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Interest Rates Get Out The Crystal Ball

Mar 26, 2010

Rates have remained at historically low levels for some time now, so they must be ready to increase, right?  Let’s assume not if but when, so the more important questions are how high and how fast?  That’s the part that requires a crystal ball.  There are so many factors affecting interest rates, where does a person begin when trying to guess what lies ahead?

 

The Federal Reserve Bank (Fed) is responsible for directing the economy using various tools -- monetary plumbing only economists understand.  One of those tools is control of the money supply.  The problem is that over time the Fed has found itself less and less in control of it.  The creation of money market funds, for example, created money in the economy that was outside of the Fed’s direct control.  If the money supply expands beyond the Fed’s targets, inflation is the result.  The opposite is true if the money supply contracts too far.  Plainly stated, it’s more difficult to manage these days.

 

Interest rate levels are another well-publicized tool for the Fed during this current recession.  Because of a dearth of economic activity, the Fed has been able to push rates to historically low levels and keep them there without inflation rearing its ugly head.  Once the economy rebounds (some say the turnaround has already begun), economic activity, along with other factors, will bring pressure to bear that will make increases in interest rates inevitable.  Because of other tools the Fed employed to save the economy from ruin, low interest rates are desirable, but not sustainable.  That’s a different discussion.

 

Rates are going up.  What makes me so sure?  When the economy does claw its way back to expansion mode, the resulting economic activity will increase the money supply, so that is one factor.  As companies grow their operations to meet their customers’ demands, some will need to borrow more money.  Unfortunately, government deficits continue to grow, and the Treasury auctions of debt securities will necessarily increase significantly.  The increase in public debt will compete with financing in the private sector, another factor forcing rates higher.  It’s all about supply and demand – limited supply, more demand, higher rates.  The Fed will be forced to go along to keep a lid on inflation.

So, how high, and how quickly will rates rise?  Even the economists don’t agree. That said, this topic merits consideration because if you borrow money, it’s prudent to look ahead and project the impact increased rates could have on your bottom line.  A good defense requires a good offense.  Revolving debt with a floating rate could be restructured as fixed-rate, long-term debt by using different assets to secure the loan.  An interest rate ceiling could be negotiated with your lender or the rate tied to a different index such as LIBOR, versus the prime rate or a lender’s internal version of it.  Perhaps an alternative borrowing source can be found.  Even if no changes in borrowing structure are possible, long-term financial plans need to make allowance for different possibilities.  Since no one can accurately predict the actual rate scenario, you might want to consider using different rates in projections in three flavors - expected, best case and worst case, just to cover all the bases.  If you need to modify your financial plan or create one if you don’t have a plan, your B2B CFO® partner can assist you.

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