Rising Interest Rates, Part 1: Return to the Natural Level?

This post originally appeared last spring. With a Federal Reserve rate increase largely expected to happen this week, I want to take a look at what happens when rates start to rise.

Although economic growth appears to be slowing, stocks continue to hit new highs. This may lead one to ask, “How does the market retain its strength?” In fact, much of this strength seems to result from the low interest rates provided by the Federal Reserve (Fed). And although it can’t be said exactly when the Fed will raise rates, expectation is currently high that it will happen on December 16. 

So, let’s consider this: What might happen to our investments—stocks, bonds, and everything else—when interest rates are finally allowed to return to their natural level? It is an excellent question, one that will affect everyone who holds these securities (which is to say, almost everyone).

In fact, there are several other questions that should be addressed separately:

1. What is the natural level of interest rates?
2. What's keeping current rates away from the natural level?
3. Will that stop? When?
4. What happens when it does stop?
5. What does that mean for our investments?

Let‘s start with question 1: What is the natural level of interest rates?

The price of money

Interest rates are actually the price of money. As such, they change with the balance of supply and demand for money. Unlike with most goods, though, there is a monopoly provider of money that can and does change the supply whenever it wants—the Fed or, more generally, the central banks. Interest rates are therefore a market, but a manipulated one.

Despite this manipulation, though, there is such a thing as the natural interest rate, one that balances supply and demand. Economic research has defined it, loosely, as the rate of interest on loans that is neutral with respect to prices, and will not tend to either raise or lower them. (A summary is available here.) This is a vague but useful definition, as it situates interest rates squarely within the Fed’s policy concerns regarding inflation and deflation.

How is the natural interest rate calculated?

Before its conclusion in October 2014, the Fed’s stimulus policy was directed at lowering rates by injecting money into the economy via buying bonds. According to basic economics, increasing the supply of money should lower the price (interest rates). It should also act to increase prices, which suggests the lowered rates are below the natural rate, consistent with the definition above.

Depending on how you calculate it, the natural rate of interest comes in around 3 percent. Given the uncertainty inherent in this type of work, that means somewhere between 2 percent and 4 percent. Note that this is a real rate, so we have to add inflation back in, which gives us a nominal natural interest rate of around 4 percent to 6 percent at the moment, theoretically.

A historical rates comparison

Using the Berra theorem—the well-known economist Yogi Berra’s idea that theory and practice are the same in theory but different in practice—we can then compare this with real historical interest rates to see if it makes empirical sense. The chart below shows the rates paid by inflation-adjusted Treasury bonds.

The general range, of around 2 percent to 3 percent before the financial crisis, supports the economic arguments and the decline during the crisis. Add 2 percent to 3 percent for inflation, and we’re right back to the 4 percent to 6 percent that economic theory suggests. The lower rates during and since the crisis largely appear to be due to a “flight to safety” and central bank actions to flood the markets with money; therefore, they seem less indicative of normal rate levels.

Comparing the natural nominal rate of, say, 5 percent with the current rate of around 2.22 percent for the 10-year Treasury bond tells us that, yes, current rates are well below what they “should” be. The Fed has apparently succeeded in its aim, to lower rates below the natural level, but it’s not quite that simple, which brings us to question 2. We’ll take a closer look at that tomorrow.