Why the Fed may not raise interest rates until late 2015

From the pages of In Business magazine.

Having reached the point of diminishing returns, the unprecedented bond-buying program associated with the Federal Reserve’s quantitative easing has finally ended, with a whopping $4.5 trillion on the Fed’s balance sheet.

The nation’s official unemployment rate has dipped to 5.8%, and the U.S. economy has averaged a healthy 222,000 new jobs per month over the past year.

The economy has also experienced two consecutive quarters of strong economic growth, including 4.2% in the second quarter, and inflation remains low.

So why, even as it announced the end of its bond-buying program, is the Federal Reserve still sending hesitant signals about when it will begin raising interest rates?

Based on previous Fed guidance, most observers assumed the Fed would pull the rate trigger in mid-2015, but after announcing the end of its bond-buying program in late October, the Fed stuck to its “considerable time” guidance on the question of raising interest rates above their historic lows.

After the Fed met some of its benchmarks, including a 6% or lower unemployment rate, its thinking has become a bit more mysterious. “With any indicator they have given us, we reach those corridors and nothing happens, and they continue to delay,” noted financial advisor Nathan Brinkman, president of Triumph Wealth Management in Madison. “That’s the frustration among people who work in the economic and market worlds.”

Whatever the magic elixir, interest rates have been kept artificially low for an extended period of time, and some business executives would like the Fed to stop vacillating. “Right now, we’re all paying 4% for money, or 3.9%, or some ridiculous number that we didn’t dream of ever paying,” said Eric Schwartz, president of the Madison-based Sara Investment Real Estate. “We don’t model those. Good developers don’t model the project on that for the next 10 years. It’d be foolish. We all know it’s coming, so let’s get on with it.”

What’s the problem?

The federal funds rate is the primary interest rate that the Federal Open Market Committee, which consists of seven members of the Fed’s Board of Governors, uses to influence other interest rates in the economy. Changes in the federal funds rate affect bank borrowing costs, and also the returns offered on certificates of deposit, savings accounts, money market accounts, and other bank deposit products.

In addition, such changes dictate changes in The Wall Street Journal’s prime rate, which is the base index for most credit cards, home equity loans, auto loans, and business lines of credit. In fact, many small business loans are also indexed to the prime rate, which has remained at 3.25% since December of 2008 and will remain there for a while longer after the FOMC’s recent vote to keep the target range for the federal funds rate between 0% and 0.25%.

Fed Chair Janet Yellen may have provided a glimpse into her own thought process when she expressed concern about income inequality. Indeed, stagnant middle-class wages are the primary reason people have yet to “feel” an economic recovery that’s now in its fifth year.

Bittles, chief investment strategist for Robert W. Baird & Co., believes the critical measures include wage stagnation and the unemployment rate, which is a bit skewed because so many people have left the labor force, offering a false impression that labor markets are sound. “Now, there are a lot of jobs coming on-stream,” Bittles acknowledged, “but the problem is that there has been no wage growth, so middle-income households and low-income households are still suffering.”

Interviewed in late October, Bittles noted that wages went down two-tenths of a percent the previous month, but ideally they need to grow by about 3.5% to 4%. “They have been growing at about 2%, which is about the inflation rate,” he noted. “Real wages [wages adjusted for inflation] have not grown at all.”

The Fed’s inflation target is 2%, but over the past 12 months, the Consumer Price Index is up just 1.7%. Bittles noted inflation is typically a function of income, and if wages aren’t going up, it’s difficult to generate any sustained inflation. “So I think that’s the first thing the Fed is going to watch — wages,” he stated.

Craig Elder, senior fixed income research analyst for Baird, added that the Fed is looking at average hourly earnings “to see if they can get any pop in them.” First, they’d like to see wage growth of about 3.5% — the first 2% from inflation and 1.5% from productivity growth. “The Fed has got the luxury right now, with inflation being low, that they don’t have to raise rates to fight inflation,” Elder noted. “This is buying them some time.”

What’s a business to do?

How much time the Fed will take is anyone’s guess, but even if it begins raising interest rates late next year, our experts believe it will be done very gradually, so there is very little need to plan for a significantly higher cost of borrowing in 2015. Even if interest rates begin to rise in early 2016, the upward trajectory is likely to be a gradual one.

Elder believes that, when the time comes, the Fed will raise rates by a quarter of a point at each Federal Open Market Committee meeting. The FOMC holds eight regularly scheduled meetings per year, and other meetings as needed. The next regularly scheduled meeting is set for Dec. 16 and 17.

“I think there is a possibility that they would do a quarter of a point and then hold off for a meeting,” Elder said. “They’re going to do it the old [Alan] Greenspan way, but when they do it, it will be very slowly because they are very afraid of raising rates too quickly and looking up a couple of quarters later and finding we’re back at recessionary levels. I think they are terrified of that.”

(Continued)

For business-planning purposes, Elder says it would be wise to plan for modest interest rate changes in 2016. He said the nation’s largest economic problem is the extremely high levels of debt throughout the country, which have “stymied everything.” Servicing that debt, even at low interest rates, is proving difficult. “If rates go up just a little bit, servicing that debt could really be a struggle for the economy, and that’s why I don’t think you could have sustained inflation or sustained high rates, because the debt just won’t allow it,” Elder noted.

