When the Fed restores interest rates to normal, how do we decide what “normal” is?

Since the financial crisis struck in 2008, central banks around the world have embarked upon what has become known as ZIRP, or, “zero interest rate policy.”  Largely, this means keeping interest rates as low as possible so as to protect borrowers and industries dependent upon borrowing (housing, auto’s, etc.) from insolvency.  Of course, a critical lesson learned from the policy mistakes made during the Great Depression was to keep money flowing and lending active, as well as keeping interest rates low in order to spur economic growth.

For the past several months, the U.S. Central Bank (Fed) Chair, Janet Yellen, has telegraphed to capital markets that interest rates would eventually be allowed to rise.  Many pundits have parsed her words to try to decipher the timing.  Left unparsed, though, was at what level interest rates would be thought to have reached “normal” levels.

We have been pondering this.  We all remember the painfully high interest rates in the 1980’s, when mortgages were being taken out in the high teens.  Certainly, that cannot be considered “normal.”  It is equally absurd to think that 30 year U.S. Treasury Bonds should yield less than 3%, as is the case today.

Barry Ritholtz, a capital markets observer, posted a chart of long term interest rates on his website that gives a history going back to 1790 (http://www.ritholtz.com/blog/2012/01/222-years-of-long-term-interest-rates/).  An eyeing of this chart would suggest that over time, the tendency for long term interest rates is about 7%.  This reversion to the mean would suggest a general rise of about four percentage points from current levels.  While there is no reason to expect this rise to happen in the near term, we should remain vigilant knowing that the current level is not sustainable and when sentiment and fundamentals change, rates may rise faster than many are predicting.

As investment analysts, now is the time to discern how a jolt to the status quo may impact the global economy, varying industries and, of course, specific financial instruments.

All questions or comments are welcomed.

Bob Bilkie, CFA®