The Knowledge Center sat down with Thomas M. Toerpe, Senior Vice President, FX and Interest Rate Derivatives, to get his perspective on how the change in interest rates may affect the economy.
Q: Long-term interest rates moved up a full percentage point this summer. What happened?
A: The increase was largely driven by the Federal Reserve’s talk of slowing down its $85 billion bond purchase program. That’s long been part of the Fed’s tool kit, and it was expected that eventually it would taper off those purchases as the economy improves. When the market got wind of the possibility, and the economic data started to come in stronger, it concluded that the Fed would start increasing short-term rates as well. That wasn’t the case, but perceptions can move markets, and they did. There was a sell-off in bonds, which drove rates upward. Once the market realized the Fed was just talking about moving away from its most extreme accommodation but planned to keep short-term rates low as long the unemployment rate remains stay above 6.5%, the market calmed down.
Q: Was inflation a factor in the higher rates?
A: No. The inflation rate has remained under control. In fact, despite all the turmoil in the economy over the past eight years, Ben Bernanke has one of the best inflation-fighting records of any Fed Chairman. Markets reflect confidence that that will continue.
Q: What’s the outlook for the rest of 2013?
A: Interest rates climbed steadily for about four months, but when new home sales fell in response, the market took a bit of a pause. If we see further pullback in the housing market, the Fed will be reluctant to reduce bond purchases too quickly, and certainly won’t be eager to raise short term rates. That would suggest we’ll stabilize around current levels, or even see a temporary drop. It’s important to note that rates have returned to early 2011 levels, when the 10 year Treasury yield ranged from 3.0% to 3.75%. In some ways, 2011 is a good comparison year for 2013 –– we had some of the same situations then as now: steady but tepid growth, uncertainty over the debt ceiling, and an overseas slowdown. Of course, we can’t tell for sure how things will play out. For example, the action –– or inaction –– of Congress could have an impact. Each time we’ve had threats of breaching the debt ceiling or shutting down government, rates have fallen. That could happen again.
Q: What happens to the economy when the Fed actually starts to tighten monetary policy?
A: There’s no doubt that once the Fed starts to increase short-term rates next year, it will have an impact on housing, business investments and the stock market. However, I think the fears are a bit overblown. The economy has been pretty resilient in the face of rising interest rates in the past. Sometimes the job and stock markets flatten when rates go up, but not always. If you look at prior housing cycles, if rates start rising because of an improving economy, it doesn’t derail the housing recovery because job and income growth more than offset higher interest costs.
Q: Bernanke’s term is up in January 2014. What impact will that have on interest rates?
A: The Fed’s policy has been one of accommodation and economic stimulus for the past five years. There’s also a clear plan for unwinding this as the economy improves, so it’s unlikely there will be an abrupt change of course in 2014. On the other hand, up to 6 voting members of the Fed – including Bernanke – will need to be replaced next year. Such a significant turnover in leadership could have a big impact on the long term direction of US monetary policy.
Q: So what should businesses and consumers be aware of in the current environment?
Typically long-term rates go up before short-term rates do. We’ve already seen the first signs that the interest rate cycle has turned, so the extremely low rates of the last year may have come to an end. Consumers and businesses should look to protect themselves from exposure to further increases, including locking in rates with a fixed-rate loan, or using hedging instruments to manage the rate risk. Learn more about interest-rate hedging here
Information provided was deemed accurate as of September 16, 2013.