The recovery in the economy will continue to show improvement over the next year, despite the recent rise in interest rates, according to a new report by TD Economics, an affiliate of TD Bank, America's Most Convenient Bank.

"The U.S. economy has repaired much of the damage caused by the Great Recession. The housing market has worked off the excess supply that led prices to plunge, consumers and businesses have paid off debt, and government deficits are improving," said TD Chief Economist Craig Alexander. "All of this sets the stage for an improvement in economic growth over the next several years."

"But stronger economic fundamentals also means withdrawing policy support, and this transition was never guaranteed to go smoothly," Alexander said. "The Federal Reserve's decision not to taper asset purchases surprised financial markets, but it has not changed the fact that interest rates have risen nearly a full percentage point since May. As the Fed itself noted, higher borrowing costs will be a headwind to growth over the next year."

A higher yield environment was always a part of TD Economics' forecast, but the speed of adjustment over the past three months has been faster than expected. As a result, economic growth will be modestly slower than TD's previous forecast in June, but it is still expected to accelerate. TD forecasts real GDP growth to average 1.6 percent in 2013, improving to 2.6 percent in 2014 and 3.1 percent in 2015.

No taper in September, but interest rate impact already being felt...

In one of the most anticipated announcements in over a year, the Federal Reserve surprised financial markets last week by deciding not to taper the pace of its monthly asset purchase program (also known as quantitative easing or QE). Since December 2012, the Fed has been purchasing $85 billion in U.S. Treasury bonds and mortgage-backed securities each month. Citing the improvement in the labor market, Federal Reserve officials began talking as early as May about eventually ending this program. Anticipation that the Fed would taper QE has been a key factor in the rise in interest rates over the last three months.

At their Sept. 18 meeting, the Fed announced it would continue the program indefinitely. The Fed's statement noted that, "the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases." Interest rates fell last week in the immediate aftermath of the decision, but the retracement was small compared to the relatively steady rise that has taken place over the last three months.

"Quantitative easing was never meant to go on forever. The Fed's concern over near-term downside risks has pushed tapering out a few meetings, but the realization that the program will end in the relatively near future means higher interest rates are here to stay," Alexander said.

Record-high affordability a buffer against rising mortgage rates...

The increase in interest rates has not come as a complete surprise. With improved economic conditions, higher interest rates should be expected. However, the speed at which rates have adjusted will slow momentum in the housing market. "Higher mortgage rates reduce housing affordability and make it more difficult for new homebuyers to enter the market," noted Alexander. "They have already resulted in a steep drop in mortgage refinancing and a decline in new home sales."

Fortunately, housing affordability currently sits at record highs. TD estimates that mortgage rates would have to rise to 7 percent before affordability is eroded to its historical average.

America is still building far fewer homes than is required by population growth. With the supply overhang largely worked off, construction will start to catch up. From the current level of 891,000, TD Economics expects housing starts to rise to 1.2 million by the end of 2014, and to 1.5 million by the end of 2015.

Policy uncertainty to continue...

One of the elements cited by Chairman Bernanke in the Federal Reserve's decision not to taper asset purchases was the continued threat of a policy shock from Washington, D.C. Over the next few days and weeks, policymakers in Washington will have to agree on a framework for funding the government and on an increase in the statutory debt limit.

"Failure to extend funding for the government after Sept. 30 or to raise the statutory debt ceiling could result in financial volatility and undermine consumer and business confidence at least temporarily," Alexander said. "We continue to cross our fingers and hope for the best in Washington. It would be nice if we didn't have to get so close to the precipice before we step back."

TD Economics provides analysis of global economic performance and forecasting, and is an affiliate of TD Bank, America's Most Convenient Bank.