Fed’s interest rate hikes may mark start of tough new economic climate

When the Federal Reserve raised interest rates last week by the largest amount since 1994, it did more than declare war on inflation.

The U.S. central bank also launched a high-stakes test of the economy’s ability to shed its dependence on limitless credit and tolerate higher borrowing costs for consumers, businesses and the government.

For 40 years, the formula for U.S. economic growth has been the same: cheap money. Consumers could borrow easily to buy homes and cars. Companies, whether profitable or not, could tap bond investors for cash to fund their operations. And Washington could afford to bail out both Wall Street and Main Street by running eye-popping budget deficits made possible by borrowed funds.

Whenever the stock market wobbled - beginning with the 1987 crash - the Fed rode to the rescue by slashing rates and flooding markets with cash.

Those days are over, at least for now.

“It’s just a completely different environment,” said Eric Winograd, senior economist with AllianceBernstein in New York.

The Fed’s three-quarter%age point increase in its benchmark lending rate this week marked an abrupt end to more than four decades of falling, and ultimately near-zero, interest rates.

The shift has rocked financial markets, driving mortgage rates to their highest level in nearly 14 years, sending bonds into their steepest plunge ever and tanking speculative investments such as technology stocks and bitcoin, a cryptocurrency.

As the economy adjusts, more tumult lies ahead. Consumers, already feeling the pinch of higher prices, will pay more for credit card balances and auto loans. The least creditworthy companies will struggle to raise money needed to hire and expand. And Uncle Sam will face tens of billions of dollars in higher annual interest bills.

American households may find the transition out of the low-rate era particularly challenging. The jump in rates has closed the door on mortgage refinancings, a source of added cash for millions of homeowners over the past year, according to data from the Federal Reserve Bank of New York.

The high inflation that prompted the Fed to act is also making it hard for people to grow their wealth.

“Stocks, bonds and cash - we’re in a bear market for all three,” said Liz Ann Sonders, chief investment strategist for Charles Schwab & Co.

Higher rates already are crimping financing for heavily-indebted companies such as Dunn Paper, a maker of specialty paper in Port Huron, Mich., which missed an interest payment at the end of March. The total value of debt considered “distressed” by S&P Global Ratings has nearly doubled over the past month to $49 billion, including securities from companies such as Rite Aid and Bed Bath & Beyond, as investors demand higher yields from such risky issuers.

The federal government, which spent freely during the pandemic, will also feel the sting of higher rates. Annual interest on the national debt will reach $399 billion this year, according to the Congressional Budget Office.

But that estimate assumes that the government will pay 2.1% to borrow money from long-term bond investors. If instead the yield on the 10-year Treasury security this year averages its current 3.25% figure, taxpayers would pay an additional $32 billion in interest, according to the nonpartisan Committee for a Responsible Federal Budget.

The added interest costs from higher rates alone is more than the combined annual budgets for NASA and the National Park Service.

Interest rates represent the price of money, the foundation of all investment and commerce.

The Fed influences borrowing costs across the economy through its control of the federal funds rate, the price banks pay for overnight loans. That rate, in turn, affects mortgages and feeds into investor calculations of stock and bond values.

As rates increase, the certainty of earning money today from a bond or certificate of deposit becomes a better financial proposition than placing a bet on a risky new technology company that may only begin posting profits in a few years. That explains why the technology-rich Nasdaq index is down roughly 30% this year.

Over the past seven decades, the Fed’s benchmark lending rate has traced an extraordinary arc. From about 1% in the mid-1950s, the Fed funds rate reached a peak of 20% in 1980, before beginning a four-decade slide to the ultralow borrowing costs of the past decade.

Rates began falling in the early 1980s after Fed Chairman Paul Volcker vanquished years of double-digit inflation by raising borrowing costs to previously unheard-of heights. Over the next two decades, the end of the Cold War and economic reform in China brought a massive increase in the global supply of labor and capital, pushing rates down further. Aging populations also contributed to the decline by increasing total savings.

More recently, financial crises led to painful recessions that the Fed sought to remedy by lowering borrowing costs to near zero.

