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Regional Outlook

Regional Perspectives Higher Interest Rates May Curtail the Region's Economic Expansion Between October 1998 and August 1999, yields on short- and long-term U.S. Treasury securities began to rise. During this period, yields on Treasury securities increased by about 100 basis points, while the yield on the 10-year Treasury bond rose by about 140 basis points. In addition, the FRB raised the Federal Funds rate last summer by 50 basis points, to 5.25 percent. The FRB cited tightening labor markets, the threat of inflation, and a strong national economy as the rationale for the increase. Some analysts believe that left unchecked, continued strong demand for goods and services could eventually push up wages, which could result in renewed inflation and increased interest rates. A study by the Federal Reserve Bank of Philadelphia stated that rising interest rates historically have had a dampening effect on the national economy. The study found that a 1 percent increase in the Federal Funds rate reduced personal income growth in the nation about 1.2 percent.9 Rising interest rates have similarly affected the Region's economic growth. In 1994, the Federal Funds rate doubled from 3 to 6 percent over the course of the year, hindering the Region's economic growth the following year. The Region's combined gross state product fell from 3 percent growth in 1994 to 1.3 percent growth in 1995 (see Chart 3). The relative effect on the nation was less with the gross domestic product dropping 1.2 percentage points to 2.3 percent in 1995. As interest rates gradually eased in 1995, the Region's economic growth started rebounding in 1996. Chart 3 9 Business Review, Federal Reserve Bank of Philadelphia, July-August 1999. Higher interest rates in 1994 did not negatively affect the performance of the Region's financial institutions that year or in 1995. Perhaps because the higher rates led to a slowdown in economic growth but not a recession, the Region's banks reported an average ROA in 1995 near 1994 levels. Average leverage capital ratios rose slightly, and nonperforming and charge-off levels remained low. Further, loan demand did not appear to be slackening, according to merger-adjusted statistics. Higher Interest Rates Curtailed Housing Activity and Capital Gains Higher interest rates in 1994, however, dampened growth in the Region's housing industry. With mortgage rates exceeding 9 percent near the end of 1994, compared with a low of 6.8 percent the previous year, permits for single-family homes dropped 13 percent in 1995 and did not recover fully until 1998. In addition, the volume of existing home sales declined across the Region, and home prices in many parts of the Region fell or showed little increase. The stock market also was negatively affected by higher interest rates. The S&P 500 Index rose only 1.3 percent in 1994. The slowdown in stock price appreciation reduced capital gains realizations in the Region by over 9 percent. Elsewhere in the country, realizations dropped by about 3 percent (see Chart 4, below). When interest rates began to ease and the stock market recovered in 1995, realizations in the Region rose almost 24 percent compared with 21 percent in the rest of the nation. The higher volatility of capital gains in the Region underscores the stronger link between the stock market and the Region's economy relative to the rest of the nation. Also, more households in the Region own stocks and mutual funds now than before, suggesting that the effect of a decline in the stock market on the Region's economy could be more significant than earlier in the decade. Chart 4 With inflation still appearing benign, it is unclear if interest rates will rise further this year and, if so, how much. Perhaps more important, it is uncertain whether, if interest rates rise, the Region's economy would react as it did in 1995. The New York Region Staff Regional Outlook Information Return to Regional Outlook main page