Borrowers May Be In For Sticker Shock

Faster productivity gains could propel real interest rates to much higher levels

Now that the U.S. economy is finally recovering, what will happen to interest rates? For borrowers and the economy, what matter are "real" rates -- the cost of money after stripping out the percentage that compensates investors for inflation.

Today, real rates are extremely low for short-term borrowing and slightly below average for long-term loans. The federal funds rate of 1%, minus the 2% inflation over the past year, gives a real fed funds rate of -1%. That's highly stimulative. The real yield on 10-year Treasuries is 2.4%, compared with a 40-year average of 2.8%.

But economic theory suggests that faster productivity growth should drive real rates well above their long-term averages over the next couple of years. Productivity growth averaged just 1.4% a year from 1973 to 1995, but 3.2% since, including 5% over the past year. According to what's known as neoclassical growth theory, which most economists accept in some form, an acceleration in productivity induces more business investment to take advantage of new opportunities. That eventually forces up real rates. If they stay too low, the economy would overheat.

How high could rates get? Brace yourself: William Poole, president of the Federal Reserve Bank of St. Louis, told BusinessWeek in November that assuming 3.5% productivity growth, the real long-term rate needed to stabilize the economy over time would be 4.5%, while the real federal funds rate could settle out at "something like" 1 percentage point less than that. Assuming inflation could drift up to 2.5%, Poole's estimates imply a 7% market rate for 10-year Treasuries (compared with 4.4% now) and 6% for fed funds (compared with 1% now). That could shock borrowers.

Poole isn't the only Fed official who sees a link between productivity and interest rates. In a September speech, Fed Governor Donald L. Kohn said that "interest rates eventually must rise after an upturn in productivity growth."

Fed officials say that they don't want to raise rates soon. But neither does the central bank like to get too far behind the curve. In the early 1990s recovery, it lifted the real federal funds rate from -0.3% in 1993 to 3.3% in 1995. If the productivity boom persists, there's a good chance that high rates are soon to follow.

By Peter Coy in New York, with Rich Miller in Washington

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