The University Record, March 25, 2002

The price of recovery: higher interest rates and inflation

By Bernard DeGroat
News and Information Services

While America’s economic recovery from the recent recession will bring accelerated growth, greater employment and higher corporate profits, it also will signal increased interest rates and growing inflation in the year ahead, say U-M economists.

“If our forecast is correct that the economic recovery will gain momentum as the year progresses, it becomes increasingly likely that the Federal Reserve will begin to move interest rates up,” says Saul H. Hymans, professor of economics.

“Once the recovery is firmly in place, the Fed has two choices—either begin to raise short-term interest rates in a series of steps that will not jeopardize the vigor of the expansion, or wait until inflation is clearly on the radar screen and then move to a restrictive policy to pre-empt the inflation. The former seems to be the lower risk policy and the one we expect the Fed to choose.”

In their annual forecast update of the national economy, Hymans and colleagues Joan P. Crary and Janet C. Wolfe expect the Federal Funds Rate (interest charged by banks when banks borrow “overnight” from each other, and which, in turn, affect consumer interest rates) to increase by 100 basis points in the second half of this year and by 200 basis points over the course of the next year to close 2003 at a level of 4.75 percent.

Short-term interest rates (3-month Treasury bills) are expected to rise above 2.5 percent by the end of this year (up from a current rate of 1.7 percent) and should be at or above 4.25 percent by the end of 2003, the economists say.

Long-term interest rates (10-year Treasury bonds and conventional mortgages) also are expected to increase over the next two years. Mortgage rates are predicted to climb from a current level of about 7 percent to 7.25 percent by the end of 2002 and to 7.75 percent by the end of next year.

Despite higher interest rates and inflation, the national economy is expected register real Gross Domestic Product (GDP) growth of 2.5 percent overall in 2002 and 3.3 percent next year, compared with last year’s rate of 1.2 percent—but still below the 4.1 percent growth rate posted in 2000.

The unemployment rate is expected to steadily improve throughout this year and next, but still will be at 5.5 percent overall for 2002 and 5.3 percent for 2003, compared with rates of 4.8 percent last year and 4 percent in 2000.