In an effort to contain inflation, the Federal Reserve ratcheted up the benchmark federal funds rate from nearly 0% in early 2022 to 5.5% by summer 2023…and those rate increases affected Americans in many ways. The rate on the average 30-year fixed-rate mortgage jumped from less than 3% to more than 7%…and rates on 60-month new-car loans rose from around 4.5% to nearly 8%, rendering homes and cars more expensive.
Good news: The Fed’s inflation-control efforts seem to be working—by mid-November 2023, inflation was easing back down to historically normal levels following the pandemic-era surge.
Does that mean inflation and interest rates soon will be back to pre-pandemic levels? Or could they instead rebound to the high levels of the late 1970s and early 1980s? Bottom Line Personal asked economic historian Richard Sylla, PhD, to put today’s rates in context and predict what might lie ahead…
Today’s interest rates aren’t really high. They feel high because rates had been unusually low for nearly 15 years. From a historical perspective, today’s rates are close to normal. As of January 2024, the federal funds rate was 5.25% to 5.5%, roughly in line with the 5.42% it has averaged since 1971.
The low interest rates of 2008 to 2021 aren’t likely to return anytime soon. For the past 150 years, US interest rates have tended to move in long-term trends lasting at least a decade and often several decades. Example: Interest rates generally rose from 1945 to 1981, then generally fell from 1981 to 2021. It seems likely that the Fed’s recent interest rate increases mark the end of the roughly 40-year stretch of falling rates that began in 1981 and the start of a stretch of rising interest rates that probably will last at least 10 years—though there will be short-term ups and downs within that upward trend.
If and when interest rates decline, it’s unlikely that they’ll fall all the way to the very low rates of 2008–2021 when the interest rate on 30-year fixed-rate mortgages was below 5%. Interest rates of that post-Great Recession/pre-pandemic era were not completely unprecedented, but prior to 2008–2021, they tended to occur only when rates were intentionally repressed by the government. Example: Interest rates were very low during World War II and into the late 1940s. That was because the Fed agreed to hold interest rates very low to make the US government’s war debt more affordable.
The historically high interest rates of the late 1970s and early 1980s are extremely unlikely to return. The challenge that faced Paul Volcker’s Federal Reserve in the late 1970s and early 1980s was exceptional—he was trying to exert control over the nation’s money supply and was willing to essentially surrender the Fed’s control of interest rates. That was a fundamental shift in US economic philosophy.
Today’s post-pandemic-era Fed is simply increasing interest rates to reduce annual inflation rates back down to its target figure of 2%. We’re already relatively close to that 2% goal—in January, the official inflation rate fell to 3.4%, down from a peak pandemic-era inflation rate of 9.1% in mid-2022.
It is uncertain if the Fed will continue increasing interest rates until inflation is down to its goal of 2%—it might decide 2.5% or 3% is close enough. So there’s a good chance that rates will remain close to today’s levels for a while.
Inflation likely will remain in the neighborhood of 3% for the coming decade. The Fed’s stated goal is to get inflation back down to 2%. Not only is such low inflation difficult to achieve, it isn’t in the US government’s best interest to achieve it. Inflation is good for debtors—it reduces the value of money those debtors must eventually repay. And the US government has become a massive debtor—the national debt recently surpassed $34 trillion, up from “just” $1 trillion in 1981. The Fed wants to get inflation back under control…but it also knows that having inflation at 2.5% or 3% would have a big economic upside.
Inflation rates remained exceptionally low from 2009 to 2020 because bankers became exceptionally cautious. The Fed added a lot of liquidity to the US economy during and immediately following the Great Recession of 2007–2009. Added liquidity usually spurs inflation—but in that case, inflation never arrived. Why not? The most plausible explanation is that the economy never became overheated because banks were so shell-shocked by the bursting of the real estate bubble, the collapse of Lehman Brothers and the global financial crisis that they held onto money rather than lend it out. New banking rules also encouraged banks to maintain substantial reserves. That was an exceptional situation.
Don’t expect the Fed to change course due to election-year political pressure. Some observers speculate that the Fed might lower interest rates in 2024—the current administration might want lower rates so mortgages and homes become more affordable as the election approaches. But rate reductions are unlikely—the Fed is focused on containing inflation…it tends not to respond to political pressure, and the current administration does not have a history of attempting to sway Fed policy.
Recession remains more likely than a soft landing. Historically, when the Fed aggressively increases interest rates to reduce inflation, the result is a recession. But news that inflation rates are nearly back to normal while the economy remains fairly strong has led to optimism that recession might be avoided.
Despite this optimism, a recession is still more likely than not. Massive government spending appears to be a big part of why the economy has not fallen into recession so far, but that spending could slow. A temporary government shutdown might be all it takes to tip the economy into recession. Or consider the housing market—mortgage rates have shot up so much that buying a home has become far more expensive. Ordinarily, that would cause home values to fall, which could lead to recession—but homeowners responded by opting not to sell their current homes, constricting the supply of homes on the market sufficiently that sales prices remained elevated. Higher mortgage rates could eventually erode home values. The “inverted yield curve” also points to recession. Short-term bonds now are paying higher interest rates than long-term ones—that usually indicates a recession is coming.
Add up the evidence, and the risk for recession in 2024 remains significant…but because it tends to take six months for the data to reveal that the economy is in recession, we might not officially learn about such a recession until early 2025.
Americans in and near retirement age should adjust their investment strategy. Retirees tend to put a hefty percentage of their nest eggs in bonds because bonds are less volatile than other investment classes. But equities and real assets such as real estate have historically fared better than bonds at times of above-average inflation, so it might make sense for retirees to hold more of these than they typically do. This doesn’t mean retirees should have ultra-risky portfolios—they probably should lean toward relatively safe S&P 500 equities rather than speculative small-cap stocks, for example.
