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What If the Fed Funds Rate Normalized?

| MoneyRates.com Senior Financial Analyst, CFA
min read

crumbled_usdYou may have noticed that interest rates are up. Certainly, Wall Street and the White House have noticed. But, while rates have risen over the past couple years, are they really all that high? History suggests that, under normal circumstances, some rates could be much higher.

Knowing where rates would be under similar economic conditions helps put the current rate level in perspective and can help you prepare for what might happen should interest rates normalize.

The Federal Reserve seeks to normalize rates

The question of what is a normal interest-rate level takes on added significance because the Fed's stated policy is to normalize interest rates, but what does that mean?

Well, in response to the financial crisis and the Great Recession a decade ago, the Fed pushed interest rates down to extraordinarily low levels. Now, more than nine years into the current economic recovery, it wants to bring rates back to more reasonable levels. In part, this is to make sure it has some room to lower interest rates the next time a recession hits.

Already, the Fed has raised interest rates by 1.75 percent in a series of quarter-percent moves beginning in December of 2015. That puts the current federal funds rate target range at 2.00 to 2.25 percent.

For some, that is more than enough. Fed rate increases have been blamed for recent volatility in the stock market.

But has the Fed gone too far? History indicates that it hasn't really. Over the past 50 years, fed rates have averaged 5.29 percent, well above the current rate target. Since rates are generally higher in the latter stages of economic recoveries, you could even argue that rates at this point should be above average rather than below.

One thing helping to keep rates lower is inflation's moderate level. Over the past 50 years, inflation has averaged 4.02 percent; but for the past 12 months, it was 2.53 percent. Adjusting historic federal funds rates for today's lower level of inflation yields a "normal' fed rate of 3.79 percent, which is still more than 1.5 percent over today's target range.

What normalization could mean for consumers

Of course, most consumers don't deal in federal funds rates -- what matters to them are things like rates on loans and credit cards. The following are what those rates would look like if they returned to normal -- and what that would imply for consumers.

  1. Mortgage rates
    Thirty-year mortgage rates are currently at 4.8 percent and, despite a substantial rise over the past year, this is still below what historically would be considered a normal level. Adjusting for the prevailing rate of inflation, a historically normal 30-year mortgage rate would be 6.62 percent.

    That means that, even though current mortgage rates may seem high in the context of what people have gotten used to in recent years, they actually could get quite a bit higher. If you have been thinking about buying a house, it might be a good idea to move forward now if you can afford it at current rates. Potential sellers should take note too. If mortgage rates continue to rise, it could put a damper on the market in the future.

  2. Personal loan rates
    The average rate on two-year personal loans is currently 10.12 percent. A historically normal rate adjusted for the prevailing rate of inflation would be 11.65 percent.

    That means that personal loan rates represent a relatively good deal in today's climate, and one that may not last should personal loan rates rise to more normal levels.

  3. Credit card rates
    The average rate being charged on credit card balances has jumped by about 3 percent in the past two and a half years, to 16.46 percent. As a result, credit card rates are now above, rather than below, a normal level based on historical rates adjusted for today's inflation. A normal credit card rate under these circumstances would be 14.58 percent.

    Credit card debt is unusually pricey right now. That makes this a good time to pay down credit card balances, or consider consolidating them into a cheaper form of debt, such as a personal loan.

It should be noted that, to a large extent, consumer interest rates move independently of the Fed. So, regardless of whether the Fed continues to pursue its policy of normalization, history suggests that there is still plenty of room for some interest rates to move higher, especially if inflation continues to gain momentum.

More resources on federal funds rates:

Fed's Low Profile Won't Stop Interest Rates From Rising

Expect More Stable Fed Rates in 2019 After Latest Hike

Fed Rate Increases Not Helping Consumers

Interest Rates Surge Despite Fed's Inaction

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