Rising rates may be the kick in the pants the economy needs
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While Fed economists argue that increased demand for safe and liquid assets, such as 10-year Treasury notes, will continue to hold short term interest rates down, many other economists argue that factors such as the slowing of the economy’s growth potential and spending habits of aging baby boomers will continue to put downward pressures on interest rates.

The apparent faster pace of economic growth bolstered by expectations of increased infrastructure spending and streamlining trade agreements to boost U.S. productivity has added pressure on the Fed to consider raising short term interest rates.

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Given the current relatively low level of inflation (2 percent), the Fed can continue its gradual increases in interest rates to about 4 percent, possibly even with a temporary inflation rate of 3 percent.

 

Such a calibration in the level of the short-term interest rates can have a beneficial impact on the mortgage market, the banking sector and on a large segment of the portfolio investment of consumers, especially those of the baby boomers and those of investors approaching retirement age.

First, consider the mortgage market. There's an entire segment of potential homebuyers who have become accustomed to the historically low interest rates. But now, having seen the Fed raise rates last week, and with two more rate increases considered very likely this year, many of these home buyers will rush to get into the market before rates go even higher.

At the very least, this should result in increased short-term demand for mortgages through the peak spring and summer selling seasons and may even drive sales enough to have a positive effect on the overall economy.

Second, let’s look at consumer and corporate lending standards and business loans. Higher interest rates may provide lenders with more of an incentive to make loans, while also providing a bit of a cushion against risk.

This will very likely loosen some of the unusually tight lending standards that we have seen recently, which have prevented millions of credit-worthy borrowers from getting mortgages over the past few years. Higher rates will also drastically reduce the number of refinanced loans being issued, which lenders may try to offset by doing more purchase loans.

Finally, the investment portfolios of a large segment of the population, (especially those investors approaching retirement) could now begin the process of balancing their portfolios between equity and fixed income investments.

This process will not only bring more savers into the credit market, but will also allow many savers to lower their risk profiles within their investment portfolios. This might also provide some relief in terms of the excessive demand for equity shares.

A more balanced set of investment portfolios might even provide the stock market with reduced overall volatility, thus, helping in guiding economic growth on a more stable and sustainable path.

It is hard to imagine that we are now talking about a 4-percent nominal interest rate as a high level for the short-term interest rate. A couple of things come to mind regarding this fact.

First, the “savings glut” explanation offered for the recent low level of interest rates has been with us for a long time, even during some phases of higher interest rates.

Second, a 4-percent nominal interest rate has historically been thought of as an equilibrium rate of interest for our economy to achieve optimal employment and a steady-state rate of growth in capital and labor productivity.

Finally, we should welcome the Fed’s announced plans for gradually raising the target short term interest rates without having any fears of igniting inflation or dampening our anticipated steady growth in economic activity.

 

Hany Shawky is dean of the School of Business at the University at Albany (SUNY) and professor of finance and economics. He is the founder of the Center for Institutional Investment Management at the University at Albany and served as its director from September 2002 through December 2007.


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