Written by: Kealan Bane
Low interest rates are great, until they are not and everyone loves them, until they don't. When the rates are lower, a borrower of money is obligated to pay back less for doing so. Interest rates are manipulated by The Federal Reserve. Over the last two-ish years, The Fed has dropped interest rates drastically. The goal of doing this was to bring more money into the economy after the COVID-19 recession, ultimately resulting in a quicker economic recovery. However, if interest rates are not adjusted back to proper levels, increases in inflations, and unsustainable markets, like housing, will arise. The rates have stayed low, which again, is great until it's not.
Today I will be taking a dive and into some of the forecasts for the World Interest Rate Probability (WIRP) going forward, as well as analyzing the interest rate graphs over time (FEDL01 Index), as well as Consumer Price Index (CPI, inflation) with the goal of finding some possible correlation between these. But first, what is The Federal Reserve Interest Rate?
The Federal Reserve interest rates are commonly known as The Federal Funds Rate and is defined as: the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Or in simple terms: the rate banks charge other banks to borrow money from them overnight.
Now this is very high level, bank to bank, but how about bank to consumers? It is almost like a domino effect. If/When The Fed raises rates for bank to bank transactions, then banks will raise rates for bank to consumer transactions, and vice versa with lowered rates. This also has a domino effect in other markets that are heavily dependent upon rates, like the housing market. Example, low Fed Fund Rate, lower consumer lending rate, leading more people being able to afford bigger/more expensive houses. Fixed Mortgage rates will be one of the first and most affected rates simply because they rely heavily on economy and inflation.
Updated: BREAKING NEWS
The Federal Reserve just announced that they will be tapering their asset purchase program. On a monthly basis, Treasuries cut by $10B and Mortgage Backed Securities by $5B.
When we went into an economic recession due to COVID-19, The Fed started buying $120B a month in US backed bonds each month. Doing this increases the cash supply in the economy but at the same time, decreases interest rates, which in return, causes inflation.
Importance? - When less bonds are purchased, interest rates go up. This is a key indicator into some of the next steps from The Federal Reserve, possible interest rate hikes.
World Interest Rate Probability (WIRP)
Let's take a look at the historical interest rates and future interest rate economic forecasts.
Historical WIRP for US
*I will go into much detail about each chart via the embedded voice over of the article*
What to look for in each chart
1) The Date
- more importantly, was the date pre COVID-19, mid COVID-19 or Post COVID-19
1) The target rate vs effective rate and the difference between the two.
- this shows where the current rates were sitting compared to the target rate.
2) The line data that is composed of all numbers, displayed in the box directly below the target and effective rate.
- this data his shows the date, the percentage of the rate hikes/cuts, and the new implied interest rate.
3) Most Importantly: The Bar Chart at the bottom.
- This chart compiles all of the data from above and builds a chart so we can see the overall trend of interest rates for the year. *Note the overall trend*
- 01/01/2018 - 01/01/2019
Target Rate: 1.50
Effective Rate: 1.33
- data shows interest rate was lower than wanted
- data shows that interest hikes were more prominent as well as increasing proposed rates MoM
- chart shows an overall trend of increasing interest rates for the given year
- 01/01/2019 - 01/01/2020
Pre-COVID-19, up until the last recorded month
- sharp bar chart decrease during the last month is the beginning of COVID-19*
Target Rate: 2.50
Effective Rate: 2.40
- data shows interest rate was lower than wanted
- data shows that interest rates had more fluctuation this year with moderate hikes and cuts, notice an steep cut of rates during the last month.
- chart shows fluctuation between hikes and cuts with a sharp rate decrease at the end of the year.
- 01/01/2020 - 01/01/2021
- In the heat of COVID-19
Target Rate: 1.74
Effective Rate: 1.55
- data shows interest rate was lower than wanted
- data shows that interest rates had contained extreme cuts all year long, with cuts getting even bigger as the year went on. Implied interest rates were dropping each month.
- chart extreme decreases in rates MoM with the last 6 months dropping hard.
Conclusion of all 3 pieces of data:
- Simply put, we can see that interest rates have a history of rising in small increments while in a stable economy. Once COVID-19 came around, interest rates plummeted. The reasoning for these major interest rate cuts is the fact that The Federal Reserve was implementing cuts to make it cheaper for the population to live during a time of excessive job loss and money hardships, as well as purchasing bonds to increase the money supply in the economy and further lower interest rates. First sight of this, according to the data above, was in January of 2020, which is also right around the time COVID-19 concerns rose in the US. From here we see plummeting interest rates for the next year or so, while simultaneously, the economic effects and health concerns of COVID-19 are only worsening. Coincidence? I don't think so.
Imbedded above is the interest rate bar chart from the beginning of this year till just before October. Briefly analyzed we see more interest rate cuts for the first few months of the year, then the interest rates somewhat consolidated up until where we are now. This consolidation is what The Federal Reserve is planning to act on via their newly proposed asset purchase taper. This will result in interest rate hikes.