One telltale indication of the Fed’s worry lines is that in late 2013, housing was beginning to show some momentum, but that traction was halted when the yield on the 10-year benchmark Treasury note jumped to 3% in January of 2014. That effectively stopped the housing market, which has not fully recovered from that turn of events. “That tells me that at 3% or 3.25%, the economy just can’t absorb that and continue with any growth at all,” Elder said. “I think rates are going to remain lower than most people feel for longer than most people believe because of that.”

Elder also noted the Fed is not just concerned about what’s happening in the U.S., it’s also concerned about what’s happening with the global economy because the European Union is struggling and can’t seem to get out of first gear. China’s growth rate is slowing, and Japan’s large economy continues to be problematic. “The Fed is looking at all that and saying, ‘Well, we better be very careful here,’” Elder said. “The last thing the Fed wants to do is lose credibility. If they raise rates and the economy slumps, they could have a real problem with credibility, and therefore they will be very cautious.”

Brad Hutter, president and CEO of Mortenson Investment Group, a Madison-based commercial real estate and private investment company, noted there is some political pressure to make sure that when interest rates rise, they do so gradually, which would assist businesses with some level of predictability. When interest rates start rising, it will influence the terms of loan refinancing for MIG and other ventures. “We’re either financing very, very short term or floating, or we’re locking up a project as far out as we can,” Hutter noted.

Brent Benjamin, vice president and commercial lender for First Bank Financial Centre in Madison, said rate uncertainty is the reason banks are reluctant to consider loans for terms longer than three to five years. “Lending on a shorter term has been the preference for the last three to four years because mostly, in my opinion, it seems to be a one-way trade,” Benjamin stated. “If interest rates were up around 8% or 9%, the banker might lock in a longer rate, and if rates go down, the bank does better than expected.

“That scenario seems impossible because right now, rates can theoretically only go up. So, when deciding the loan term, the bank is locking in interest rates for borrowers with the assumption that our funding costs could stay the same or go up, but there’s really very little possibility that it could go down much.”

From a planning standpoint, Benjamin noted that lines of credit usually come with variable interest rate financing, but those normally variable rates have not budged since 2009. With lines of credit, the financing covers short-term needs such as inventory or accounts receivables; in normal circumstances (i.e., a stronger economy), businesses usually have to ride out those variable interest rates. “So the questions are: what can you, as a business owner, do in the future if interest rates go up in terms of pricing your product? Is there the ability, if rates go up, that you will be able to charge more?”

In addition, businesses would have to review policies related to their cash cycle and take an inventory of how they are extending credit to customers, how long they should give customers to pay, and how fast they should pay vendors. “Once you start utilizing your line, which might increase in interest cost, those types of things start to cost you more money,” he noted. “Right now, if you are sitting on a receivable from somebody that owes you money for a sale of your widget, you’re not necessarily incurring a large cost waiting for that.

“As rates go up, you’re going to want to pay more attention to that and say, ‘Well, if you don’t pay me in 30 days, I’m going to start charging you interest because I’m being charged a lot of money to wait.’”

For John W. Thompson, president of Thompson Investment Management, it’s worth noting that historically, interest rates on high-quality bonds and loans have been higher than the rate of inflation. “If you use the [recent] increase in Social Security benefits of 1.75% as a gauge of inflation, interest rates should be higher than that,” he stated.

Looking forward, Thompson said one would expect historical norms to reappear. “I don’t think anyone would know when, but it would be normal for short-term Treasury bill rates to equal the inflation rate,” he noted. “Then all other rates would be priced off of that. If it were longer term, the rates would be higher. If there was a credit risk, the rate would be higher for that reason as well.”

In Thompson’s view, if you think the economy will be stronger in the future and the Federal Reserve would not need to be concerned about the economy reverting to recessionary conditions, it would be wise (if possible) to obtain long-term funding now. “We don’t know what the economy or interest rates are going to do, but a businessman should avoid risks whenever possible, and that would mean taking interest rate changes out of the equation,” he advised.

Still psyched out

An incremental increase in rates should not have a negative impact on the economy, but that’s not a sure bet, according to Vern Jesse, an attorney for Murphy Desmond. Jesse, whose legal focus includes real estate transactions, has seen how nervous investors get at the mere mention of interest rate hikes, and he notes there is still a very strong psychological component that lingers from the Great Recession of 2008-09. “If we see some modest interest rate increases, it shouldn’t have any real effect, but I’m not so sure that it won’t,” Jesse said. “That’s my concern.”

“If you get a little bit of a rise — it has to be gentle — it actually would be good for the banks, and it would be good for the government,” noted Schwartz. “In the long run, it would be good medicine. In the short run, it could be painful. Anything drastic will pinch the economy. Psychologically, that’s what we’re all worried about.”

Click here to sign up for the free IB ezine — your twice-weekly resource for local business news, analysis, voices, and the names you need to know. If you are not already a subscriber to In Business magazine, be sure to sign up for our monthly print edition here.