The last several years we've seen historically low interest rates. Eventually these rates will rise and that may be sooner rather than later. This is the second in a three part series about managing the risk of rising interest rates. Read the first post here.
Interest Rates Forecast to Rise as Economic Indicators Improve
Interest rates have stayed low since the end of the Great Recession in 2009. Whether fixed or variable, low interest rates have been financially beneficial for producers who rely on lines of credit to finance their operations, or who have invested in new equipment, facilities or land with longer-term loans. However, as the economy continues to improve, interest rates are likely to rise.
Fed Funds rate: a harbinger of interest rates
The Fed Funds rate is the short-term interest rate set by the Fed and upon which other short-term U.S. interest rates are based. The Federal Open Market Committee (FOMC) has left the Fed Funds rate at zero since early 2009. Why?
The FOMC has been concerned about the persistently low inflation rate below its 2 percent target level, combined with its assessment of significant slack remaining in the labor force. Low interest rates were intended to encourage economic activity and remove the slack from the labor force, while keeping inflation from falling too far or turning into deflation. Deflation, or falling prices, is harmful to the economy, because it leads businesses and consumer to postpone purchases. The FOMC has also expressed concern over the tepid recovery of the housing market, which produced a surge in foreclosures and short sales. The FOMC responded to this concern by using Fed purchases of mortgage-backed securities and Treasuries to lower longer-term yields to boost home sales and prices.
No one knows exactly when the Fed will raise interest rates. Once it does begin to raise the Fed Funds rate, then normally a series of rate increases follows to keep inflation in check. The Federal Funds Rate chart below shows the previous tightening cycles when the Fed raised interest rates. The chart clearly illustrates that short-term interest rates are likely to move higher from their current levels. If inflation remains close to the Fed’s 2 percent target, then it’s likely the Fed would raise rates more slowly than in previous cycles. However, if inflation increases faster than the FOMC expects, then the Fed would likely respond by faster and more aggressive interest rate increases such as occurred in 1994.
Source: www.federalreserve.gov
Key interest factors: unemployment and inflation
Sources: Bureau of Labor Statistics, Bloomberg Consensus Forecasts, and www.federalreserve.gov
The FOMC has said it is committed to keeping interest rates low until unemployment falls below 6 percent and inflation reaches its 2 percent long-term target. However, now that the unemployment rate has reached 5.9 percent (see Unemployment Rate chart), the FOMC has broadened this goal to encompass a wide set of labor market indicators to ensure that the labor market is fully healed before raising interest rates. Some of these indicators currently show that slack remains in the labor force. As a result, the consensus forecast is for the Fed to wait until the middle of 2015 or later to begin raising the Fed Funds rate.
The FOMC has also expressed concern about inflation remaining below its 2 percent target [see Core Personal Consumption Expenditures (PCE) Price Index chart below]. The majority of FOMC members forecast the core PCE inflation rate to rise over the next few years, which means that the FOMC will likely consider raising interest rates as soon as its employment goals are met, provided this inflation expectation is met. More recently, the FOMC has been concerned that falling oil prices and the stronger dollar may cause inflation gauges to decline. However, the stimulative impacts of lower oil prices on the economy may negate the impact of declining oil prices on core price inflation, which is the FOMC’s focus.
Source: Bureau of Economic Analysis, Bloomberg Consensus Forecasts, and www.federalreserve.gov
The Target Fed Funds Rate table shows the most recent consensus forecast of FOMC members. They expect short-term interest rates to rise from near zero to 2.875 percent by 2016 — and then to 3.75 percent on a longer-term basis when the U.S. economy, the labor market and inflation return to acceptable levels.
In addition to driving short-term interest rates, the Federal Funds rate also usually leads to rising longer-term rates during the early stages of a Fed interest rate tightening cycle. Higher inflation expectations or above-trend economic growth could also contribute to longer-term interest rates rising further than current expectations due to apprehension from longer-term fixed income investors.
Information in this post was provided by AgriBank. AgriBank is FCS Financial’s funding source. It is one of the largest banks within the national Farm Credit System, with more than $80 billion in total assets. Under the Farm Credit System’s cooperative structure, AgriBank is owned by 17 affiliated Farm Credit Associations. The AgriBank District covers America’s Midwest, a 15-state area from Wyoming to Ohio and Minnesota to Arkansas. More than half of the nation’s cropland is located within the AgriBank District, providing the Bank and its Association owners with exceptional expertise in production agriculture. For more information, visit www.AgriBank.com.
