Can the Economy Handle Current Rates?

We’ve been hearing a lot of debate recently about the U.S. economy’s ability to withstand rising interest rates.

However, as shown in the LPL Chart of the Day, current interest rates are historically low relative to the robust output growth we’ve seen recently, proving that the Federal Reserve’s (Fed) path of increasing interest rates isn’t unusually cavalier given economic strength.

Interest Rates are Historically Low for Current GDP GrowthNominal gross domestic product (GDP), or GDP without removing the inflation component, grew 5.5% year over year through the end of the third quarter, the fastest pace since the third quarter of 2006. In contrast, the fed funds rate was 2.25% on the upper end at the end of the quarter, for a spread of 3.25%. Since the end of 1970, the spread between nominal GDP growth and the upper bound Fed funds rate has been about 1.2%, signaling that the Fed still has ample room for hikes based on output growth.

“The Fed is raising interest rates gradually to keep inflation near the target for price stability and maintain a tight labor market,” said LPL Research Chief Investment Strategist John Lynch. “We still believe the fundamental U.S. economic landscape is compelling, and despite market concerns, monetary policy remains accommodative and the Fed’s plans are data-dependent.”

Of course, we have yet to see the final fourth-quarter GDP numbers. While we believe GDP growth moderated last quarter, we don’t expect significant slowing based on the economic data we’ve seen. Rates are still historically low: the upper bound fed funds rate is 2.5%, while the inflation-adjusted interest rate (or the fed funds rate minus year-over-year Consumer Price Index growth) is 0.3%.

We also don’t expect the current pace of interest rate hikes to threaten this cycle. As we covered on the LPL Research blog earlier this month, inflation-adjusted rates are also well below levels that preceded economic recessions.

Still, the economic environment is complex, and the U.S. economy’s solid progress has contrasted with tepid global growth for most of this cycle. As mentioned in our Outlook 2019, FUNDAMENTAL: How to Focus on What Really Matters in the Markets, we expect the data-dependent Fed to be less aggressive than initially feared as policymakers juggle domestic and global conditions.

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