How High Can Interest Rates Go?

For those of us that tune into the financial news regularly, we know that our central banks – both in the US and in Canada – are a little more hawkish than they’ve been in the past few years. In simple terms, they’re raising interest rates. Slowly.

Generally, interest rates only increase when economic fundamentals are strong. A strong economy is likely to have low unemployment, growing wages, increasing prices, and businesses and individuals that are borrowing to expand and increase consumption.

An increasing interest rate helps limit the flow of money. A higher interest rate means it costs more to borrow, both for businesses and for the consumer. An increased cost of borrowing should correlate into limiting consumption and slowing the rate of ever increasing prices.

Presently, we see a lot of positive economic news coming out of the US: Healthy consumer debt/equity ratios, President Trump’s proposed tax cuts look to incentivize entrepreneurs and big corporations to re-invest and expand in the US, and some of the lowest unemployment rates since 2008.

However, things in Canada aren’t as rosy. There is some uncertainty with NAFTA, higher housing costs, mandated higher minimum wages in some provinces, and we have seen some reports of Canadians having the highest household debt ratios compared against other nations around the world.

Logic would say, the US central bank would be likely to start increasing interest rates on the premise that a lot of economic growth could come out of the US economy very quickly if the stars align.

Likewise in Canada, with higher than average housing costs and consumers willing to shoulder more debt that ever, the Bank of Canada may want to increase rates to encourage consumers to reduce their debt loads.

When we have low interest rates for a prolonged period of time, governments, businesses and consumers tend to take on far more debt. However, this does cause a problem for central banks when they want to increase interest rates to slow price growth. If interest rates are increased too quickly, governments, consumers, and businesses will have a hard time meeting their payment obligations and can lead to default.

A famous cliche is to ask 10 economist what interest rates will do. Ironically, you are likely to get 20 different answers. Simply put, this is an ever changing landscape and no one knows what will happen.

There are two obvious extremes:

  1. Interest rates will continue to increase to much higher levels, however, rate increases may slow down as there is too much debt outstanding at all levels and repayment becomes a challenge.
  2. Interest rates decrease, and continue decreasing into negative interest rate levels. This is likely to see even more debt layered on the average consumer.

Forecasts and predictions are based on prior events and then extrapolated. A more reasonable assumption would be to look at what has happened in the past.

Below is a chart of US interest rates going back 160 years. If you project the trend into the future, the chart could infer that we may have another 30 years of low interest rates (give or take a couple years).

Viewing this logically, we as a society, need a long time span to pay off debt or otherwise accommodate the high amount of debt that governments, corporations, and consumers have accumulated worldwide.


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