When Will Interest Rates Go Up?

In November, the FOMC announced a plan to taper asset purchases as some measures of economic stability have recovered from their pandemic slump. However, interest rates remain at their lower bound. In addition, inflation is rising at a rate not seen for decades.

Rising input and labor costs have put pressure on businesses nationwide. Many business leaders are now looking to the Fed for guidance on when interest rates will increase and whether rate hikes will slow the pace of inflation.

Current State of the Economy

When determining the appropriate policy response, the FOMC members will consider the economic position of the country as well as the inflation and unemployment rates. Currently, economic output has recovered from pandemic lows, based on GDP. Real GDP has increased in each of the three quarters of 2021. During 2020, real GDP contracted by 3.5%. Estimates for the first three quarters of 2021 showed growth of 6.3% in Q1, and increases of 6.7% in Q2, and 2.1% in Q3. Additionally, GDP has now surpassed pre-pandemic levels. Current dollar GDP in the advanced estimate for Q3 is $23.19 trillion compared to 2020’s $20.94 trillion and 2019’s $21.75 trillion.

During the pandemic, uneven global shutdowns led to serious supply chain difficulties. As a result, prices in many industries rose. Today, supply chains have not fully recovered, and inflation is still rising rapidly. The Consumer Price Index [CPI] rose 0.9% in October, bringing the 12-month increase to 6.2%. This is the fastest 12-month pace since 1990. FOMC members have indicated that inflation could moderate when pandemic-related supply chain issues are resolved, but they have recently removed the word “transitory” from reports.

The spike in unemployment due to the pandemic has moderated as the recovery has progressed. As of November, unemployment was 4.2%, down considerably from pandemic highs but still well above the pre-pandemic level of 3.5%.

FOMC Actions Thus Far

The FOMC announced a tapering plan at November’s meeting. Stating that the substantial further progress test had been met, FOMC members approved a plan to reduce Treasury purchases by $10 billion per month and agency mortgage-backed securities purchases by $5 billion per month. November and December’s reductions were approved at the November meeting, but other monthly reductions will require additional approval. At the current pace of reductions, asset purchases should conclude in summer 2022.

At the 2021 Jackson Hole Symposium, Fed Chair Jerome Powell said that Fed tapering should not be taken as a direct indicator of future interest rate increases. He said that interest rate increases will be based on a “different and substantially more stringent test.” While the Fed chair did not elaborate on the parameters of this test, the recent growth in GDP and consistent job gains have led many to believe that the economy is on track to meet the FOMC’s expectations in the coming months.

Interest Rate Expectations

FOMC projections from September’s meeting show that half of FOMC members predict interest rate increases by the end of 2022 with a median projected Fed funds rate of 0.3% by the end of that year. The other nine members projected that the Fed funds rate will remain at the lower bound through the end of 2022. Looking forward, the median projected Fed funds rate for 2023 was 1.0% with only one member projecting that the Fed funds rate would remain at the lower bound through 2023. These projections show that the FOMC members believe that interest rate increases will be necessary in the near future, but the timing of those rate increases is still up for debate.

Outside of the FOMC’s official statements, there is much speculation among experts about when the Fed funds rate will rise. Reuters conducted a poll of economists in mid-October and, at that time, the majority of economists predicted that the Fed will wait until 2023 to raise rates.

However, after the release of CPI data for October, short term bond yields increased. The yield on the two-year Treasury note jumped nearly 10 basis points to 0.503%. Long term yields have not risen as quickly, leading to a flatter yield curve. A flatter yield curve generally means that the market is expecting the Fed funds rate to rise in the near future. Futures traders are now predicting an interest rate increase by the summer of next year. Many also anticipate a second interest rate increase by the end of 2022.

Managing inflation is one of the core mandates of the Federal Reserve. With current inflation at a three-decade high, many expect the Fed to raise interest rates to combat the rising prices. However, the Fed maintains that the current inflation environment is heavily influenced by pandemic-related supply chain issues. Raising the Fed funds rate is unlikely to help clear up backlogged ports or facilitate smooth transition of products on a global scale. The unique causes of the current inflation make the FOMC’s response more difficult to predict. The timeline for rate increases will likely depend on how inflation reacts when supply and demand forces come into balance when supply chains normalize.

Other factors for the FOMC to monitor when determining the appropriate monetary policy are economic output and job gains. If employment conditions continue to improve at their current pace, and GDP continues to grow, an interest rate increase in mid to late 2022 is likely to be appropriate. More definitive information will be available following the FOMC’s meeting in mid-December when updated projections will be released.

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