The economy generally prospered during the 1982-2007 era of falling rates, known as “The Great Moderation” for its blend of low inflation and steady growth.

But the period of near-zero rates that followed the 2008 crisis and lasted almost without interruption until this year bred financial excess: companies with chronic financial losses that stayed alive thanks to periodic infusions of inexpensive loans; novel investment structures designed to evade regulatory scrutiny; and trendy stocks that rode a wave of public enthusiasm before crashing against financial reality.

With risk-free savings offering paltry returns, investors flocked to these higher-risk alternatives.

“Zombie” companies, which remain in business only by borrowing money to make their interest payments, proliferated. Among them: Clear Channel Outdoor Holdings, a provider of billboard advertising, which lost money in each of the past two years, yet made more than $710 million in interest payments.

As the stock market nearly doubled from its March 2020 pandemic low, investors over the past two years gravitated to special purpose acquisition companies (SPACs). These were “blank check” shell corporations used to acquire private businesses and take them public without the customary regulatory hurdles. Many became notorious financial debacles, such as electric truck maker Nikola, which went public via a SPAC in June 2020 and saw its share price sink from nearly $80 that month to less than $6 today. The company last year agreed to pay the Securities and Exchange Commission $125 million to settle charges that it had defrauded investors by misleading them about its products, technology and sales outlook.

“Meme” stocks also became fashionable as millions of Americans turned to investing during the pandemic. Early last year, investors on a Reddit message board highlighted shares of GameStop, a flagging video game retailer, and drove them to $347 from $17. Since then, the stock has dropped 60%.

“There was a lot of froth that needed to come out of the markets as a consequence of ultralow rates, which distort the allocation of capital,” said Neil Shearing, chief economist for Capital Economics in London.

The Fed’s rate hikes have made investors more discriminating. In the bond market, investors now demand a greater reward before they buy the riskiest securities.

In January, companies issuing high-yield or “junk” bonds needed only to offer an additional 2.8 percentage points of return above risk-free U.S. treasuries. Now, those companies - already facing a tougher business climate because of a slowing economy - must offer investors more than 5 points of additional yield. The additional expense may make the difference for some between staying in business and going bust.

Easy money also lifted the value of assets - which benefited those who already owned some, thus widening inequality. The wealthiest 1% of Americans own 54% of all stocks and mutual fund shares, up from about 44% when the Fed first dropped interest rates to zero, while the poorest half of Americans now own a smaller share, according to Fed data.

Even as the Fed vows to raise rates steadily over the next year, some doubt its ability to pilot the $24 trillion U.S. economy back to what Fed Chair Jerome Powell this week called “more normal levels” of interest rates and keep it there.

The Fed’s latest projections call for its key lending rate, which was near zero as recently as March, to rise to 3.4% by the end of this year and 3.8% by the end of 2023, which would be the highest levels since 2008.

“This is an economy that is set up for much, much lower interest rates,” said Ajay Rajadhyaksha, global chairman of research for Barclays. “I do not think we will get to 3.8%.”

The Fed’s aggressive, if belated, rate hikes are slowing the economy more quickly than policymakers appreciate, he said. That weakness will eventually force Powell to reverse course.

The Fed’s current rate hike campaign, which began in March, is designed to cool off the worst bout of inflation the U.S. has seen since the Volcker years.

Before the pandemic, policymakers spent years worried that inflation - and interest rates - were too low.

After the 2001 and 2007 recessions, the Fed cut rates by more than 5 percentage points to spur growth. But once it dropped its key rate near zero and held it there for seven years starting in late 2008, officials warned that such aggressive measures would not be possible in response to future recessions.

The unusual recovery from the pandemic recession overwhelmed those concerns. Trillions of dollars in federal stimulus, coupled with the impact of supply chain snarls and the war in Ukraine, combined to drive inflation to a 40-year peak of 8.6%.

Now, the Fed projects its policy rate in the long run will hover at 2.5%, a level it has not been able to hold consistently since the 2008 crisis.

Powell, who was late to recognize the inflation threat last year and was surprised again last month at how quickly prices rose in May, acknowledges the road ahead is unclear.

“No one knows with any certainty where the economy will be a year or more from now,” he told reporters last week.