Interest Rates and the Post-Pandemic Economy
The COVID-19 crisis propelled our lives into unknown territory in 2020, including an unprecedented economic shock that upended businesses and disrupted the livelihoods of millions of citizens. A recovery is underway, due most obviously to the successful development of vaccines which have thwarted the spread of COVID and created a degree of optimism that normal times may return. However, a less obvious but very important factor from an economic standpoint has been the exceptional interventions of central banks, foremost among them the US Federal Reserve, which implemented bold economic stimulus measures at the onset of the pandemic. As businesses and financial markets faltered in 2020, the Fed stepped in by slashing interest rates, purchasing securities, directly lending businesses the money they needed to operate, temporarily relaxing regulations, and supporting loans to non-profit institutions (Cheng, et. al. 2021). Among the most important actions was the Fed's decision to drop interest rates to nearly zero.
Of all the tools that the Fed can use, one of the most powerful, fundamental, and far-reaching is their control over interest rates. An interest rate represents the cost of borrowing money, and conversely, the financial return to those who lend it. Put simply, the interest rate is the price of money. From the standpoint of managing the economy at a macro level, the US government controls interest rates through the Federal Reserve and in doing so can influence the waxing and waning of economic activity. When interest rates are lowered, investments and loans are cheaper, and economic activity generally increases. On the other hand, raising rates is a way to manage growth safely and avoid rampant inflation by moderating economic activity (Sastry & Wessel 2021). When interest rates shift, both consumers and businesses react, and their responses to shifts can significantly influence the economy at large.
During the early days of the pandemic, businesses came to a halt, companies were laying off workers, the stock market plummeted, and the banking system underpinning the global economy was at risk of failing. The Fed implemented expansionary monetary policy through lowering interest rates to attempt to slow and eventually reverse the collapse. In effect, this means that the Fed took measures that made investments and loans by companies and individuals cheaper in order to spur economic activity. The two most notable rates that were brought down to nearly zero were the discount rate and the federal funds rate. The Fed charges banks to take out loans through the discount rate, and since it has been lowered to .25% (lower than during the 2008 financial crisis), it has been easier for banks to keep functioning by borrowing from the Fed. In turn, these banks are able to give out loans to their customers and other banks. The second important interest rate is the federal funds rate, which was reduced to a range of 0–.25%, cheapening loans between banks to promote lower borrowing costs in consumer related investments (Cheng, et. al. 2021).
These measures appear to have been successful. The effect of the rate drops rippled through the economy, benefiting both consumers and businesses. For individual consumers, the federal funds rate’s drop impacted mortgages by making it cheaper to borrow money to refinance or purchase a home. In fact, home purchasing and refinancing activity increased dramatically through the pandemic—up 64% from 2019 through 2020 (Consumer Financial Protection Bureau 2020). Consumers also benefited from these measures through the effect on credit card loans, which makes debt cheaper and faster to pay off. On the other hand, this also leads to a risk of overleverage for individuals, meaning they may take out too many loans that they cannot pay off. On the business side, reduced interest rates are supporting a boom in Merger & Acquisition activity. With low rates making capital relatively cheap, a record number of businesses in 2020 borrowed capital to expand their business operations in anticipation of a return to economic normalcy (Dowd, 2021; Dogra & Murugaboopathy 2021). An all-time high of $1.77 trillion in M&A deals occurred through the first four months of 2021, an increase of 124% from the previous year (Dowd 2021). On top of the near zero interest rates, stimulus funding and postponed deals finally entering the market have also been significant factors to this unprecedented surge in deals.
Near zero interest rates have many clear benefits to both individuals and businesses, raising the question as to why they are not permanently kept low. At a macro level, the primary concern is inflation. Persistently low interest rates can “overheat” an economy and cause prices to rise too quickly, creating an inflationary cycle in which prices spiral upward and consumers’ purchasing power declines. In fact, the Fed is currently keeping a close eye on inflation for exactly this reason. Inflation is high at the moment, at around 5.4%, while the ideal rate is considered only 2%. But the Fed has labelled it merely transitory, meaning inflation is temporarily high as the economy gets back on its feet. This helps to justify the low interest rates and encourage continued spending, as consumers tend to spend based on their expectations of future inflation (Glum 2021). Based on concerns about inflation, one of the biggest questions in economics right now is when the Fed will decide to raise interest rates back up to pre-pandemic levels.
