Investors have fixated on the Federal Reserve (Fed) and the resumption of its interest rate increases after its March meeting. However, interest rates are subject to more pressure than actions of the central bank. There is also the demand side of the equation. After almost non-existent growth in credit demand since the financial crisis, the U.S. economy might be on the verge of an upsurge in both federal and private-sector borrowing, which could push rates decidedly higher through 2018.

The Fed’s quarterly flow of funds data continue to show why interest rates have stayed so low for so long during this economic expansion. Borrowing in the U.S. capital markets has been the slowest for any cycle in modern times. If demand for credit is weak, the price of credit—interest rates—would likely stay low. Through 2016, there were few signs that this condition was changing.

Faster growth in borrowing and the attendant acceleration in the growth rates of the money supply have often marked the final stages of a cyclical expansion. Stronger demand for credit and Fed tightening typically pushed interest rates to levels that caused recessions. In the 1970s and 1980s it was common to see borrowing in the capital markets at double digit rates. It was as high as 15% per year in 1984-85. Since the beginning of this expansion in 2009, that growth has averaged only 4%. In the very long expansion from 1991 to 2001, that growth was also moderate, averaging 5.5% per year.

In the 1991-2001 expansion, borrowing by the federal government was the weakest. In this expansion, by contrast, borrowing in the mortgage market has been unusually weak. From 2009 through 2014, the amount of mortgage debt outstanding declined–an unprecedented development. Since 2014, that debt has been increasing at only a 2% pace, far slower than at any time in the past 40 years. The chart shows that there has been no net increase in mortgage debt in the past 10 years.

Mortgage debt outstanding in the U.S.

Other sources of credit demand haven’t made up for the lack of mortgage borrowing. Even borrowing by the corporate sector has not been robust—averaging around 5% per year versus near double-digits in previous cycles. Borrowing by state and local governments has also been anemic in this cycle. While business borrowing has strengthened somewhat in the past two years, federal government borrowing has slowed, keeping total borrowing unusually weak for this advanced stage of a cyclical expansion.

The financial crisis created several factors that weakened borrowing

The obvious question is why borrowing is so weak in this cycle. One reason could be low inflation. Inflation rewards borrowers because they pay back debt with cheaper dollars. Inflation also increases the nominal amount of dollars needed to support real economic growth. Low inflation has reduced the incentive and the need to borrow.

An exceptionally slow recovery from the housing bust of 2008-09 is probably another factor. For a variety of reasons, this has been the slowest recovery in housing activity in modern times. By this stage of previous cycles, housing starts were above a 2 million annual rate. Today they are around a 1.25 million pace. A slow pace of home construction has translated into weak demand for mortgage loans.

Tighter lending standards could also be at work. In the wake of a financial crisis, banks and other financial institutions try to make sure that they lend only to the most credit-worthy borrowers. Regulators also insist upon stricter lending standards. Because the 2008-09 crisis was so severe, the tightening of lending standards was also unusually severe.

Watch for an unusual potential convergence of private-sector and government borrowing

If inflation stays moderate and the housing cycle remains subdued, borrowing by households and businesses could continue to increase relatively slowly. That might not be true, however, for the public sector. If defense and infrastructure spending increase sharply, borrowing by the federal government and state and local governments could increase significantly. In theory, that would probably result in higher interest rates.

Borrowing by the federal government typically increases during recessions, not well into a cyclical expansion. Because private-sector borrowing typically declines during recessions, rates can decline even as federal borrowing increases. If, instead, private-sector borrowing is increasing when government borrowing accelerates—a possibility for 2018—pressures on rates could intensify.

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