Ok, we have now seen data on the interest rates leading up to COVID-19, we have seen data on interest rates in the heat of covid as well as current interest rates. How about future interest rates, post COVID-19, as well as The Fed taper? Let's take a look.
Future Forecasts for WIRP for US
*I will go into more detail about each chart via the embedded voice over of the article*
Embedded above we have the future forecasted interest rate probability, focusing on the present, as of today, until February 1st of 2023, post COVID-19.
- Present: 11/03/21 - Future: 02/01/2023
- Post COVID-19
Target Rate: 0.25
Effective Rate: 0.08
- effective rate is much lower than the target rate
- NOTE: both of the target and effective rates are significantly lower than the target and effective rates of the previous years. This is due to the massive rate cuts.
- data that every single date after December consist of an increase in rate hike percentages as well as rapidly and consistent growing implied rates.
- chart data shows drastic increases in interest rates for the foreseeable future.
- taking The Fed's new taper into consideration we can see the plausibility behind this.
-NOTE: interest rates are not expected to increase until March of 2022.
Interest Rate Graph Over Time (FEDL01 Index)
I figured for ease of understanding I would embed a very simplistic graph of the US interest rates over the last 5 years. This graph helps build a mental image of truly how drastically the US interest rates have dropped, as well as tying the historical charts together into one simply understood chart.
1) The Red Line
- this is quickly drawn line to help bring attention to true decrease in interest rates
2) The white percentage calculator with a gold oval in the bottom left corner after the drop
- this feature calculates the true percentage drop in interest rates
-the data true percentage drop in circled in the gold oval
Looking at this line chart we see historical stable interest rate hikes for the past 3 or so years, just like seen in the previous data. More importantly we can see not only how much the rates were cut, but how fast they were cut. We see a -96% drop in rates over a short time span.
Consumer Price Index (CPI, Inflation)
Lower interest rates cause inflation. Like stated earlier, lower interest rates allow for more people to afford more expensive items due to the fact that the repayment amount is much less, or in other terms, borrowing money is cheaper. Lower rates encourage people to go out and spend money because it is "cheaper" in a way. This tactic seems great for bringing more money into the economy to speed up the recovery process of a recession, however when you have more of something, it is worth less, and in this case that "thing" is money. When an economy experiences a mass influx of money entering the system, that money is now worth less, resulting in inflation.
By The Federal Reserve buying bonds, which lowers interest rates, and on top of that, cutting rates even more, sure, they are bringing more money into the economy to help recover from the drastic economic effects from COVID-19, but at the same time they are causing inflation and inflation risk.
Below I will display an easily understood chart that simply graphs the CPI, consumer price index, a.k.a, inflation, over the last 5 years.
1) The Red V:
- this brings attention to the COVID-19 recession
2) The wording "COVID-19 Recession"
- this just labels the red V
Looking at the simple line chart of inflation, it is evident that inflation was in a consolidation period for the last 3 or so years, COVID-19 hit the economy and for a brief moment inflation actually dropped. This is thought to be because the economy was hit so hard and so fast that so much money was taken out of circulation, resulting in a drop of inflation. The Fed quickly saw what was happening and this is when/why they started their asset purchase program and rate cuts to bring money back into circulation. Inflation started to rise back up to usual levels, or easier said, the cut rates and asset purchase program was successful in bringing money back into circulation.
The Federal Reserve continued to cut rates and buy more bonds and inflation kept rising. As a result so much money has been brought into circulation due to cheap interest rates and people buying more stuff. Inflation risk is high now, hence The Fed tapering bond purchases.
One last graph I would like imbed is the FDEL01 Index overlaid by the CPI Index. This graph simply shows the correlation between decreasing interest rates and increasing inflation.
1) The wording "Interest Rates"
- this simply clarifies which line chart is for interest rates
- the wording is placed over the line chart responsible for interest rates.
2) The wording "Inflation"
- this simply clarifies which line chart is for inflation
- the wording is placed over the line chart responsible for inflation
As seen above, when interest rates drop, inflation rises. This is due to the fact that more money is put into circulation due to the fact that it is cheaper to borrow, so people buy more.
One thing to note is that inflation did not shoot up as soon as interest rates shot down. This is solely because it took time for the people of the United States to realize and comprehend that interest rates are low, and therefore they should buy something. This takes time, hence why it took time for inflation rates to rise on the graph.
The news released this morning about how The Federal Reserve is now planning to taper their asset purchases has been one of the most anticipated releases for months now.
Looking at the data that has been presented: the trillions of dollars The Federal Reserve has spent on purchasing bonds, analyzing the past, present, and future interest rates and forecasts, and inflation movement, it can be seen how certain movements within each affect and cause certain movements of the others as well as affecting the market or economy as a whole.
It will be very interesting to see how the economy and financial markets react to this.
One economic and market response that seems somewhat plausible is, hopefully, a decrease in inflation due to higher interest rates, which weeds out the people living a lifestyle they might not be able to afford if the interest rates were back up to higher more normal rates. This can also have an effect on the roaring housing market we are experiencing, but that topic is for another time.
I hope that the compilation and analysis of correlation for these indicators was of some interest, insight and new knowledge to all who read!