Data showing the U.S. economy is growing again has renewed the debate about where interest rates are headed—a question with big implications for both the economy and investors.
The U.S. gross domestic product report released Oct. 29 showed that the economy grew by 3.5% last quarter, a higher percentage than many were expecting, and fixed-income markets took it as a sign that a rate increase will happen sooner. Treasury prices fell after the release of the GDP figure, and the yield on 10-year U.S. Treasuries rose 0.08 points to 3.5%.
That's still a historically low rate, reflecting the fact that the Federal Reserve is holding the short-term federal funds rate near zero in order to stimulate the economy. It's the reason why yields on bank savings and money market accounts are so paltry.
Such low rates aren't sustainable for long periods of time out of fear, among other things, that low rates can overheat the economy, spark inflation, or drastically devalue the U.S. dollar. "At some point the Fed needs to be thinking about tightening monetary policy," says Villanova School of Business economics professor Victor Li.
Reason to Worry About Inflation? So far the Federal Reserve has given no such clues. The Fed's Open Market Committee said in a statement Sept. 23 that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Few expect the Fed to change its stance drastically at its Nov. 3-4 policy meeting.
Many market participants believe the Fed could be forced to raise interest rates much sooner, perhaps in early 2010. Others think the Fed will keep rates steady for several months or even years. The split between these two sides is mostly determined by how quickly they believe the economy can recover from the worst recession in a generation.
"There is some economic momentum that the market hasn't acknowledged," says LPL Financial Chief Market Strategist Jeff Kleintop, who believes the Fed could start raising rates in 2010. The Fed has pumped trillions of dollars into the financial system. A recovery will push that money out into the economy, where it can spike fears of inflation, he says.
By contrast, those who believe rates will stay low are far more worried about the slow economy than rising inflation.
The Fed is "going to find it difficult to raise [rates] much, if at all," argues William Rutherford, president of Rutherford Investment Management. "The economy is still not very strong in spite of the GDP numbers."
First American Funds chief economist Keith Hembre says high unemployment is the main reason not to worry about inflation. "Labor costs are by far the biggest costs in the economy," Hembre says, and the large number of jobless Americans should continue to keep the cost of labor down.
The Fed's Very Fine Line Some worry the high federal budget deficit could push up interest rates. But Hembre argues the deficit could end up constraining economic growth in future years, as the government is forced to raise taxes or cut spending to fill it, a process that could further slow the economy.
The Fed is walking a tightrope: Make clear that it takes the inflation threat seriously, but make sure it doesn't end economic growth before it really begins.
"If they tighten [rates] too soon, before the recovery is stable enough, then they risk further weakening the economy," Li says. "If they do it too late, inflation becomes a problem."
The direction of interest rates can have a big effect on investors.
For example, the financial sector has benefited from lower rates, which has helped banks begin recovering from the huge losses of the last two years. "As rates rise, it raises the cost of borrowing for banks," Kleintop says. "Is our financial sector able to sustain a higher cost to their lending?" he asks, especially if those higher rates occur relatively soon—like in 2010.
Lower interest rates hurt the value of bonds and might also damage the appeal of utility stocks and other equities prized for their dividend yields, Kleintop adds.
Rutherford, who believes interest rates will stay relatively low, is investing money overseas. The reason is that low interest rates would tend to weaken the dollar, which boosts the value of overseas investments. Of course, a weak dollar can also push higher the prices of commodities like raw materials or oil.
An Inflection Point So much of the interest rate outlook depends on where the economy is headed. And, having just moved from recession to growth—for one quarter at least—the economy is at an inflection point. Such moments can be difficult to interpret, says Jerry Webman, chief economist at Oppenheimer Funds. "It's always difficult to know if we're building a trend or seeing a blip," he says. "The question is whether the momentum picks up—or not," he adds.
Interest rates right now are well below normal levels. "If the economy goes back to normal, you can make a case for going back to normal for policy," says Brian Reynolds, chief market strategist at WJB Capital Group.
In other words, Reynolds adds, the Fed's approach is more likely to follow the economy and the financial markets than the other way around. For now, the Fed and investors are both taking a wait-and see-approach, stuck in the same interest rate limbo.