Short-term and Long-term Interest Rates: Too High or Too Low?

The Federal Reserve (Fed) has set a goal to lower interest rates by the end of this year. However, for many households and small businesses in the US, interest rate cuts are not happening as quickly as they had hoped. On the other hand, large corporations that can tap into the corporate bond market and investors benefiting from a booming stock market may not find the Fed’s loosening measures necessary.

The Impact of Standard Interest Rate Changes

Changes in benchmark interest rates have a strong impact on various short-term interest rates, such as bank deposit rates and money market funds. However, the impact may be less significant for long-term interest rates, such as corporate bond rates.

Many people believe that the Fed’s target interest rate is restrictive. For Americans, just looking at credit card interest rates reveals a lot. According to the Fed, the average interest rate for commercial bank credit card plans in the fourth quarter of 2023 was 21.5%. This is the highest rate in 30 years but significantly lower than the 14.9% rate in the fourth quarter of 2019, before the pandemic.

A recent study by former US Treasury Secretary Larry Summers and co-authors suggests that high borrowing costs for households could explain the lingering mystery: Why do consumers feel uncertain, despite a strong job market and moderate inflation?

Small businesses also heavily rely on credit cards. According to a recent survey, 56% of them frequently use credit cards for spending. Credit limits are closely tied to short-term interest rates. Credit constraints for small businesses can lead to lower job growth. Businesses with fewer than 100 employees account for about one-third of private employment, and research shows that growing small businesses are a crucial factor in US job growth.

Long-term Interest Rates and Their Behavior

In contrast, long-term interest rates have not surged as much as the Fed’s target rate since the pandemic. The 10-year US Treasury bond rate is currently around 4.3%. Although higher than pre-pandemic levels, historically, this figure is relatively low and significantly lower than the 5% rate seen in the fall of last year.

Back in February 2005, then-Fed Chairman Alan Greenspan declared that low long-term interest rates compared to short-term rates were a “conundrum.” At that time, the long-term interest rate was at a level equivalent to the current one, with a 10-year bond yield of around 4.2%. However, the Fed’s target for the standard interest rate was much lower, at 2.5%.

The relatively low long-term interest rates partly stem from investors’ expectations that the Fed will eventually cut rates. It may also reflect investors’ confidence that the central bank will remain committed to inflation control, according to economist Anna Cieslak of Duke University.

Investors believe that the Fed can control inflation and prevent the economy from falling into a recession. This is reflected in low corporate bond yields and a surging stock market. The spread between treasury bonds and corporate bonds is narrowing. Stocks have also reached new highs, with the S&P 500 gaining over 30% compared to a year ago.

On the other hand, mortgage rates – a critical capital factor for many households – remain significantly higher than pre-pandemic levels, and the spread between mortgage rates and treasury rates continues to increase. High mortgage rates have made homeownership unattainable for many.

As a result, large corporations can easily exploit the public markets with favorable borrowing conditions, while small businesses and households face greater challenges. Meanwhile, increasing stock assets provide a tailwind for the economy. Overall financial conditions in the US are becoming less stringent. According to Fed’s own index, based on a range of measures including overnight interest rates, bond rates, mortgage rates, housing and stock prices, conditions in January were the most accommodative since August 2022.

Economist Jonathan Wright of Johns Hopkins explains, “Ultimately, the interest rate that policymakers can most directly control is the short-term interest rate.”

According to WSJ, the Fed’s decision on interest rates will continue to impact various sectors, affecting the borrowing costs for households, the growth of small businesses, and the overall financial landscape of the United States.

This article was written for Business Today.