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What is the Duration of High Interest Rates?

Dr. Alice Mills was considering selling her veterinary practice in Lexington, Ky., this year, but she decided to postpone the move due to concerns about selling in a period of increasing interest rates.

“In a year, I think that there’s going to be less anxiety about the interest rates, and I’m hoping that they’re going to go down,” Dr. Mills, 69, said. “I have to put my faith in the fact that the practice will sell.”

Dr. Mills is one of many Americans anxiously wondering what comes next for borrowing costs — and the answer is hard to guess.

It is expensive to take out a loan to buy a business or a car in 2023. Or a house: Mortgage rates are around 7 percent, up sharply from 2.7 percent at the end of 2020. That is the result of the Federal Reserve’s campaign to cool the economy.

The central bank has increased its policy interest rate to a range of 5.25 to 5.5 percent — the highest level in 22 years — which has led to higher borrowing costs across the economy. The goal is to reduce demand and discourage sellers from raising prices too much, thereby slowing inflation.

But nearly a year and a half into the effort, the Fed is approaching the end of its rate hikes. Officials have projected only one more increase of a quarter point in 2023, and John C. Williams, the president of the Federal Reserve Bank of New York, said in an interview that he didn’t see a need for further hikes.

“We’re pretty close to what a peak rate would be, and the question will really be — once we have a good understanding of that — how long will we need to keep policy in a restrictive stance, and what does that mean?” Mr. Williams said on Aug. 2.

The economy is reaching a turning point, and many consumers are wondering when interest rates will drop, how quickly, and by how much.

“Eventually monetary policy will need over the next few years to get back to a more normal — whatever that normal is — a more normal setting of policy,” Mr. Williams said.

So far, it is uncertain what “normal” means. Fed officials do anticipate cutting interest rates next year, but only slightly — they believe it could take several years for rates to return to a level between 2 and 3 percent, similar to pre-pandemic levels. Officials do not predict a return to near-zero rates like those seen in 2020, which allowed mortgage rates to reach record lows.

This outlook reflects optimism: Historically low rates are typically considered necessary only when the economy is struggling and needs stimulation.

In fact, some economists outside the Fed believe that borrowing costs could remain higher than those seen in the 2010s. This is because the neutral rate — the point at which the economy is neither stimulated nor depressed — may have risen. This suggests that today’s economy may be able to sustain a higher interest rate than before.

Several significant changes may have contributed to this shift, such as the increase in government debt in recent years, businesses moving towards domestic manufacturing and the need for green investments driven by climate change.

Whether this turns out to be the case will have significant implications for American companies, consumers, aspiring homeowners, and policymakers.

Kristin Forbes, an economist at the Massachusetts Institute of Technology, believes it is essential not to focus too much on predicting the neutral rate, as it fluctuates and is difficult to identify in real time. However, she believes it might be higher than in the 2010s. Back then, the economy struggled to recover from the Great Recession and regain its strength.

“Now, the economy has learned to function with higher interest rates,” Ms. Forbes said. “It gives me hope that we’re returning to a more normal equilibrium.”

Many economists believe that slightly higher rates would be favorable. Before the pandemic, declining demand for borrowed money led to lower rates, and the Fed had to lower them to rock bottom during economic crises to encourage spending.

Even near-zero rates were not always sufficient; after the 2008 recession, growth recovered slowly despite the Fed’s efforts to stimulate it.

If the regular demand for money is slightly higher, it will be easier to stimulate the economy during periods of economic difficulty. Lowering rates would attract more home buyers, entrepreneurs, and car buyers. This would reduce the risk of economic stagnation.

To be clear, few prominent economists expect rates to remain as high as in the 1980s and 1990s. Some believe the Fed’s main policy rate could stabilize around 4 percent, while others anticipate it to be lower, somewhere between 2 and 3 percent, according to Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington.

This is because some of the factors that have pushed rates down in recent years are still present and could even intensify.

“Several of the explanations for the decline in long-term interest rates before the pandemic are still with us,” explained Lukasz Rachel, an economist at University College London, citing an aging population and low birth rates as examples.

When fewer individuals require housing and products, there is less demand for borrowing money for construction and investment, naturally leading to lower interest rates.

These factors lead Mr. Williams, the president of the New York Fed, to expect the neutral rates to remain close to their pre-pandemic levels. He also mentioned the shift towards internet services, where streaming a movie on Netflix does not require the same ongoing investment as operating physical video stores.

“We are moving more and more towards an economy that doesn’t require factories and significant capital investment to produce a large output,” said Mr. Williams, adding that he believes the neutral rate is probably just as low as it was.

This has significant implications for monetary policy. When inflation of around 3 percent is taken into account, the Fed’s policy rate is currently around 2.25 to 2.5 percent in real terms. This is significantly higher than the 1 percent or lower level that Mr. Williams considers necessary to have an impact on the economy.

If inflation continues to decline, holding the policy rate steady would inadvertently tighten the economy further in real terms. This would require officials to cut rates to avoid overdoing it, potentially as early as next year.

“I think it will depend on the data, and depend on what’s happening with inflation,” Mr. Williams said when asked if the Fed might lower interest rates in the first half of 2024. “If inflation is coming down, it will be natural to bring” the federal funds rate “down next year, consistent with that, to keep the stance of monetary policy appropriate.”

For Dr. Mills, the Kentucky veterinarian, this could be good news, bringing her closer to partial retirement.

“I would love to get back into zoo work,” she said, explaining that she previously worked with big cats and would love to do so again after selling her cat-exclusive practice. “That’s something for retirement.”

Audio produced by Parin Behrooz.

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