The topic of interest rates has been heavy on the mind of world-renowned investors such as Warren Buffett, as well as the world’s consumers, in the recent past. Interest rates can have a huge impact on the cost of a wide array of necessary goods and services, including grocery items, home heating, gasoline, and even housing costs.
Interest rates have been at historically low levels for years, which was due in part to low inflation, but also as a stimulative measure to produce economic growth. However, it appears that is unwinding, and in this article, we’ll take a look at whether interest rate increases may occur, and if so, in what magnitude.
Why Interest Rates Matter
Interest rates are critical for economic growth, as well as controlling inflation. The reason is that lower interest rates encourage consumers and businesses to borrow money in order to invest it in something. That could be a new factory, a new small business, a house, or anything else that requires capital investment. The idea is that if it is relatively cheap to borrow money, businesses and consumers are more likely to do so, as the hurdle in terms of achieving economic profit over and above the interest rate paid is lower.
That works in the opposite direction as well, so raising interest rates is a way for policy makers to curtail what could be perceived as excessive borrowing, which could then result in overinvestment. If overinvestment occurs, it could result in very hot economic growth, which generally results in inflation.
In other words, interest rates can be used as one tool to either encourage economic investment, or curtail it, depending upon prevailing conditions with growth and inflation.
Factors That Determine Interest Rate Levels
Now, let’s take a look at the factors that help determine interest rates, which will provide some clues as to whether rate increases are appropriate in 2022, and if so, by what magnitude.
One factor, as mentioned, is the rate of economic growth. There are many ways to measure growth but the most cited one is gross domestic product, or GDP. That is simply a measure of economic activity of a country on the whole, aiming to capture everything that takes place in a country’s economy, and placing a dollar value on it. In this way, observers can determine how quickly or slowly a country’s economy is growing, and if a recession is on the way, or even already underway.
GDP in the US has risen extremely quickly since the worst of the pandemic in 2020, and in fact, since the bottom in early-2020, GDP is up about 24% on an absolute basis. The US economy continues to hit new records in terms of economic output, and crested $24 trillion on an annualized basis early this year.
The fact that the economy is making records isn’t cause for concern for interest rates, necessarily, but the rate of growth is what could cause some angst among policy makers. The reason is because if an economy grows very quickly, it generally results in rapid price increases for goods and services, which is inflation. Thus, it follows that the GDP discussion should also include inflation numbers as they are correlated.
Inflation can also be measured in a variety of ways, but the most common one is the Consumer Price Index, or CPI. This is a collection of goods and services that are priced at regular intervals, and the combined pricing is then put into an index to measure overall inflation. The CPI has risen quite sharply since the pandemic began, as not only has the economy grown rapidly from the bottom, but various supply chain issues have created shortages in certain sectors of the economy. That has combined to generate high levels of inflation, and the CPI is up more than 6% in the past year as a result. The US has spent the past decade at less than 2%, so current levels of inflation are extremely high.
What Does This Mean For Rates?
With GDP and inflation running hot, the natural response is to raise interest rates, as that is a primary tool to fight an overheated economy that has inflation. Whether the economy is overheated now is up for debate, but virtually everyone agrees the US has an inflation problem at the moment.
The last time rates were raised meaningfully was a gradual increase that took place from 2016 to 2019, when the benchmark Fed Funds rate rose from less than 0.5% to 2.5% over a period of almost three years. At the time, GDP was rising quickly – at 4% to 5% annually – but inflation hadn’t taken hold in a meaningful way. Given this, the increase in rates during that period would have been aimed at preventing an overheating economy, rather than fighting inflation.
If we contrast that with today, we have GDP rising at 3% to 4%, but inflation is spiking much higher than normal. That implies that rising rates today would be aimed not at preventing an overheating economy, but rather to fight inflation that is already very high. All else equal, that would argue for potentially quicker and larger rate increases as the situation is quite different this time around.
The ultimate magnitude of rate increases will depend upon several factors, but if we take GDP and inflation as a guide in comparison to prior hiking cycles, it is clear investors should expect a Fed Funds rate of at least 2.5% in the relatively near future. That would be another ~200 basis points higher than today, or equivalent to eight quarter-point rate hikes. That aligns with guidance from policymakers, and would put this hiking cycle in line with the prior cycle in terms of magnitude. The difference this time around is that it is likely to take much less time to get those eight hikes than it did in prior cycles, given where inflation is today.
While no rate hike cycle is exactly comparable to prior ones, investors can take clues from prior cycles to gain insight into how the current cycle may play out. Prior rate cycles were slow and gradual to combat a hot economy. Today, the issue is not an overheating economy, but rather, overheating inflation. That argues for a swifter and potentially more meaningful response from policymakers on rates, so we see the current cycle as producing a quick road to at least eight rate hikes in the relatively near term.
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