Management

What’s the Future of Interest Rates?

Expect a gradual return to interest-rate normalization.

June 20, 2014
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The new Federal Reserve Chair Janet Yellen was bound to change how the Fed communicates its current and future monetary policy when she took over the reins from Ben Bernanke.

The March 19 Federal Open Market Committee meeting, the first Yellen chaired, gave market participants much to digest regarding the future of interest rates.

The first change was in regard to the agency’s forward rate guidance. This is the notion that the Fed can affect interest rates today by making assurances about how they will conduct policy tomorrow.

The Fed, for example, can influence today’s 10-year Treasury interest rate by committing to keep short-term interest rates low for the next couple of years. This is known as the Expectations Theory of Interest Rates, which states that today’s long-term interest rates are the average of expected future short term interest rates over the life of the debt instrument.

Because long-term debt is not a perfect substitute for shortterm debt—investors typically are risk-averse and prefer short-term debt—economists also add a “term premium” to the average of expected future short-term interest rates when evaluating long-term rates.

Two Fed policies have reduced both components of long-term interest rates to encourage businesses and households to borrow, spend, and invest (which, in turn, should lead to economic growth):

1. Quantitative easing—printing money to buy longer-term Treasury bonds and mortgage-backed securities—reduced the term premium on long-term debt to zero. As the Fed continues to taper quantitative easing, the term premium will increase to a more normal level, pushing up long-term interest rates.

2. Forward guidance. This is an attempt to influence bond market participants’ expectations of future short-term interest rates. If the Fed can convince bond market participants that it will keep short-term interest rates lower for a longer period of time, then longer-term interest rates also will stay low.

These expectations, however, depend on the Fed’s credibility regarding its commitments to keep short-term interest rates low even as the economy improves. To maintain its credibility, the Fed has changed its forward guidance from a quantitative approach to a qualitative approach. The agency dropped two thresholds—the 6.5% unemployment rate and the 2.5% inflation rate—for when it may begin to raise the federal-funds interest-rate target.

The threshold now is based on a wide range of measures related to labor market conditions, indicators of inflation pressures, and measures of inflation expectations.

So what is the expected scale and speed of future interest-rate increases? The Fed’s updated projections indicate that the first fed-funds rate increase will take place sometime in the middle of 2015.

The pace of normalization of interest rates, to around 4%, will be gradual with the fed-funds interest rate ending 2015 around 1% and ending 2016 over 2%. We believe the 10-year Treasury interest rate will end 2014 below 3.3% and end 2015 over 3.5%.

The Treasury yield curve will, therefore, steepen in 2014 as longterm interest rates rise faster than short-term interest rates. This will increase credit unions’ net interest margins as borrowing short term and lending long term becomes more lucrative. Credit unions’ yield on assets will rise in 2014—reversing a six-year decline—due to rising interest rates and faster loan growth.

When it comes to predicting interest rates nobody said it better than Edgar R. Fiedler: “If you have to forecast, forecast often.”

That’s because when it comes to predicting the price of money, money supply and demand are in a constant state of flux and Fed officials can change their minds.
 

 

 

 

 

 

STEVE RICK is CUNA’s senior economist. Contact him at 608-231-4285.

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