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Rates Are Capped Without Higher Inflation

by Anthony J. Ogorek Ed.D., CFP™

After nearly a decade of falling interest rates, the Federal Reserve raised the overnight rate for banks lending to each other by 0.25%. This move, while not significant signals that the Fed believes the economy is strong enough to withstand a sustained rise in rates. The question on the minds of most people is, how far will the Fed go, and how quickly will they get there?

The consensus opinion is that they expect short rates to rise by a full percent during 2016. The expectation is that they will continue raising rates until the overnight rates reach 3.5%. This may sound like quite an increase from where we have been, however, their target rate is still a full 2% below the average for short term rates over the past several decades.

It remains to be seen how the economy will respond to rising rates. Regardless of the Fed’s wishes or agenda, reality will intrude on their plans. For instance, rising mortgage rates will increase the monthly payment for homeowners who have adjustable rate mortgages, or for borrowers originating new mortgages. In the current low wage growth environment, rising rates would likely eliminate an increasing number of buyers from homeownership – but not due to affordability.

Lenders maintain ratios of income to debt when making loans. If your income remains stagnant, the increased debt load imposed by higher rates will cause lenders to disqualify borrowers who cannot meet their debt ratios. People who hold variable rate loans such as credit cards and variable rate mortgages will be directly affected by rising short term rates. These borrowers have caught a break with cratering energy prices. Rising energy prices will surely limit the Fed’s ability to raise rates much in the future.

Wage growth is the primary driver of inflation. In order for the Fed to hit its rate targets, it is imperative for inflation to rise. Rising U.S. rates will only lower the prices of imports. Without higher inflation, rates cannot rise very much.