Interest Rate Forecast 2016-2017: Fed Likely To Tighten For 2 More Years

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by: Bill Conerly

Summary

The Federal Reserve has finally begun to tighten short-term interest rates, announcing a quarter percentage point increase Wednesday in the target range for the federal funds rate to 0.25 percent to 0.5 percent.

I believe the Fed will push rates up for about two years.

Long-term rates will rise less rapidly, but for just as long.

The Federal Reserve has finally begun to tighten short-term interest rates, announcing a quarter percentage point increase Wednesday in the target range for the federal funds rate to 0.25 percent to 0.5 percent. I believe the Fed will push rates up for about two years. Long-term rates will rise less rapidly, but for just as long.

The Fed rate hikes are likely to be at "half throttle," about one and one-half percentage points per year for two years. The Fed has pushed rates up or down at the rate of three percentage points per year in the past, so expect a milder rate of change this cycle.

Two years from now, at the end of 2017, the Fed Funds rate will sit at 3.25 percent. Relative to the core inflation rate of 2%, this will be just a hair below normal. For most of the coming two years, then, short-term rates will be well under historic norms.

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Long-term rates will rise less rapidly. Bonds and mortgages are somewhat impacted by Fed action but more driven by inflation expectations and global demand for credit compared to the global supply of savings. Inflation is currently low and is likely to remain low, given the expected path of interest rates. The global economic growth outlook is moderate, putting just a little upward pressure on rates. Long-term interest rates will rise by roughly one percentage point per year. The ten-year treasury bond will yield just over 4 percent at the end of 2017, and mortgages will cost 6 percent.

Plenty can go wrong with any interest rate forecast - don't mistake this for an exact science. If weakness in Asia infects the United States economy, then the Fed will suspend rate increases. Weak economic growth would also depress long-term interest rates.

Right now, inflation is not responding to the drop in unemployment. If that changes, then the Fed may feel it is behind the curve and has to accelerate its rate hikes. Inflation forecasts have been notoriously bad recently. I don't expect inflation to accelerate if the Fed tightens, but it's certainly possible. Businesses and investors should be ready for three percentage points of interest rate increase over 12 months, though that's not my most likely forecast.