Markets & Economy
What's ahead for interest rates?
April 24, 2014
Catherine Gordon: Joe, as the Federal Reserve continues to wind down its bond purchasing program, what impact have we seen on bond markets in general, and particularly what guidance is the Fed giving us on where interest rates may go from here?
Joe Davis: Sure, well, I think you know we have seen some upward pressure on interest rates, from extremely low levels to still low levels. The 10-year Treasury today is below 3%. And so I think going forward, we will continue to see a stress at the Federal Reserve on forward guidance, meaning underscoring the fact that interest rates are in the short-term, [namely] the Fed funds rate, is going to remain at zero for a very long time. And so in terms of our outlook we came into the year saying that the 10-year Treasury, we're hard pressed to see a rapid rise in the long end of the Treasury curve, say, around 3½%. And in fact, today if anything, rates are somewhat lower. So that underscores our point that inflation and economic fundamentals will ultimately drive when the Fed lifts off of zero, and it's going to be some time after they taper.
And so two things—one is that the threshold for the Fed to deviate from their tapering program is extremely high. We would have to see either extremely strong growth or extremely weak growth, none of which are likely. And so I think we're going to see the end of 2014, the Federal Reserve having ceased adding to their balance sheet, [it] being well north of $4 trillion. And to that point, the continued focus on when the Federal Reserve may raise rates, we continue to be of the mind that more likely than not it will be in the second half of 2015. And that assumes that inflation, if anything, is too low, perhaps at 1% [and] starts to rise to 2%.
So we're critically focusing on wage growth. And so, if anything, inflationary pressures are very mild and tepid, and again that's something we've talked about for several years. So I think it's a good thing we're talking about ultimately the Federal Reserve potentially raising rates, but that is neither imminent nor is it likely to be very rash when they start to raise rates. They may raise rates to perhaps 1%. They may pause and reassess. Real rates will still be low, which means adjusted for inflation, it may be another two years before they normalize policy to perhaps even 3%. So I think these concerns of rapid rises in interest rates, that's not what keeps me up at night. What keeps me up at night is something happens that we don't expect. But I think either of those scenarios are actually fairly low probabilities.
Catherine Gordon: Well, it's certainly a key question on our clients' minds. So thanks for your answer.
Joe Davis: Thank you, Catherine.
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An update from Vanguard Chief Economist Joe Davis
If the U.S. economy continues its modest growth, will interest rates head higher? Vanguard Chief Economist Joe Davis offers his outlook.
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- All investing is subject to risk, including the possible loss of the money you invest.