American first-graders have only ever known low interest rates. The world they were born into has been tight-fisted to savers, and these youngsters have been unable to earn much from their piggy banks. But even as the era of rock-bottom rates is likely to end soon, they shouldn’t get too excited.
With the job market on the mend and the economy growing steadily — if not spectacularly — the Federal Reserve is likely to raise rates later this year, perhaps as soon as this week. That means even the littlest of our prudent savers might finally earn a return — for a few years, at least. But the bigger picture is clear: Low rates aren’t going away anytime soon, and even if the Fed does raise rates now, near-zero rates could quickly return, perhaps before today’s elementary school kids can drive.
That might not be great news for the little savers and their piggy banks, but it’s pretty good news for their parents — they need not rush to take out a mortgage or car loan trying to beat a rate increase.
When exactly the Fed will move isn’t known. For one guess, we can look at the futures market, where investors and traders can place bets on the federal funds rate, the short-term interest rate that the Fed controls. The odds of a rate increase this week are roughly 1 in 4; by the October Fed meeting, the odds are close to 40 percent; and by December, 60 percent.
A rate hike, whether at the meeting of the Federal Open Market Committee this Thursday or at some later point, is a long time coming. The Fed has kept short-term interest rates at near zero for almost seven years. Rates were first cut as the economy collapsed during the Great Recession and were kept low to boost the sluggish recovery. The chart below shows the “liftoff” date — the point when the Fed began a sustained series of rate increases — for the federal funds rate over the past 60 years. If history is a guide, the next liftoff date will likely occur at least 11 years after the last one.
But whether the Fed begins liftoff in September or December is trivial. The climb is likely to be slow regardless. Futures contracts predict a gentle ramping up of interest rates, with the federal funds rate hitting about 1.4 percent by the end of 2017 and around 1.7 percent by mid-2018.
If these futures contracts are right about the path of interest rates, this will be the slowest interest rate “normalization,” as it’s dubbed, on record. Previous normalizations have usually seen interest rates increase by 2 percentage points in the first year after liftoff, but rates are expected to rise less than 1 percentage point over the next year. The chart below shows the relative increase over three years in the federal funds rate, beginning with each liftoff pinpointed in the first chart. Investors predict, with justification, that the Fed will go very slowly with rate increases this time around — Fed Chairwoman Janet Yellen said in March: “Most of my colleagues and I believe the return of the federal funds rate to a more normal level is likely to be gradual.”
Sometimes normalization is interrupted by a recession, and so the Fed begins to cut rates a few months or years after steadily raising them. This happened following the rate increases that began in February 1999, for example, as the chart shows.
The expectation that rate hikes will happen at a glacial pace is partly due to the conflicting economic signals the Fed is getting as it seeks to fulfill its so-called dual mandate of achieving stable prices and full employment. Take the job market, for instance. The unemployment rate hit 5.1 percent in August, the lowest level since early 2008. This is the level the Congressional Budget Office estimates to be the “natural” rate of unemployment — the normal level of joblessness for the U.S. economy and the point at which if unemployment went any lower it could spark an increase in inflation. But inflation, on the other hand, remains very low. Prices rose 0.3 percent year over year, as of July 2015, according to the Fed’s preferred measure of inflation. That’s far below its stated 2 percent inflation target. Inflation so low is usually an indication of what economists call “slack,” or the underutilization of resources like labor and machinery.
The predicted slow-and-steady pace of normalization means Americans should not overreact to an increase of one-quarter of 1 percentage point, the amount the Fed is expected to raise rates whenever it happens. But an increase, however slight, will trickle through to many other kinds of interest rates: mortgages, car loans, corporate bonds, etc.
As the chart below shows, the Fed uses its fine control over short-term interest rates to affect other rates throughout the economy. It’s not a perfect one-for-one relationship. Corporate bond rates, for instance, can spike on fears of default even while the federal funds rate remains stable, as happened during the worst parts of the financial crisis in 2008 and 2009. But all in all, the future path of the federal funds rate is a good indication of where these others are heading.
In other words, families shouldn’t rush to take out a mortgage or car loan, and businesses need not splurge on borrowing to start new investment projects just yet. While rates have probably bottomed out, it’s unlikely they will shoot suddenly upward anytime soon.
Those diligent first-graders, eagerly saving their allowances, might still be disappointed in how little interest they’ll earn over the next few years. And on top of that, they will probably have to learn another hard truth: Economies stumble, regularly.
It’s a safe bet that the U.S. will face another recession. The current six-year period of expansion is already 17 months longer than what is typical. If a recession comes in the next three years, as history indicates it very likely could, the futures market predicts that rates won’t have gone higher than 2 percent — and may be lower. The Fed’s orthodox approach to fighting recessions is to cut interest rates, and to combat past recessions, the Fed has typically brought down interest rates by 3 to 4 percentage points, depending on the severity of the downturn. But in this case, returning rates to zero will likely be the most it can do.
All this is to say that whenever the Fed embarks on its first rate hike in nearly a decade, the long-term trajectory is likely to be relatively low rates. And while those prudent first-graders might hope otherwise, it’s quite likely that rates will be back at zero again before they finish high school.