What is a "Normal" Level of Interest Rates?

What is a "Normal" Level of Interest Rates?

By Financial Advisor Frank Koster

If you have listened to or read the financial news recently, you likely have encountered commentary by countless experts, including economics professors, U.S. senators, and commercial real estate titans, expressing concern about the rising interest rate environment we are currently enduring. Their general concern is that the Federal Reserve will choke off economic activity to an extent that results in a recession, potentially a severe one. Although the pace at which the Fed has been raising rates is unprecedented in the last 40 years, is the current level of interest rates really that onerous? Relative to employment and the rate of inflation (the Fed’s dual mandate), are interest rates excessively high? Let’s look at the Federal Funds rate over time.

The plot above is a roughly 70-year history of the Federal Funds rate. The daily average across the entire period equates to 4.6%. Fed Funds peaked at more than four times that average in 1981. At that time, the spike in the price of oil and commensurate broad-based inflation of the late 1970s and early 1980s induced then Fed Chair Paul Volker to increase the Federal Funds rate to above 20%. This dramatic response highlights the dangers of runaway inflation, as well as how puny the interest rate increases we are experiencing today really are.

The response by the Fed in the early 1980s had the desired effect of cooling the economy, successfully reducing the rate of inflation to acceptable levels over the ensuing years. Since that period, interest rates have been in an overall state of decline, with the Federal Funds rate eventually hitting zero during the financial crisis of 2008-2009.

In the 13 years since the financial crisis, the Federal Funds rate has been held at or near zero for 10 of those years and has not risen above 2.5% until this year. This interest rate period is anomalous, both in terms of the zero lower bound and the length of time these low rates persisted. As I have said often over the course of my career, “anomalous markets often require, or result in, unprecedented responses.” It is no wonder the Fed is raising interest rates at an elevated pace, given the current level of inflation, an exceedingly tight labor market, and the interest rate regime that has persisted for most of the preceding 13 years.

It is difficult to know what the near- or long-term effects on the economy and markets will be, but I like the idea of normalizing interest rates. The cost of capital has been exceedingly low over the last 13 years, which obscures risk and leads to inflated valuations. Normalized rates will have the effect of separating the wheat from the chaff, a process that has already begun.

Mary Daly, President of the Federal Reserve Bank of San Francisco was on CNBC this morning. She shared her view that The Federal Funds rate would likely land between 4.75% and 5.25% during the first quarter of 2023 based on what is known today. If that comes to fruition, referring back to the chart above, that looks pretty normal to me…

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