What’s (Not) Up With Interest Rates?
Credit is the lifeblood of any healthy economy and the price of credit (or the cost of borrowing) is measured by the annual rate of interest charged. There are as many different rates of interest as there are types of credit available. For example, consider borrowing from a bank to purchase an automobile. If you’re fresh out of school and newly employed, the interest rate on your auto loan might be in the double-digits. But if you have a long, well-established credit history, you might be able to buy a new car with zero percent financing.
Or, consider what sovereign governments have to pay investors to borrow in the capital markets. The United States can borrow for ten years right now at an annual rate of 2.19%. Brazil, on the other hand, must pay investors close to 10% per year to borrow for ten years.
How are interest rates set? Interest rates are established like any price, by market forces, via the supply and demand for loanable funds (there is one important exception which we will discuss in a minute). Think about that bank making an auto loan. They have several things to consider when deciding to extend credit to someone: (1) the creditworthiness of the borrower, (2) how many years to pay the loan back, (3) the cost of funds that the bank has to pay to depositors, and (4) the rate at which the purchasing power of the currency declines over time (the inflation rate).
Let’s focus on the last point, inflation. Savers and bond investors hope to earn income on their funds at a rate that exceeds the rate of inflation, otherwise they lose the purchasing power of the income stream. Therefore, one component of the interest rate setting process by the market must consider what the future rate of inflation is expected to be.
The last slide in the Market Observer video showed that there has been a very close correlation between the US inflation rate (as measured by the CPI) and market interest rates (in this case, 3-month Treasury Bills). While other things come into play when thinking about how interest rates are set, such as credit quality and the term to maturity, inflation expectations are a key consideration. It is the reason that the US can borrow at just over 2% for ten years while Brazil must pay almost five times as much: inflation in the US is below 2% compared to almost 9% in Brazil.
This is why any discussion of the future course of interest rates must take into account inflation expectations. The US Federal Reserve, through Monetary Policy, started targeting core inflation at 2% in 2012. Since that time, inflation has struggled to get anywhere close to 2%, with the most recent reading at 1.7% (July, 2017). This has been a conundrum for many economists, policy makers and market participants, particularly since unemployment is now at a low 4.3%. Even though the US economy is barely growing at a 2% real annual rate, some expect wage pressures to start pushing consumer prices higher. So far this has not happened.
Persistent low inflation has created a lively debate within the Fed’s Federal Open Market Committee (FOMC). The FOMC decides where to set the one interest rate that is not market determined, the Federal Funds Rate (the overnight lending rate on bank excess reserves). The Fed has been trying to “normalize” the Fed Funds rate recently after almost a decade of keeping the rate near zero since the depth of the Great Financial Crisis of 2007-2009. Even though the effective Fed Funds rate has now been raised to over 1%, the market is pricing in only a 36% chance that the Fed will raise the Fed Funds rate for the third time this year in December. Meanwhile, the bellwether 10-year Treasury yield has dropped again to 2.19%.
For some time now, there has been much talk about the prospect of rapidly rising interest rates, particularly since the Fed first raised the Fed Funds rate in December, 2015, from zero to 0.25%. But the Fed controls only one rate, the overnight bank lending rate. They do not set mortgage rates, or auto loan rates or other bank lending rates, much less the yields on longer term treasury, corporate or municipal bonds.
While we are not in the business of predicting the future course of interest rates, our guess is that as long as inflation stays low and the economy limps along at an average 2% real GDP growth, long-term rates are more likely to stay low than to rise significantly from here.
Posted on Mon, August 21, 2017
by Jess Poisl filed under