thirty-five years ago, this interest rate rose to 20% as the Fed combatted inflation.
How will this impact you?
For savers, you can expect a small increase in the rates you earn from banks although it will hardly be enough to afford you more than a cup of coffee.
Borrowing rates will go up. This will make a homeowner’s monthly payments higher which may cause home values to stagnate. Auto loans and business loans will also cost a bit more.
People who own bonds will see a decline in the value of their holdings. New bond buyers will see higher returns although a rising interest rate environment most likely means that the decline in principal value will match or exceed the increase in interest in the near term.
