How the Stock Market Crash Could Impact Interest Rates

The Federal Reserve may rethink raising interest rates for the first time since 2008. But even if it does, it wouldn't be all bad news for governments.

Traders on the floor of the New York Stock Exchange last month.
(AP/Richard Drew)
Many municipal market watchers have been anticipating a hike on short-term interest rates this year for the first time since the financial crisis. But with new turmoil in the global markets, some believe the Federal Reserve will hold off a rate hike until the end of the year.

The Fed wouldn’t necessarily raise interest rates to counteract the recent stock market slide caused by an economic slowdown in China, said a panel of experts at a Brookings Institution event last week.

“It’s not about the market movements, per se,” said Donald Kohn, a Brookings economic fellow who served on the Federal Reserve Board of Governors during the last financial crisis. “It’s what those movements say about what’s going on underneath.”

The Federal Reserve Bank usually lowers interest rates to spark the economy, by making borrowing easier. The Fed hikes interest rates to slow things down in times of turmoil by making it harder to borrow money.

Many economists are still concerned about slow wage growth, however. Most panelists believe the Fed will likely hold off raising rates in September, citing the need for more information.

“This is about risk management,” said Julia Coronado, chief economist at Graham Capital Management. “The Fed has cultivated this recovery so carefully for seven years -- are you really going to take the risk [that the time is] now?”

Still, most predicted that the board was more likely to raise rates by the end of the year. If so, it would be the first interest rate hike since 2008 and would have an impact on the municipal market. The biggest change, said Matt Dalton, CEO and CIO of Belle Haven Investments, is that fewer governments would be able to save money by refinancing debt. Short-term interest rates in the market would tick upward and fewer governments would choose to issue debt.

But it's not all bad news.

For one, said Dalton, fewer refinancings would shrink the supply in the municipal market. A smaller supply could increase demand for what’s left, which is good for issuers when negotiating their bond sale price.

The other positive is that the Fed’s imminent decision only impacts short-term interest rates, not long-term ones. And in fact, sometimes a hike in short-term rates can actually cause a downward tick in long-term rates -- saving money for governments that can afford to issue long-term debt.

For example, between 2004 and 2006, the Fed raised the short-term rate from 1 percent to 5.25 percent. During that time period, the rates on a 10-year Treasury bond only went up a half percentage point. And yields on the 30-year bonds actually went down slightly. The reason is because when short-term interest rates are increased, it actually dampens the impact of inflation, which is what plays the larger role in setting long-term interest rates.

“I wouldn’t be shocked and actually wake up to see the 10-year Treasury bond go even lower,” said Dalton.

Liz Farmer is a former GOVERNING fiscal policy writer.
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