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What is the outlook for interest rates for the rest of the year?

Interest rates are one of the most asked about economic variables. This is because of the important role interest rates play, and because they affect a broad range of activity. Individual households and businesses are affected by changes in interest rates because they change the costs of borrowing as well as the benefits of saving. Indeed, even relatively small changes in interest rates can lead households and businesses to make major decisions about purchasing houses and cars, or investing in new capital equipment. At the same time, overall economic conditions reflect the sum of all individual decisions made by households and businesses, such that changes in interest rates that affect individual decisions also work to influence macroeconomic conditions. That is, rising interest rates that dampen borrowing and spending may also work to slow down the overall economy that can have far-reaching impacts.

Interest rates are also difficult to predict. This is because there are many different factors that influence interest rates. At first glance, it may appear that we only need to discern what the Federal Reserve will ‘do with interest rates’ to know where rates will be headed. While the Fed does exert influence over interest rates, this influence is far from perfect. The Fed itself directly controls only one interest rate. This is known as the discount rate, the rate at which the Fed lends funds to private banks. Other interest rates, including the Federal Funds rate which is fairly directly controlled by the Fed, are ultimately determined by various financial markets.

All of that being said, if we can figure out what the Fed may do, we have a reasonable shot at predicting the course of short-term interest rates. Currently, risks to the economy seem evenly split between higher inflation (which would argue for higher rates to slow the economy) and slower economic growth (which would argue for lower rates to stimulate the economy). Right now, it seems that a safe bet is that the Fed won’t do much to alter short-term interest rates in 2007.

Banks prefer to ‘borrow short and lend long’. That is, banks typically pay rates similar to short-term rates on the funds we ‘lend’ to them via savings. They also tend to charge rates similar to long-term rates on the funds they lend to households and businesses. Therefore, long-term interest rates tend to be pretty important for households and businesses. Longer-term rates, like those on 10-year Treasuries and mortgages, have dipped a bit so far in 2007. If the Fed keeps short-term rates either unchanged or slightly higher, then I expect there to be slight upward pressure on long-term rates. If the Fed does lower short-term rates later this year, then long-term rates may continue to fluctuate around their current levels.

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