It’s a delicate balancing game, and the eyes of the world are on the Fed and the FOMC (see box). Through the rest of 2021 and into 2022, these organizations will keep a close eye on a number of factors, inflation among the most important, to gauge the health of the economy and determine the best time to safely and slowly start raising interest rates again (Khanna & Prasad 2021). Generally, as the economy recovers and stabilizes, interest rates will slowly go back up. In their September 22nd meeting, the Fed stated that for the time being, interest rates will stay near zero (Federal Reserve 2021). Other important measures like tapering off asset purchasing were also indicated to begin later this year and conclude in the middle of 2022. Though tapering will certainly be a target in the near future, the Fed is currently “focused on boosting economic growth versus controlling inflation” (Pound 2021). However, many Fed-watchers believe that interest rates will slowly increase in 2022 to support the Fed’s long-term goal of a 2% average inflation level (Glum 2021).
The FOMC: Staying the Course for Now
The Federal Open Market Committee is the policy-making body of the Federal Reserve. The 12-member committee, many of whom are seasoned economists, meets eight times per year to review the economic outlook and make policy decisions. Their meetings are followed extremely closely by the business and economic community, and they currently face the challenge of unwinding the “sweeping measures” taken to save the economy without risking the recovery. Following their September 22nd meeting, they reported that long-term inflation is still below their goal of 2%, and so despite recent inflationary pressure they will “maintain an accommodative stance of monetary policy,” leaving interest rates at 0 to .25 percent until average inflation has risen above 2% and labor markets have reached maximum employment. So, for now, the FOMC is sticking to the current course (Foster 2021).
References
Dickler, J. “The Fed Is Holding Its Rates near Zero for Now. Here's What It Means for You.” CNBC. CNBC, September 22, 2021. https://www.cnbc.com/2021/09/22/as-the-fed-holds-rates-near-zero-for-now-what-that-means-for-you.html.
Royal, James. “Biggest Winners and Losers from the Fed's Interest Rate Decision.” Bankrate, September 22, 2021. https://www.bankrate.com/banking/federal-reserve/interest-rate-pause-biggest-winners/.
Dowd, Kevin. “Despite Pandemic Fears, a Record-Breaking 'Frenzy' of M&A Activity Is Underway.” Forbes. Forbes Magazine, July 2, 2021. https://www.forbes.com/sites/kevindowd/2021/05/02/despite-pandemic-fears-a-record-breaking-frenzy-of-ma-activity-is-underway/?sh=76224eb12006.
Dogra, Gaurav, and Patturaja Murugaboopathy. “Global M&A Surges to Record High for Third Straight Month.” Reuters. Thomson Reuters, June 4, 2021. https://www.reuters.com/business/media-telecom/global-markets-ma-2021-06-04/.
Khanna, Aryan, and Eswar Prasad. “October 2021 Update to Tiger: The Global Economic Recovery Is in Danger of Stalling.” Brookings. Brookings, October 11, 2021. https://www.brookings.edu/research/october-2021-update-to-tiger-the-global-economic-recovery-is-in-danger-of-stalling/.
Sastry, Pari, and David Wessel. “The Hutchins Center Explains: Quantitative Easing.” Brookings. Brookings, July 29, 2016. https://www.brookings.edu/blog/up-front/2015/01/21/the-hutchins-center-explains-quantitative-easing/.
Cheng, Jeffrey, Tyler Powell, Dave Skidmore, and David Wessel. “What's the Fed Doing in Response to the COVID-19 Crisis? What More Could It Do?” Brookings. Brookings, June 3, 2021. https://www.brookings.edu/research/fed-response-to-covid19/.
“For Release at 2 P.m. EDT September ... - Federalreserve.gov,” September 22, 2021. https://www.federalreserve.gov/monetarypolicy/files/monetary20210922a1.pdf.
“Data Point: 2020 Mortgage Market Activity and Trends,” August 2021. https://files.consumerfinance.gov/f/documents/cfpb_2020-mortgage-market-activity-trends_report_2021-08.pdf.
Glum, Julia. “What Is 'Transitory' Inflation, and When Will Prices Come down?” KOAM, October 16, 2021. https://www.koamnewsnow.com/i/what-is-transitory-inflation-and-when-will-prices-come-down/.
Foster, Sarah. “November Fed Meeting Preview: Is It Finally Time to Taper and What to Do about Higher Inflation?” Bankrate, September 20, 2021. https://www.bankrate.com/banking/federal-reserve/fomc-what-to-expect/.
Pound, Jesse. “Full Recap and Analysis of Fed Decision: Powell's Market-Moving Comments, When the Taper Is Coming.” CNBC. CNBC, September 22, 2021. https://www.cnbc.com/2021/09/22/watch-jerome-powell-speak-after-fed-wraps-up-september-meeting-live-blog.html.