Waiting for Interest Rates to Rise

Interest rates are at all-time lows. They will rise someday -- likely when the economy recovers.

Why they do, two groups could be caught off guard:

  • Individual investors, who have been plowing money into bonds for the last four years. (Remember, bond prices move inversely to interest rates).
  • Big banks like Citigroup (NYSE: C  ) and JPMorgan Chase (NYSE: JPM  ) , which own a lot of Treasury debt and derivatives tied to interest rate moves.

So the question is, when will interest rates rise?

No one knows, but history tells us loud and clear that the moves could be sharp and out of the blue. Rarely is it a slow crawl upwards. 

Two weeks ago, I sat down with John Taylor, a Stanford economist, former Treasury official, and former advisor to Mitt Romney. I asked him about the history of interest rate moves. Here's what he had to say (transcript follows).

Morgan Housel: Interest rates are near 0% today. They won't stay there forever. The question of how they get back up, do you think it'll be a slow crawl back up or is it going to be a leap back up that's going to take people, and especially banks, by surprise?

John Taylor: Well they'll definitely be a surprise. Even a gradual one will be a surprise because in history, the most difficult thing in central banking to me is really when to withdraw if you like the stimulus and how to create a soft landing, sometimes it's called. And it's the most difficult thing because the instruments are not perfect. The channel from say the Federal Funds rate to the economy is very uncertain. There's always political pressures or judgment calls. In fact it's been rare where we've been unable to avoid if you like the boom-bust and have really a smooth growth and I think the eighties and nineties were really examples where we avoided much of the boom-bust, but it's hard. And that's why I come back at that kind of policy, is where we should try to focus. Not exactly; the world is different, but that kind of steady as you go where people can anticipate. And even if you can see rates are moving up, if you can anticipate that, it's going to be much better than surprise increases.

Morgan Housel: But the history of interest rates definitely supports the leap higher rather than the crawl higher, does it not?

John Taylor: Absolutely, yeah.

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