What's your plan for 5 years of 5% interest rates?

It's a decent possibility.

Photo by Gabriel Tovar on Unsplash

The title of this post deliberately echoes that of one I wrote about 10 months ago, entitled “What’s your plan for a world of 8% interest rates?”. In that post, I recounted a discussion with a real estate developer friend who was worried about what would happen if interest rates went to 3% (they were around 1% at the time). I told him that he should have plans for 8%, because inflation wasn’t about to just go away on its own.

Now, the federal funds rate has reached 4.57%. Futures markets expect the rate to rise to a bit over 5% in June, and then to start to fall later this year:

Source: Atlanta Fed

The Fed’s own projections predict that the rate will peak at about the same rate — just over 5% — in December, before starting to fall.

Why do both markets and central bankers expect rates to peak and fall fairly soon? Probably because inflation has come down from its peak. Headline inflation peaked at about 8.9% in annualized terms back in June of last year and has since fallen to 6.3%:

blue = month/month, red = year/year

Core inflation, which the Fed actually targets, has also showed a less dramatic decrease, of about one percentage point:

blue = month/month, red = year/year

This drop is probably due to a combination of the Fed’s rate hikes — which manage expectations and have restrained asset prices — and the big drop in oil and wheat prices after the initial shock of the Ukraine war.

The drop in inflation has justifiably caused many to breathe a sigh of relief. As long as there no more big shocks, it seems like we’ve probably avoided the dreaded 8% interest rate scenario. And the Fed’s rate hikes have probably reestablished at least some of the inflation-fighting credibility it lost when it refused to start hiking in 2021, which means that the even more terrifying scenario of a runaway inflation spiral is no longer on many people’s minds.

That’s very good news. But it doesn’t mean we’re out of the woods yet, and the projections of a quick peak and decline in interest rates could be very overoptimistic. It’s possible that interest rates might peak in the 5% range, but linger there for years. And if that’s true, a lot of investors and businesspeople who are making plans based on the assumption that rates will be back at 3% in a couple of years could be in trouble.

In fact, there are a couple reasons to think 5% might be the new normal. Some come from economic theory. But one reason is just history — inflation has a nasty tendency to bounce back after a modest decline.

The 1975 scenario