Why consumers and businesses will likely see higher interest rates: It has to do with a strong economy

Guess what? Interest rates may be going up. The Federal Reserve believes that the economy is in good enough shape that it is time to start weaning it off the massive stimulus it has been pumping into the system. Is that good news? The answer, of course, is yes.

Is the economy really in good shape? Yes, it is. Growth is strong. During the spring and summer, the percentage increase was the second largest on record. Even better, the level of activity now exceeds where it was when the pandemic hit.

In addition, the nation’s unemployment rate has plummeted, dropping nearly 10 percentage points since the April 2020 pandemic peak. Job gains are robust and there are more job openings than the number of people unemployed.

In other words, the economy is back. And that is key, because the Fed has a dual mandate: maximum sustainable employment and stable prices.

The maximum sustainable employment portion seems to be in sight, but stable prices? I am not so sure.

Strong growth coupled with high inflation point out the tensions in the Fed’s mandate: Sometimes, a rapidly expanding economy can trigger price increases. When you add a global supply chain meltdown to the robust economic activity, you have real consumer price problems. Inflation is running well above the Fed’s target of a 2% average.

So, what does a good Central Bank do when the economy no longer needs its assistance and inflation starts showing its ugly head? Raise rates.

And that is the path on which the Fed has embarked.

When the pandemic hit and the economy crashed, the Fed used every tool at its disposal. It lowered the rate it controls, the federal funds rate, to near zero, and all other rates followed.

The Fed also opened the liquidity spigot, buying massive amounts of securities. It has added more than $4 trillion to its balance sheet and ultimately the economy. One reason the stock market has surged is the enormous influx of funds wound up not just in the economy, but in the financial markets, as well.

With the recovery well-established, it was time to rethink policy. At the September meeting of the Federal Open Market Committee (FOMC), the Fed’s rate-setting group, it was announced that “if progress continues broadly, as expected, the committee judges that a moderation in the pace of asset purchases may soon be warranted.”

In other words, the Fed is starting to get out of the economic support business.

What does that mean for the average person? It starts with interest rates and spreads to the general economy and the markets.

The purpose of buying securities was to lower interest rates across the spectrum of assets, from very short-term, such as three-month Treasury bills, to long-term, such as 30-year fixed-rate mortgages. The Fed did a fantastic job, and rates are still at or near historic lows.

By reducing its asset purchases, and most likely selling some later, the Fed will be ending the downward pressure on rates. Interest rates are likely to rise.

The reduction in asset purchases is not the only reason interest rates should increase. At its last FOMC meeting, the Fed signaled it could start raising the funds rate as early as the end of next year.

When the Fed signals a coming change in policy, the markets react. If, as expected, the economy remains solid and inflation continues to be elevated during 2022, the Fed will very likely hike the funds rate, and the markets will follow.

Are rising interest rates bad? It depends on why they are increasing.

The Fed’s actions to begin the rate increase process is based on the reality that the economy is able to stand on its own. Massive Fed and federal government stimulus got us out of the recession and have supported the robust growth we have seen for more than a year. That assistance is no longer needed, so the Fed’s actions are a positive sign.

But rising rates mean the cost of consumer and business borrowing increases. Payments on new mortgages, auto loans, construction and capital investment loans all rise when rates climb. And that has a restraining effect on economic growth. As far as the Fed is concerned, though, that isn’t bad. With inflation running hot, it wants growth to moderate so the price increases will slow.

There is also a potential impact on equity markets. Some of the liquidity wound up in the equity markets and supported the rapid rise in prices. That support will wane and could reverse.

In addition, higher rates influence equity prices. The price of a stock depends on the value of the returns the investor gets over time. That stream of returns must be priced in today’s dollars, and to do that, interest rates are used to find what is called the present value. The higher the rates, the lower the value of future income and the lower the current price of an asset.

That means the rate rise can spill over into the equity markets. I am not saying markets will fall. They don’t have to if earnings stay strong. But it does point to a potentially slower rate of increase in stock prices.

Higher rates are coming. They have to, as the current levels make no sense. Think about it: If you buy a 10-year Treasury note that yields 1.5%, but inflation averages the Fed’s target of 2% over those 10 years, you are losing purchasing power every year.

Yes, higher rates create costs to consumers and businesses. But they are also sending the message that the economy is back. We should recognize that as something good.

Joel L. Naroff is the president and founder of Naroff Economics, a strategic economic consulting firm in Bucks County.