Why Interest Rates Will Likely Remain High
It’s been bothering me for well over a year. Everyday, as I listen to the talking heads on at least one financial news network, it seems like the question asked the most is “when do you think the Fed will begin lowering rates”? Repeated, almost ad nauseum, the hosts ask this question of the guests as if they all have a crystal ball, and more annoying, why does it matter?
Fed Funds vs Real Rates
What bothers me is that the rate they’re asking about - the Fed Funds Rate - doesn’t really matter at this point. The Fed Funds Rate is the shortest of short-term rates and is not the most important driver of Real rates. It’s defined as the target rate at which commercial banks borrow and lend their excess reserves to each other overnight. Some people even call it “the Overnight Rate”.
Real rates are the ones we us
e every day – car loans, credit cards, mortgages, business loans, etc. They are determined by supply and demand in the U.S. Treasuries Market with the 10-year Treasury acting as the primary benchmark.
Until 2008, the Fed Funds Rate acted as a driver of real interest rates. It didn’t always work perfectly, but as the Open Market Committee raised and lowered this rate, other government bonds with longer dated maturities would typically follow. However, the effectiveness of this strategy has somewhat diminished since 2008.
QE and QT
In 2008, the Federal Reserve began something known as QE or Quantitative Easing. From 2009 – 2014 they bought more than $4 trillion worth of assets, mostly Treasuries and Mortgage-Backed Securities. By taking the supply of available Treasuries out of the market, the price of Treasuries rose - and when bond prices rise, rates go down. The Fed effectively was able to lower both short and longer-term rates – rather than just short-term rates as they had done historically - essentially allowing our economy and housing market to recover. With the onset of Covid they began buying again in 2020, bringing the total amount held by the Federal Reserve to approximately $8 trillion.
Then, in 2022 they changed their strategy to begin raising rates using a process known as QT or Quantitative Tightening. Currently, they are allowing $40 billion per month (it started at $80 billion) to “roll off” their balance sheet back into the markets. But there’s more - in addition to the increase in supply from the Federal Reserve, Congress will borrow an additional $1.5 trillion this year, which will be financed with more Treasuries, leading to approximately $2 trillion of NEW debt being issued this year and likely next year.
Since the Federal Reserve started this phase (QT), real rates have risen substantially, and with the massive supply of new debt instruments flooding the markets, I believe rates will remain elevated and somewhat stable for the foreseeable future. Perhaps what we’re seeing is a return to interest rate normalcy, but it’s difficult to make that case when you’re carrying a $34 trillion debt as a nation and the methods being used to maintain stability have never been used before.
Michael P Henderson, CFP® CKA®
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