Beyond the rate hike

Dissecting the impact of the Fed’s worst-kept secret

From the pages of In Business magazine.

Remember June 2006? Pirates of the Caribbean 2, Nanny McPhee, and Big Momma’s House 2 were bringing moviegoers out to theaters, while on the small screen, CSI and its Miami sequel were the only CSIs on the air, and a plane-full of tourists was still trying to figure out why the bushes kept rattling in Lost.

June 2006 also happened to be the last time the U.S. Federal Reserve raised interest rates. Two years later, rates would flatline and remain that way until December 2015, when the highly anticipated 25 basis point raise sent business pulses and news operations aflutter.

After going so long with rates near zero, the news is still alarming to some but delaying a rate increase would have been even more shocking, since the Fed was somewhat at risk of losing face after chairwoman Janet Yellen had been telegraphing such a move over the past year.

The Dec. 16 decision to raise rates by 25 basis points, or a quarter of a percent, is likely the first of many increases, but with rates so low most financial experts agree these won’t break the bank, so to speak, at least initially. The key, everyone agrees, is the speed at which rates continue to rise.

Interest rate hikes have helped spark the U.S. economy since the 1980s, but current weak commodity prices, such as the tanking price of oil, have some economists concerned.

Like so many others, wealth advisor Andrew Burish, managing director of The Burish Group/UBS Financial Services, which manages about $4 billion in assets, had been anticipating the decision. He expects the Fed to continue raising rates cumulatively for 125 basis points through 2016 so that by the end of the year, rates would be about 1.25% higher.

There are several reasons why, he notes, from solid improvements in consumer spending, housing, vehicle sales, and employment. In other words, the economy is on a positive track. “There’s no reason why they shouldn’t start,” Burish says. “Inflation is about 2% and interest rates are lower than that.” In fact, he adds, higher interest rates are actually a sign of a healthy economy.

Historically the nation’s economy has improved after interest rate increases, and since the 1980s there have been five such episodes. While world events may seem more dubious at present, the country’s consumption and domestic demand growth is healthy, writes Mickey D. Levy, chief economist for Americas and Asia at Berenberg Capital Markets, in a recent Wall Street Journal op-ed.

The U.S. economy grew 2.1% in the third quarter of 2015, surpassing a projected increase of 1.5%. Construction and retail activity is up; in both October and November well over 200,000 non-farm jobs were created while unemployment held at 5%.

Another positive outlook: the National Association for Business Economics predicts economic growth to average 2.6% in 2016 (slightly down from 2.7% in September) and expects job numbers to continue to climb. By the end of the year NABE suggests the unemployment rate could fall to 4.7%.

Caution looms

Yet caution still exists. A week before the December meetings, some economists were still sounding alarms and urging the Fed to rethink an increase.

Economic historian Barry Eichengreen of the University of California at Berkeley cautioned Yellen against raising rates in light of falling commodity prices, which some experts blame for igniting the Great Depression decades ago. In July 2014, crude oil was selling for $98.13 a barrel. By December 2015, that price had tumbled to $36.93. That drop, Eichengreen says, will prevent inflation from reaching the Fed’s 2% target.

He also worries about the Fed having to backtrack in 2016 due to “a troubled external environment.” Despite his misgivings Eichengreen still anticipated the rate hike.

Corey Chambas, CEO of First Business Financial Services, was also in the caution camp prior to the Fed’s announcement and on the fence as to whether rates should increase at this point in time. “The economy is still tippy,” he acknowledges. “I would characterize it as okay but no better than that.”

Recent announcements from Kraft/Oscar Mayer and Tyson Foods fuel Chambas’ uneasiness. Both large employers will be shutting their local doors in the near future. “We don’t have people talking about growing or adding new equipment,” Chambas states, “and when people or companies continue to downsize and cut costs, that tells me the pie is not growing.

“That’s the problem with being in a world economy that isn’t strong. If it weren’t for the rest of the world we’d be stronger.”

Another consideration sparking the Fed’s decision, he opines, was the threat of them losing credibility if they didn’t act. “A year ago everyone was very, very convinced that they would raise rates early or certainly by the summer of 2015. They didn’t.

“Sooner or later the market would start not believing them.”



Flawed rationale?

Like many others, Demetri Delis, senior econometric strategist for Piper Jaffray & Co. in Chicago, is not at all surprised that the Fed raised interest rates. “The market was waiting for it, pricing it in, and expecting it.”

“The Fed is not naïve. They can go back on their decision if it doesn’t pan out as hoped.”— Demetri Delis, senior econometric strategist for Piper Jaffray & Co.

Yet, in his opinion, the data they used to sway the argument for a rate increase was not at all supportive of the hike.

“They’re going to try to raise rates when everybody else in the world is becoming more competitive? Japan, China, and Europe are all devaluing their currencies to make their exporting capabilities more competitive so they can fend off the strengthening U.S. dollar.” A stronger U.S. dollar makes it difficult for American manufacturers to compete against foreign companies that can sell their products at much cheaper prices.

The nation is in a sort of psychological funk with worries of terrorism running rampant and equity markets dipping as of late. “The current rate environment is neither normal nor healthy,” notes Chambas.

