This post originally appeared last spring. With a Federal Reserve rate increase largely expected to happen this week, I want to take a look at what happens when rates start to rise.
Although economic growth appears to be slowing, stocks continue to hit new highs. This may lead one to ask, “How does the market retain its strength?” In fact, much of this strength seems to result from the low interest rates provided by the Federal Reserve (Fed). And although it can’t be said exactly when the Fed will raise rates, expectation is currently high that it will happen on December 16.
So, let’s consider this: What might happen to our investments—stocks, bonds, and everything else—when interest rates are finally allowed to return to their natural level? It is an excellent question, one that will affect everyone who holds these securities (which is to say, almost everyone).
In fact, there are several other questions that should be addressed separately:
1. What is the natural level of interest rates?
2. What's keeping current rates away from the natural level?
3. Will that stop? When?
4. What happens when it does stop?
5. What does that mean for our investments?
Let‘s start with question 1: What is the natural level of interest rates?
The price of money
Interest rates are actually the price of money. As such, they change with the balance of supply and demand for money. Unlike with most goods, though, there is a monopoly provider of money that can and does change the supply whenever it wants—the Fed or, more generally, the central banks. Interest rates are therefore a market, but a manipulated one.
Despite this manipulation, though, there is such a thing as the natural interest rate, one that balances supply and demand. Economic research has defined it, loosely, as the rate of interest on loans that is neutral with respect to prices, and will not tend to either raise or lower them. (A summary is available here.) This is a vague but useful definition, as it situates interest rates squarely within the Fed’s policy concerns regarding inflation and deflation.
How is the natural interest rate calculated?
Before its conclusion in October 2014, the Fed’s stimulus policy was directed at lowering rates by injecting money into the economy via buying bonds. According to basic economics, increasing the supply of money should lower the price (interest rates). It should also act to increase prices, which suggests the lowered rates are below the natural rate, consistent with the definition above.