SC Connecticut News

The Federal Reserve is anticipated to cut interest rates in September. This has led to questions about whether borrowers should wait to take out loans. Research indicates that many individuals mistakenly delay taking out mortgages or other long-term loans in hopes of securing a lower interest rate following the Fed's expected rate cuts.

"Our research shows that there is actually no reason to wait," the study notes. "The current interest rate on long-term loans has already dropped to reflect information about future anticipated cuts to short-term rates."

Similarly, when the Fed announces plans to gradually raise interest rates, people often rush to lock in long-term loans before further increases. However, this too is a mistake. The announcement causes an immediate jump in long-term rates, negating any advantage of rushing into debt.

"In both cases, people fail to recognize that the current long-term interest rate already reflects the average of expected short term-interest rates over the life of the long-term loan," researchers explain. Long rates have priced in all public information about Fed policy regarding short rates, and expected future changes in short rates do not predict corresponding changes in long rates.

This misconception extends beyond households; corporate managers and bond investors also erroneously believe they can forecast future changes in long-term interest rates based on expected changes in short rates. Even professional forecasters make similar errors.

"This confusion occurs because people lump short- and long-term interest rates into the same coarse category of 'interest rates,'" researchers state. Categorical thinking leads individuals to overlook differences within categories, causing reasoning errors.

The misconception can impact economic effectiveness as well. When the Fed announces plans for gradual rate increases, immediate rises in long-term interest rates are intended to reduce borrowing and slow economic activity to combat inflation. However, households and firms often rush to borrow before further increases, potentially adding inflationary pressure instead.

"Surprisingly, we find that categorical thinking about interest rates increases with education and income," researchers reveal. Sophisticated actors who control significant investment dollars are more likely to make this mistake due to their knowledge of anticipated Fed policy on short-term interest rates.