Academic journal article ABA Banking Journal

Interest Rates-At a Cyclical and Secular Turning Point

Academic journal article ABA Banking Journal

Interest Rates-At a Cyclical and Secular Turning Point

Article excerpt

TWO MAJOR CHANGES ARE taking place in the financial markets. First, the long-term or "secular" decline in interest rates appears to have ended. Second, interest rates are beginning to experience another short-term or "cyclical" climb as the economy moves further into its expansion phase.

Over the past year, interest rates have moved dramatically. In June 2003, yields on 10-year U. S. Treasury notes stood at just 3.13%--the lowest level in 40 years. In recent months, pricing trends have firmed, suggesting that the basis for last year's low point in interest rates has passed.

Two issues now must be addressed. How quickly might the Federal Reserve raise interest rates during the next one to two years as it shifts policy gears in an expanding economy? How might interest rates behave in the long run?

The Federal Reserve has suggested that it will boost interest rates at a "measured" pace, primarily because it believes inflation will stay relatively subdued. We agree with this assessment. Although the job market has improved, it is not yet tight. Meanwhile, productivity gains should continue to offset upward wage pressure. Worldwide capacity also seems to have enough slack to prevent companies from easily passing on increased costs. As a result, the federal funds rate is likely to rise in 25-basis-point increments, ending this year at about 2.00% and 2005 at around 3.50%.

As investors show confidence that the Federal Reserve has not started too late to control inflation, 10-year Treasury yields should rise relatively modestly in the second half of 2004 to 5. …

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