Interest rates are one of the most fundamental features of an economy. They can influence an economy’s performance as well as provide a gauge of its health. Higher interest rates mean fewer people or businesses can borrow money to consume or invest, resulting in a slower economy. Conversely lower rates can help stimulate the economy. Used as a measure, higher rates can indicate a stronger economy since the accompanying stronger demand for loans could drive rates up. Higher rates could also indicate expectations of higher inflation. Conversely, lower rates could indicate a weaker economy or slower inflation. And as a further indicator, the difference between some interest rates can actually provide a good forecast of future economic strength or weakness.
Many interest rates are highly influenced by two types of fundamental rates; U.S. Treasury security rates (yields), and the Federal Funds rate. U.S. Treasury securities, of which there are approximately $20tn outstanding, are critical to the global economy because they are backed by the creditworthiness of the world’s largest economy, they are highly liquid, they are held by investors worldwide, and their rates are set in large, open markets. Every week, investors from all over the globe buy securities from the Treasury, and in turn the Treasury pays the investors back with interest until the securities mature. The Treasury does this because it needs to borrow money every week to cover the federal budget deficit. Treasury securities range in maturities from 30 day bills to 30 year bonds. Perhaps the most influential rate is the yield on the 10 year Treasury note, which is used as a benchmark to set rates on mortgages, credit cards, personal loans, auto loans, student loans, commercial loans, and the Prime Rate. That is why financial market media outlets focus so closely on the “10 year.”
Another highly influential interest rate is the Federal Funds rate. Unlike Treasury yields which are set in open markets, the Fed Funds rate is explicitly pegged by the Federal Reserve Bank. It is the rate that banks lend to each other overnight so that they can cover daily reserve requirements. If a bank has to pay a higher rate overnight, it will in turn have to charge a higher rate on other loans. Therefore the Fed can use this rate to help manage the economy. For example, when the economy is running too fast and unemployment is becoming too low, there is a risk of higher inflation in the future. In this case, the Fed raises the Fed Funds rate to slow the economy, raise the unemployment rate and lower inflation. When the Fed feels the economy and inflation are too weak, and unemployment is too high, the Fed lowers this rate to stimulate the economy.
So short term rates are influenced by the Fed and longer term rates are set in the Treasury market. Normally the Fed does not hold large amounts of Treasury securities, but during the Great Recession, the Fed took the unprecedented step of intervening in the Treasury market to drive down long term rates. The Fed started buying Treasury securities in bulk in the open market, driving up the price of those securities, and driving down their yields (security prices and yields move in opposite directions). This process was called Quantitative Easing (QE) or “expanding the Fed’s balance sheet.” It was a new monetary policy on top of the traditional policy of cutting the short term Fed Funds rate, which the Fed had already lowered to an unprecedented range of 0% - 0.25%.
Now that the economy is back on its feet and unemployment is quite low at 4.4%, the Fed is reversing those positions. It has raised the short term Fed Funds rate four times to a range of 1.0% - 1.25%, which is still quite low, historically. It is likely to raise it again one more time this year and two to three more times in 2018. In addition, it has announced plans to start raising longer term rates by reducing the size of its balance sheet over approximately the next five years. The Fed will do this by gradually stepping out of the Treasury market such that prices will fall and rates will rise. Therefore, the Fed is raising both short term and long term interest rates to stave off future inflation.
What to look for
The Federal Reserve meets to set interest rate policy eight times a year, and most market participants believe that the Fed will hike the Fed Funds rate again at the December meeting, although it is possible at the September meeting. Changes in inflation can also affect interest rates and Fed actions. For instance if unemployment drops even faster than it recently has, and wage inflation results, Treasury yields may rise and the Fed may become more aggressive in its rate increases. A surge in oil prices or other commodities, or a weaker dollar could also increase inflationary pressures and result in more rapidly rising rates. Falling inflation would have the opposite affects, as would more global uncertainty that would cause investors to seek the safety of U.S. Treasuries, again driving prices up and yields down. Fed actions and inflation are the critical developments to look for.
What it means for your business
The Fed will almost certainly continue to drive up short term interest rates, and it seems more probable than not that long term rates will rise as well. These trends are likely to mean higher rates on credit cards which will crimp personal consumption. Higher rates for mortgages and autos will pressure those industries. Higher commercial rates could reduce investments in durable goods, software, IT and telecoms, and even hiring. Businesses exposed to these sectors are at risk that their buyers will come under financial pressure and have difficulty repaying trade debt. A trade credit insurance policy can help mitigate the risks of both slow payment and outright non-payment of accounts receivable.
Euler Hermes provides timely analyses on this and other subjects in our Weekly Export Risk Outlook (WERO), as well as monthly and quarterly analyses on the global macroeconomy and specific countries and industry sectors. Visit the Economic Research section of our website to learn more