Higher Interest Rates and Real Growth: Will This Time Be Different?

As we prepare to turn the page and transition into 2015, one big change on the horizon is the expected start to the normalization of monetary policy in the middle of next year. Therefore, one of the major risks to our outlook for the year ahead is the potential for higher interest rates to adversely affect the rate of economic growth. In this report we analyze the relationship between real economic activity and interest rates since the late 1980s. We then extend our analysis further to determine how responsive the real economy has been to interest rate changes during prior Fed tightening cycles. Finally, we conclude with a discussion of how the upcoming Fed tightening cycle may be different in light of credit conditions today.

Our Expectations for Interest Rates Next Year: The Baseline

Our expectation next year is for the Federal Reserve to begin normalizing monetary policy in June by increasing the target fed funds rate (Figure 1). In advance of the Fed’s rate hike, we expect interest rates, particularly at the shorter end of the yield curve, to gradually migrate higher while longer-term interest rates should remain relatively anchored. Thus, our expectation is that the yield curve will become flatter in the coming year (Figure 2). By the end of next year, we see the fed funds rate sitting at 1.00 percent, leading to a prime rate, which is used as a benchmark for many consumer loans, at 4.00 percent. We see the conventional mortgage rate at 4.62 percent. For an example of how flat we expect the yield curve to look next year, we are forecasting the 10-year rate by the end of this year to only rise to 2.86 percent. The changing interest rate environment next year brings to the forefront the question of how the economy will respond to a higher interest rate environment.