Mother Nature just dealt our country a major one-two punch in the form of Harvey and Irma – two destructive hurricanes. The carnage left in their wake could end up costing as much as $200 billion to bring southeast Texas and parts of Florida to some semblance of normalcy. The full impact on the economy has yet to be felt, but many experts expect the disasters to put some strain on an economy that was just starting to gain traction. This could result in a pause by the Federal Reserve to continue its policy of short-term interest rate hikes.
What Will the Fed Do?
The Fed has already raised the short-term rate twice in 2017 and it has indicated that it plans at least one more rate hike before the end of the year. There are two more meetings scheduled in 2017.
Generally, the Fed only concerns itself with two major economic factors when determining whether to raise rates: economic growth and inflation. If the economy starts to heat up as indicated by job growth and wage increases then that raises the prospect of higher inflation, which the Fed wants to manage. A little inflation is OK, but the Fed wants to prevent runaway inflation which is much harder to control. So when the economy heats up the Fed applies the inflation brakes by raising the short-term interest rates. Conversely, when the economy weakens the Fed will cut rates just as they did following the Great Recession.
Because inflation has been so low for the past five years, the Fed has kept interest rates near zero in an effort to spur economic growth. Even today, after months of a growing economy, inflation remains below the Fed’s target which makes it difficult to justify further rate increases. If they do increase the rate it will be because of anticipation of higher inflation in the future.
The point of this explanation is to say that if the fallout from Irma and Harvey creates any degree of strain on the economy then the Fed is not likely to add any pressure by raising the rate this year, especially since inflation is still well under control. In fact, some market observers believe the Fed may even lower the rate a notch. Although there has not been much research on the effect of natural disasters on monetary policy, Fed observers believe that big natural disasters tend to put the Fed in a cautious mode. It is more likely to ease monetary policy to offset the negative impact on the economy.
How Will the Bond Market React?
On the other hand Treasury yields have been telling a different story, and they have a much bigger impact on borrowing costs than the Fed rate. Treasury yields have been rising since just before the 2016 election. Bond yields tend to rise during a growing economy mostly in response to investor supply and demand. When the economy is growing, investors move away from lower risk bonds and into higher risk equities. That drives bond prices down which automatically drives their yields up.
As Hurricane Irma was completing its sweep of Florida the yield on U.S. Government debt increased. The 10-year Treasury note rose to 2.125 percent, back near its five-year high. If the yields on Treasuries continue on their current trajectory then borrowing costs for mortgages and student loans will increase.
An interesting study of hurricanes and their impact on the bond market suggests that economic activity generated by the massive rebuilding effort following Irma and Harvey will likely put upward pressure on long-term interest rates. The study found that of the dozen most destructive hurricanes in the past three decades, eight resulted in increased yields on Treasuries within six months after the storms. The average increase was 40 basis points.
The explanation for this is based on the notion that the most destructive hurricanes spurred a greater amount of economic activity through rebuilding. Because the amount of money needed to rebuild after Irma and Harvey is so massive, it’s like an economic stimulus program which will occur in an environment of already increasing interest rates. The study’s authors admit that the findings are not scientific – but the pattern in undeniable. If the pattern continues then we can expect higher long-term rates about six months from now.
What Should Student Loan Borrowers Do?
The timing should be of particular note to student loan borrowers. Each year the Department of Education resets rates on federal student loans for new borrowers and it uses the outcome of the most recent May Treasury auction as its guide. In May of 2017 the yield on 10-year Treasuries increased to 2.4 percent resulting in a 0.69 basis point increase in the federal student loan rates. The next May Treasury auction is months from now.
There’s not much new student borrowers can do except wait to see what the new rates will be next year. However, student loan borrowers who are repaying their loans and may be considering refinancing their loans to lower their interest costs may need to act sooner.
Student loan refinancing is done through private lenders that will take your existing federal and private student loans and consolidate them into a single private loan with a new term and interest rate. Generally, private lenders can offer a lower interest rate which can save the borrower money over the term of the loan. However, to qualify for the lowest rates you, or a cosigner, need to have very good or excellent credit.
>> Read More: How to consolidate student loans
The one big caveat with many private student loans is they are typically issued with variable rates. That means if interest rates continue to rise then the variable rate on the loan will increase as well. In a rising interest rate environment you should only consider private student loans with fixed interest rates. Now would be a good time to lock in a fixed rate because lenders usually tie their rates to an index such as the Prime Rate or LIBOR. If the economy picks up its growth pace, which most economists expect, then private student loan rates will also increase.
Author: Jeff Gitlen
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