Where will the interest rates go?

Reviewed: March 24, 2015
By FinanceWeb

Rate increases come with the idea of a broad economic recovery. The Great Recession caused the Federal Reserve to use its rate setting powers to foster a Great Recovery. They set the federal funds rate near zero percent, and it has remained there. A badly damaged economy found new roots and began to flourish. Another factor that emerged along with the fall in oil prices was a downturn in most of the world economies. The relative difference between a growing U.S.economy and essentially flat economies elsewhere caused U.S. dollar to gain value to the point that export profits began to suffer.

The New Federal Reserve Guidance

The Federal Open Market Committee (FOMC) removed the word “patient” from the prior guidance. The expressed concerns were with the current state of the recovery and labor markets. However, when describing the approach to interest rates and the relative strength of the dollar, it was clear that interest rate hikes were on the table. It is a small but significant adjustment that opens the door for rates to help with a longer view of economic growth. The Fed did not immediately raise rates, and the loss of “patient” does not translate into impatience. The Committee noted trends in 2015 in which the pace of economic activity seemed to slow.

Where Will Rates Go?

The simple answer is that rates will rise; the factors that affect when are more evident than how much. The Fed has concerns over the rate of job growth, incomes, inflation, and spending. Consumer confidence is important to their equation. They must balance inflationary pressures with the need to position the dollar against other currencies. The interest rate liftoff will mark a milestone in the recovery; it means the economy is strong enough to handle higher costs for money. For the first federal funds increase in many years, the liftoff of interest rates in 2015 could have far-ranging effects. For example, will sellers use traditional flat pricing models for automobiles or use available incentives to overcome the strong dollar in European markets.

Weak Sectors

There is a widely held view that the housing market has not recovered as well as most other vital sectors. This is troubling given the historic low rates for mortgage financing. Exports have slowed, and there are many new job seekers. Some effects are weather-related and seasonal. Time will provide more and better answers, and the Fed’s policy position permits a cautious approach. Unemployment can drop further without an automatic increase. Other factors also weigh in the thinking.

The Long-Term Goal

Traditional thinkers look to earlier eras and suggest that the federal funds rate must sit at about three percent to hedge against another cyclical downturn in the economy. There are many assumptions in this model based on a historical view of a markedly changed world; the globalized economy may have different attributes than in the 1980’s when the dollar last grew to near record highs.