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TIPPING POINTS

After a 40-year fall, rising interest rates threaten to shake the economy

Reuters/Brendan McDermid
worried about rising rates
By Allison Schrager
Published Last updated This article is more than 2 years old.

Interest rates—the price government, companies, and households pay to borrow money—have an extraordinary influence on economic activity. If interest rates go up, borrowing gets expensive and the economy slows because we have less money to spend and companies are less inclined to hire and invest. For lenders and savers, interest rates represent the return for lower-risk investments in savings account and US Treasury Bills, influencing their spending, the risks they take, and how much they value future investment.

The last forty years were an extraordinary time for the interest rates of American bonds, with both long and short-term rates trending down, fostering growth and easy credit. American bonds have become the world’s premier risk-free asset, owned by investors all over the world. But the tide is now turning, rates are starting to rise, and it could change the economy as we know it.

 

 

Why are interest rates increasing?

To understand why rates are going up and if they’ll rise further, first we need to understand why they fell for so long.

Until recently, economists thought interest rates were mean-reverting, meaning they believed there was a long-term average rate around which interest rates hover. But the last 40 years have led economists to question that conventional wisdom. Interest rates fell, and kept falling, for several reasons.

One is US Federal Reserve policy. The Fed’s interest rate policy (both the rates it sets today and what is says it will do in the future) has a direct impact on short-term rates and some impact on long-term rates. Since the financial crisis and, arguably, during much of the preceding two decades when Alan Greenspan was chairman, the Fed pursued lower rates to keep the economy booming.

Long-term interest rates are also a function of market demand and inflation expectations. Rates used to be higher in the 1960s and 1970s because bond buyers, seeking higher returns so their investment kept up with inflation, drove up bond yields, or the rate bonds pay. But starting in the early 1980s, under Fed chairman Paul Volcker, central bank policies gave investors confidence inflation would stay low and predictable, so bond buyers accepted lower yields.

There was also more demand for US bonds as the global economy created more wealth in emerging market and oil rich countries. Those governments wanted to stabilize their currencies and capital flows by buying bonds in stable, rich countries like the US. The large increased demand for bonds from foreign buyers drove up the price of bonds, the same way demand increases price in any market. Bond prices are inversely related to yields, so more demand means lower bond yields, and therefore lower interest rates.

The price of bonds also reflects risk and economic growth prospects. When investors perceive more risk—in bond markets, the economy, and inflation—they are less inclined to own long-term bonds, which are less liquid, more volatile and more prone to inflation risk than short-term bonds. When they sense more risk, they’ll only buy bonds if they are paid higher yields as compensation for their risk-taking.

In the last few years, interest rates have started to rise. The Fed is starting to increase interest rates, slowly, and is expected to continue doing so, which will increase short-term rates and to some extent long-term rates. The yield on a 10-year bond is almost 3%, up from 1.5% two years ago.

It is still too soon to tell if rates will return to their historical average of about 6% (using data that goes back to 1962,) or if this is just a blip. But there are reasons to worry the tide is turning and rates will trend up. Even if the Fed does nothing more, rates might increase anyway because economic growth has been stronger due to the natural business cycle.

In the aftermath of the financial crisis, investors sought safety and were willing to take low returns for relative certainty. But after 10 years of steady growth, investors are more willing to take risks in pursuit of higher returns and relatively low-yielding bonds look less attractive. Additionally, the big buyers of bonds, Asian and oil rich countries, have less spare wealth and more compelling investment options at home, which may reduce their appetite for foreign bonds. Less demand among investors for debt could push rates up even further as bond prices fall.

Inflation is picking up and there’s serious discussion of changing inflation targets. If inflation rises or becomes less certain, rates will also go up.

Risk premiums on bonds may also start to rise, as big, rich countries—like the US, the UK, and countries in the Eurozone—no longer seems as politically secure as they once did, and continue to run deficits and offer unfunded pensions and health care. Risk premiums in the form of higher rates may not be increasing yet, but when they increase they increase quickly, and more instability makes this possibility more likely.

What do higher rates mean for the global economy?

Interest rates have been lower than their historical average for twenty years and markets have short memories. The risk is the global economy has adapted to a low-rate world and a change, especially if it is sudden, could cause major disruptions. Governments are now borrowing more, and corporations and households are leveraged. A large sustained increase could be destabilizing if companies and governments trying to refinance their debt face much higher rates, and debt payments start to eat into profits and other government spending.

Higher rates will create winners and losers in all parts of the economy. The cost to households will be higher rates on credit cards, mortgages, and student and car loans. Debtors will face higher interest rate payments. But there are benefits for savers, who will get a higher return on their low-risk assets, like savings accounts and CDs. New retirees will get more income for their savings, which means they can spend more in retirement.

There are also mixed consequences for the macro economy. The world runs on low rates. The IMF is concerned low rates have led companies to take on more debt. If rates increase they may be unable to meet their obligations and there could be a wave of corporate bankruptcies. Alternatively, pension funds will be better funded, because they use interest rates as a discount rate when they calculate their future liabilities. Higher rates mean their liabilities are smaller, so they need to save less.

Another risk is not just that interest rates go up, but that they become more volatile. Investors and borrowers have become used to stable rates when they make long-term decisions. More rate volatility creates more uncertainty, increases risk premiums, and pushes rates up further.

The specter of rising interest rates has not been a big risk in a 40-year low rate environment. But nothing lasts forever, especially when it comes to bond markets.

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