Why Higher Interest Rates Haven't Impacted the Economy Yet [Video]

The Federal Reserve recently left short-term interest rates unchanged for their third meeting in a row.  While this rate tightening cycle is likely coming to an end, the Fed has still raised interest rates by more than 5% since March 2022. It’s been the fastest pace of tightening in decades, but the data shows the economy has remained resilient. The U.S. economy grew at a 4.9% annualized pace in the third quarter with robust consumer and government spending.  Companies continue to add jobs and increase wages. The current 3.7% unemployment rate is still historically low. 

Why have the Fed's rate hikes had only a marginal economic impact? As the two charts below show, there is a large gap between headline interest rates and the effective interest rates homeowners and corporations are actually paying on existing debt. 

Figure 1 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% - nearly 4% below the headline mortgage rate:

Figure 2 reveals a similar dynamic in the corporate bond market:

The yield-to-maturity of the ICE BofA High Yield Index sits at 8.4%, a proxy for what new high-yield borrowers pay. However, the average coupon on the bonds within the index, which more accurately reflects borrowers’ actual interest rates, is only 6.1% - more than 2% below the current high-yield borrowing rate.

The two charts help illustrate the Fed’s limited impact on the economy thus far.  During the pandemic, many homeowners and companies took out fixed, low-interest-rate loans. 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 also mostly unchanged. 

The gap between headline interest rates and the effective rates on existing debt has shielded the economy from the immediate impact of the Fed's rate hikes. 

Will the Fed pull off a fabled “soft landing" or will elevated interest rates eventually hamstring the economy?  Stay tuned for more…

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