The Rise Is Right

Interest rates are on the rise. It has been nearly a decade since the Federal Reserve last hiked rates. Now, according to the Fed's forecast, rates will increase slowly, but steadily, over the next three years.

Is this good news, or bad?

Mostly good. Rates are rising because the economy is improving. For the past seven years since the Great Recession, short-term rates - those the Fed controls - have been effectively zero. Zero interest rates are not consistent with a healthy economy. Indeed, the Fed adopted a zero interest rate policy as an emergency measure in response to that debilitating downturn.

That the Fed now feels comfortable raising rates off zero is a good sign, and is mostly a reflection of the fast-improving job market. About 200,000 jobs have been created each month, on average, for nearly four years. This is more than double the pace of job creation needed to employ those coming into the work force.

The result is quickly falling unemployment. The unemployment rate now stands at 5 percent, consistent with most estimates of full employment. It is important to note that there is always unemployment, even in the very best of times, given the large number of workers between jobs.

There are still too many underemployed, including part-timers who want more hours and discouraged workers who stopped looking for jobs and are not counted as unemployed. But at the current pace of job creation, even these underemployed will be working as much as they would like by mid-2016.

There is a reasonable concern that the Fed may be raising rates too soon, which could undermine the economy. This would be very worrisome, as the Fed would have no good options in response. However, there is the alternative mounting risk that the Fed may wait too long to raise rates, which could result in undesirably high inflation in the future.

Balancing these risks is a matter of judgment, and I think the Fed used good judgment in its decision to begin raising rates.

Americans who have most of their savings in money market funds, certificates of deposit, and other cash-like investments welcome the higher rates. These are mostly older households that shouldn't be taking any risks with their savings. They've suffered as the interest rates on their investments have declined, and although it will take a while before interest rates rise enough for their financial pain to subside, the worst is over.

Rising rates are bad news for those of us who own stocks. The stock market has essentially gone sideways this year as investors anticipated the Fed's move. Stock owners were the biggest beneficiaries of the Fed's aggressive policies since the recession, so it is not surprising that they will suffer the most as rates rise.

Those who own longer-term bonds will also take it on the chin. If you own risk-free Treasury bonds you'll do OK, at least for a while, because nervous global investors like the safety of U.S. government debt. However, if you are more of a risk-taker and have invested in the bonds of less creditworthy companies or those issued by the governments of emerging nations, you are hurting. That pain will continue.

Households with lots of debt, especially credit cards and home equity loans, will also feel it. Not much at first, as rates are still very low, but over time as rates increase the larger interest payments will become more of a burden. If you have card or home equity debt and can pay at least some of it off, this is a good time to do so.

Fortunately, most homeowners have taken advantage of the heretofore historically low rates by locking them in. Many have refinanced more than once as mortgage rates have steadily declined. The typical homeowner has a 30-year fixed rate loan with a 4.5 percent mortgage rate. The Fed can raise rates all it wants, but these households will be unaffected.

If you are in the market for a new loan to buy a car or an appliance, you will eventually have to pay a higher rate. However, it may take a while before you see it, as lenders will likely shoulder at least some of the burden of the Fed's rate hikes to continue making loans. Lenders may also become less persnickety about your credit score or employment history when deciding whether to make you a loan.

How much of an impact higher rates will have depends on how high they rise. This is very uncertain, but if you buy into the Fed's own forecast, which is probably prudent, short-term rates will rise from just over a quarter percentage point today to 3.5 percent by late 2018. This is the rate consistent with an economy operating at full-employment, growing at its potential, and with inflation at the Fed's target of 2 percent.

This seems like a big increase in a short period, but it is more modest than the rate increases we've been through in times past. I think we are up for it. If I'm right, it will mean the economy has finally fully recovered from the Great Recession.

Mark Zandi is chief economist at Moody's Analytics in West Chester. For questions and comments contact help@economy.com.