Rising Interest Rates: Economic and Policy Implications

Rising Interest Rates: Economic and Policy Implications

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INSIGHTi

Rising Interest Rates: Economic and Policy
Implications
August 4, 2022
Interest rates have risen significantly since the beginning of 2022 (see Figure 1). This is partly because of
tighter monetary policy—the Federal Reserve (Fed) has increased its federal funds rate (the short-term
interbank lending rate) target range from 0%-0.25% in March to 2.25%-2.5% in July 2022 in an attempt
to reduce inflation, as required by its statutory mandate. But long-term rates have increased even more
than the federal funds rate in 2022 and started rising before March. And the rise in long-term interest rates
in 2022 has been global, although less pronounced than in the United States.
Figure 1. Selected Interest Rates
January 1972 to June 2022

Source: FRED.
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Causes and Considerations
Each loan or bond has a unique, market-determined interest rate based on its specific risk profile, but
macroeconomic forces also cause all interest rates to follow similar trends. Three macro trends causing
rates to rise in 2022 are monetary tightening, the economic recovery, and inflation.
First, the Fed has raised interest rates and reduced its holdings of Treasury securities and mortgage-
backed securities. Although the $47.5 billion per month securities holdings reduction is too small to have
much of a direct impact on rates, markets have nevertheless responded to these actions by revising their
projections for future interest rates upward, and long-term rates have risen this year because current long-
term rates are based on expectations of future rates.
Second, interest rates tend to be cyclical because demand for credit is cyclical—when economic activity
and incomes rise, households and businesses want to borrow more, pushing up interest rates. As the
economy has recovered from the recession, credit demand has risen.
Third, higher inflation tends to push up interest rates because investors require higher interest to
compensate for inflation reducing their purchasing power upon repayment. Inflation has risen to about
7%-9% (depending on the measurement used) in the past 12 months from around 1%-2% in the years
before that. Economists distinguish between nominal interest rates, which are not adjusted for inflation,
and real rates, which are. Over time, economic theory predicts that nominal rates will increase by at least
as much as inflation, but so far, nominal rates have not risen as much. Thus, real rates are still very low
compared to earlier decades even though nominal rates have been rising. For example, the federal funds
rate is still negative in real terms (see Figure 2)—meaning the interest paid on federal funds is not great
enough to compensate for inflation. In contrast, the last time inflation was as high as now, the federal
funds rate rose to as high as 19% (around 10% in real terms) before inflation fell.

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Figure 2. Federal Fund Rate
1960-2022

Source: CRS calculations.
Risk-free interest rates fell to unusually low levels because of the recession caused by the COVID-19
pandemic and, before that, the 2007-2009 financial crisis because demand for credit was very low.
Interest rates were also low because of long-term trends related to demographics, productivity, and
saving, as well as the three decades of low inflation until 2021.
If the economy continues to be influenced by those long-term trends, then interest rates are unlikely to
rise to 20th-century levels again. But since the low interest rate environment occurred under continuously
low inflation, high inflation could cause a trend break that pushes real rates higher, at least for a time. And
even if real rates remain low, so long as inflation is high, nominal rates are likely to be higher.
Economic Implications
Higher interest rates put downward pressure on interest-sensitive spending on capital investment,
consumer durables, and residential investment—all three declined in the second quarter. Higher interest
rates (relative to U.S. trading partners) also attract foreign capital inflows into the country, which raises
the value of the dollar, which reduces spending on exports and import-competing goods. The real dollar
index has risen 5% since December 2021. Together, these factors reduce total spending, causing economic
activity to slow. Recent recession fears have revolved around whether the Fed will trigger a “hard
landing” by raising rates too much.

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However, the contractionary effects of recent interest rate increases should not be overstated. Economic
activity is mainly affected by real interest rates, not nominal rates. Monetary policy is still stimulating
activity when real rates are negative. This suggests that nominal interest rates may have to rise
significantly more for inflation to fall. Fed leadership projects that nominal rates will rise to a range of
3.1%-3.9% by the end of 2022. Rates might have to be increased more than planned to successfully
reduce inflation, since, in that range, real rates would still be negative even if inflation fell to 4.8%-6.2%,
as leadership projects.
Financial Implications
All else equal, higher interest rates reduce the value of asset prices, including stocks, bonds, and houses.
Low interest rates are seen as a key factor in the financial boom that followed the COVID-19 outbreak.
That boom has now reversed—in the first half of 2022, the U.S. stock market fell by 20% and bonds fell
by over 10%. So far, overall house prices have not fallen, as prices change far more slowly in housing
markets than in financial markets. Higher rates and higher prices have led to a sharp fall in housing
affordability, however, which, along with declining sales, could presage a housing downturn.
Lower asset prices reduce household wealth and impose losses on the holdings of financial firms. In
addition, companies that have fallen in value could have trouble raising funding in the future.
Budgetary Implications
Low interest rates have allowed the publicly held debt to reach its highest peacetime share of output while
keeping net interest payments on the debt relatively low. If nominal interest rates remain higher,
eventually, as the existing debt is rolled over at prevailing interest rates, net interest will become much
higher. According to the Congressional Budget Office, even small increases in interest rates significantly
increase projected deficits over 10 years. That might crowd out other government spending politically and
reduce fiscal capacity to respond to future recessions.

Author Information

Marc Labonte

Specialist in Macroeconomic Policy

Disclaimer
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IN11979 · VERSION 2 · NEW