Interest Rates Will Climb This Year

When the leaves are on the trees, the Fed will start raising rates.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

March 14, 2002

Interest rates are already bounding upward in reaction to the surprisingly strong economic growth this quarter, and they will edge higher during the rest of the year. They're not likely to surge, however, because inflation will remain tame.

Look for 10-year Treasury notes to yield nearly 6% by the end of the year, up from the current yield of about 5.25%. Likewise, the rate on 30-year fixed-rate mortgages will move up from around 7% now to a range of 7.5% to 7.75%, and rates for investment-grade corporate bonds, now about 7%, will also gain a half a percentage point or so.

While the trend for interest rates will be up, the pace will be herky-jerky. When economic growth shows signs of accelerating, nervous bond traders will push interest rates higher. When the speedometer needle drops back down, as we expect during the April-June quarter, rates will drift a bit lower.

On balance, the economy's direction is upward. Jobs increased in February for the first time in seven months, manufacturing production and orders are on the upswing, and retail sales are solid. With indications that housing and automobile sales will remain strong, most signs point to an economy that will put pressure on labor, materials and financial markets. Adding upward push is the stimulus package of extended unemployment benefits and accelerated write-offs for some business investment. The economic boost will be small, perhaps adding 0.2% over the next 12 months, but the $50-billion price tag will add to the federal budget deficit, giving wary bond traders another reason to insist on higher yields.

The strengthening economy will bring the Federal Reserve off the sidelines by summer, when it will start a series of small hikes in the federal funds rate (the rate for money that banks borrow overnight). That will push banks to raise the prime rate, their benchmark for business loans, particularly loans to small businesses. Other forms of borrowing, such as home equity loans and credit cards, are also pegged to the prime, so they'll go up, too. By year end, look for the prime to increase about one percentage point, to about 5.75% from 4.75% now. Other short-term rates will move similarly: Three-month Treasury bills, now about 1.75%, will yield about 3% by year end, and one-year certificates of deposit will go from about 2% now to about 3.5%.

How soon the Fed will move, whether as early as June or a bit later, depends on how policymakers view many different economic signs. The monthly unemployment rate is one of the most important—the Fed will want to see clear signs that unemployment is no longer rising before it hikes interest rates. The jobless rate inched lower in January and February, largely because some laid-off workers stopped looking for work. It will probably bump up a bit between now and midyear before leveling off at about 6%.

Why would the Federal Reserve move when inflation pressures seem to be far off? The Fed would rather avoid inflation with gradual interest rate hikes than be forced into more drastic action once inflation has taken hold. The Fed's aggressive stimulus last year, aimed at averting or softening a recession that's now over, created so much money that "if the Fed maintained this position for an extended period, inflation would develop," says Michael Moran, chief economist with Daiwa Securities America.