Historically, retirees or baby boomers hoping to retire could count on interest earned on their savings, but that train left the station long ago. “It is not a good scenario,” he states.

From that perspective, the decision to raise rates may be good news and good timing, but Chambas also believes the Federal Reserve was between a rock and a hard place. Either the economy is strong enough to handle it or it’s not, which could push the country toward another recession. “Then everyone loses.”

How fast is too fast?

“The Fed is not naïve,” Delis insists. They can go back on their decision if it doesn’t pan out as hoped. Nothing will really change with the first announcement of a 25-basis point increase. “Had they said there would be many more [increases] without trying to absorb whatever is happening in the market already, the market wouldn’t take it well. At that point I think equities would start taking a dive.”

A gradual rate increase is important for another reason, as well: a rapid increase in rates would drive up the federal government’s borrowing costs and put upward pressure on the annual deficit, which currently stands at about $564 billion.

Meanwhile the national debt, or the cumulative amount of money the U.S. owes its creditors, stands at a record $18.5 trillion.

The subsequent rate increases will be gradual with Yellen promising careful examination of the economy’s response, and the market will hang on her every word. Flexibility is key and the ability to respond to changing conditions essential. The latest projections are for rates to be at 1.375% by the end of 2016, 2.375% a year later, and 3.25% by the end of 2018.

Burish agrees that a slow increase in rates is good. “It’s like turning up the temperature a bit.”

Cheers and jeers

Chambas says savers, or people with money markets and CDs, will benefit from the Fed’s latest move, as will the banking industry, particularly large banks that have had their net interest margins eroded over the last few years.

And now that the Fed pulled the trigger, the winners, Delis says, will also include the Chinese, Japanese, and Europeans because of their export capabilities. The American public will be able to cash in on lower prices for imports such as automobiles and electronics but unfortunately at the expense of the nation’s manufacturers, who will be hurt once again.

Borrowers such as commercial developers who are itching to get projects built will also be impacted but not much, according to Chambas. “But the reality is, if there’s a project — an apartment building or office building — that made sense with prime at 3.25% but doesn’t make sense with prime at 3.5%, it just doesn’t make sense!”



Insurance assurance

How interest rates affect the insurance industry

One of the winners of the Fed’s rate hike, assuming increases continue, is the insurance industry, but industry executives don’t expect too much.

“First of all, this rate increase will be insignificant across the board,” states Peter Pelizza, CEO and executive vice president of Rural Mutual Insurance Co., “It’s still a non-issue but comes with a lot of hype.”

“We have a frozen pension plan that is very interest sensitive.”
— Peter Pelizza, CEO and executive vice president
of Rural Mutual Insurance Co.

He may not be doing cartwheels yet, but clearly the Fed’s decision to increase interest rates is welcome news for the insurance industry. As the state’s largest Wisconsin-only insurer, Pelizza’s company provides insurance for auto, home, farm, and commercial lines. He recently explained how interest rates affect the insurance industry: “We have investment portfolios and things called surplus, a policyholder reserve fund, or money set aside to pay claims,” he says. “Insurance companies need so much surplus to stand behind their premium so the more they can grow their surplus, the more premium they can write.”

Companies look for ways to invest premium dollars to receive the best yields. Those investments must be protected and the bond market has not been kind. “If you’re looking for safe havens, whether bond markets or anything other than equity or fixed-income type of investments, our yield on our investment portfolio is horrific, relatively speaking, or 2.2% to 2.3%.”

An interest rate hike generates more surplus and lets insurance companies support more premium. Sometimes, Pelizza says, that results in lowered rates, making the price more attractive to policyholders, and that often creates a win-win situation for the industry and consumers. It won’t happen with just a 25 basis point increase, he admits, because inflation runs contrary to that. It might take a two- to three-percentage point rise before insurance companies or consumers see such advantages but the increases need to start somewhere.

Interest rates also cross over into pension plans. “We have a frozen pension plan that is very interest sensitive,” Pelizza says. “As interest rates go up it puts the pension plan in a better position because it improves the plan’s liability position.”

Insurance companies with pensions or frozen pensions carry that on their balance sheets and must continue to fund it. As interest rates rise a pension plan becomes more attractive, the need to fund it eases, and those dollars can be used elsewhere.

“We’re on a pretty well-funded basis,” Pelizza says of Rural Insurance’s plan, “but ultimately to be 100% on our long-term liability we need interest rates to go up 2%. That’s our pension plan and believe me that’s better than most out there.”

Philosophies vary in the industry, he explains. “Life insurance companies are more directly impacted by interest rates, I believe, than are property-casualty companies.”

Good property and casualty companies should make money from operations, not investments. “We are going to make money from writing an auto policy at $100, paying out so much in claims and expenses, and at the end of the day making a penny. They don’t say, ‘we will write this, lose a penny, but make three pennies in investment.’”

Good insurance companies don’t look for investment to be the answer to making money, he explains. “After everything that happened in the financial collapse of 2008 and 2009, why would you put yourself in a position that’s out of your control? As long as we can make money from operations — make the penny — we’re okay.”

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