The following was published in Prairie Business Magazine's February 2018 issue, written by Dennis Walsh, Chief Credit Officer at First International Bank & Trust.
Four rate increases by the Federal Reserve in the last year have caught the attention of individuals and businesses as Prime Rate has jumped from 3.50% to 4.50%. Ironically Prime Rate was at a historically low level of 3.25% for over seven years following the 2008 downturn. For those of us that remember rates over 20% in the early 80’s and consistently over 12% for most of a decade, these rates seem very low. By contrast many in business and especially financial services have never experienced double digit borrowing rates. Rate increases have stimulated discussion about future rate trends and potential impacts to businesses and individuals.
The Federal Reserve has indicated a possibility to continue rate increases in 2018 with speculation that rates may increase another .5 to 1.0%. However, their decisions will be impacted by economic trends and especially by inflation and GDP growth. Also, the global economy will impact domestic rates as much of the world still has lower interest rates than America. Continued domestic growth coupled with strong global growth, especially in major economies, could signal a longer term increasing rate trend.
A long term trend of higher rates has unique impacts for each sector of our economy. For example, a 2% increase in residential mortgage rates would slow housing demand and would place downward pressure on property values. As rates increase, buyers qualify for smaller mortgages because a greater amount of their income is allocated to interest. The family that qualified for a $350,000 mortgage may only afford a $320,000 level which impacts values.
Businesses considering purchase of long term assets also are impacted by higher rates. The impact is strongest for assets that provide a lower level of return on investment such as real estate. Additionally the carrying cost of inventory and underperforming assets become larger concerns as rates increase. Higher interest rates require all businesses to reassess borrowing costs in management decisions. Also businesses that have grown with debt and are carrying significant long term debt feel the immediate impact of higher interest costs to their bottom line.
Agriculture producers are significantly impacted by higher interest rates because of the large capital requirements for ownership of land and expensive equipment. Agricultural real estate has historically low return on investment so the low interest rates of the past 15 years have helped to stimulate agricultural real estate values. Higher long term rates coupled with current commodity values and declining agricultural income could put significant pressure on agricultural real estate values.
We learned in the 1980’s that interest rates have a secondary impact on the value of the dollar versus foreign currencies. If we see significant strengthening of dollar values we can expect pressure on industries with dependency on exports such as manufacturing and especially agriculture. If dollar values increase by 10% versus foreign currency, we can expect a similar decrease in significant regional commodities such as wheat and edible beans where the majority of production is exported.
Commodities such as soybeans that are less dependent on export demand may not experience the same downward pressure, but if currency values in countries such as Brazil decline, we may see increased soybean imports pressuring local values.
Some businesses which are not dependent on large fixed assets may feel little direct impact from higher interest rates. However if the rates slow economic growth or negatively impact business clients all businesses will experience indirect impacts. The high rates of the early 1980’s were used as a tool to stop rampant inflation but they also slowed economic growth to a crawl.
For business and individuals we can speculate on interest rate trends, but none of us know what will happen. Just as we need to make adjustments for outside forces such as weather, competition and impact of economic trends, we need to manage the impact of interest rates. During times of historically high interest rates, many businesses in our region grew and remained profitable. Strongly managed businesses will continue to enjoy success in spite of interest rate impacts.