How low can they go? That’s been the question about interest rates for much of the past year as rates reached all-time lows and then went lower still. As a result, the cost of borrowing to buy homes, cars or business equipment is as affordable as ever. This has been a boon for many households and businesses, which have taken advantage of low rates to improve their financial position even as the pandemic has wreaked havoc on the global economy.
These two conditions – low interest rates and a struggling economy – are inextricably linked. The Fed uses its benchmark rate as a critical lever for regulating the national economy and balancing maximum employment with stable prices. During economic slowdowns, the Fed lowers its rate to encourage borrowing by consumers and businesses. Conversely, when the economy is overheating, the Fed will increase its rate to slow the flow of capital and keep inflation in check.
For many households, falling rates are most evident in mortgage interest rates. Over the past decade, 30-year fixed mortgage rates dipped to about 3.5 percent several times. Those were all-time lows until the pandemic, which has seen mortgage rates fall below 3 percent. Homeowners and homebuyers have taken advantage.
Nationally, refinancing activity is up about 46 percent, while purchase activity is up about 17 percent, according to the Mortgage Bankers Association. In Southern Nevada, record-low rates have increased buying power, allowing buyers to get more house for their money and existing homeowners to lower monthly payments, unlock equity or both.
Similarly, many businesses have also taken advantage of the low-rate environment. Whether seeking capital to expand operations or support new investment in production, businesses have been able to benefit by borrowing at extremely low rates. Other companies have benefitted by refinancing existing high-interest loans with lower-rate loans, freeing up cash flow for more productive uses. Falling interest rates on credit cards, auto loans and other consumer credit products have also helped stimulate consumer spending in conjunction with trillions of dollars in federal stimulus programs.
The two federal pandemic-related stimulus packages passed so far have been essential to supporting the national economy, but they have driven federal debt to $27 billion, more than 127 percent of national gross domestic product. This is a concern, for sure, yet the drop in interest rates means the federal government can borrow money at lower costs too. Federal interest as a percent of gross domestic product is currently 1.6 percent, which is slightly elevated but in line with the average rate over the past two decades (and well below levels reported through most of the 1980s and 1990s). The bill on the growing debt load will come due someday; but, for now, the suppressed rate environment does make repayment more manageable.
For all their benefits, low interest rates do come with potential risks. The first is inflation, which results when capital outstrips supply in the economy and drives up prices. This is why the Fed closely monitors inflation in relation to interest rates and raises its benchmark rate when prices start to rise too quickly. I noted earlier how businesses have benefitted from borrowing under low rates, but a concerning trend is that a growing portion of corporate debt is below investment grade, making it a riskier but higher paying proposition for investors seeking higher returns. That risk could manifest later should struggling companies default on their obligations.
Even with the potential risks that come with the low-rate environment, they are still preferable to the alternate scenario of double-digit interest rates that were a reality four decades ago. In the late 1970s, inflation skyrocketed from a manageable 5 percent to a staggering 14 percent in just four years. That period of disorderly inflation prompted record-setting double-digit interest rates as the Fed attempted to temper rising prices. At their highest point, 30-year fixed mortgage rates reached 18.5 percent. Compared to the buying power of today’s rates, that’s the difference between a $300,000 house and a $108,000 house.
I doubt we will see rates at those levels any time soon. In fact, the low-rate environment is likely going to persist into the foreseeable future. While that means good things for anyone who needs to borrow money, I look forward to a return to more normalized rates since that also likely means a return to a more normal national economy and more sustainable balance between those who borrow and those who lend.
Members of the editorial and news staff of the Las Vegas Review-Journal were not involved in the creation of this content.