Rates vs Reality: Why Higher Interest Rates Have Not Impacted the Economy Yet
Photo Credit: Yohan Marion, Unsplash
The Federal Reserve has raised interest rates by over 5% since March 2022. It has been the fastest pace of tightening in decades, but data shows the economy has been resilient thus far. The U.S. economy grew at a 5.2% annualized pace in the third quarter, the fastest since Q4 2021, due to robust consumer spending, increased government spending, and companies restocking inventories. Companies continue to add jobs and increase wages in the labor market, and the current 3.7% unemployment rate is low compared to history. Construction spending rose +10.7% year-over-year in October despite higher financing costs, with activity increasing in both the public and private sectors.
Why are the Fed’s rate hikes having only a marginal economic impact?
The two charts below show a large gap between headline interest rates and the effective rate on existing debt. The first chart below shows the average 30-year fixed-rate mortgage was 7.62% at the end of September. However, the effective interest rate on all existing mortgage debt was only 3.74%, or nearly 4% below the headline mortgage rate. Figure 2 reveals a similar dynamic in the corporate bond segment. The yield-to-maturity on a broad high-yield corporate bond index currently sits at 8.4%, a proxy for what new high-yield borrowers would pay. However, the average coupon on the bonds within the index, which more accurately reflects borrowers’ actual interest rate, is only 6.1%, or 2.5% below the current high-yield borrowing rate.
US 30-Year Fixed-Rate Mortgage
US Corporate High-Yield Bonds
The two charts help to explain the Fed’s limited impact thus far. Many homeowners and companies took out fixed, low-interest-rate loans during the pandemic. While interest rates have increased significantly over the past 20 months, these borrowers’ monthly payments are unchanged, which means their financial situations and spending habits are mostly intact. The gap between headline interest rates and the effective rate on existing debt has shielded the economy from the immediate impact of the Fed’s rate hikes. However, this does not mean the economy will forever be immune to higher interest rates. The gap will likely narrow as mortgages and corporate bonds mature, and borrowers refinance at higher interest rates.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
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