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Interesting Times: Are You At Risk of Becoming a Frog in a Pot of Warming Water?
FOMC Update

The Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) met March 20-21 and voted unanimously to increase the federal funds rate by 0.25%. The move was once again anticipated and the immediate market impact on interest rates was uneventful. The FOMC cited continued strengthening of the labor market, strong employment gains, and continued pickup in economic activity as the primary drivers of current economic conditions. Effective March 21, the prime rate increased to 4.75%.

The FOMC also continued its previously approved policy to slowly reduce its balance sheet of both Treasury securities and mortgage-backed securities by reinvesting less than the amounts maturing, explained in a previous edition of INTERESTing Times. This action will place more supply of these securities in the open market (and presumably increase the interest rate cost on these securities as the FOMC becomes less of a buyer). Combined, the roll-off from the Fed’s balance sheet will increase from $20 billion per month to $30 billion per month beginning in April. This also comes at the same time the federal government is increasing its borrowing as a result of the recent budget agreement to spend more money and the recent tax cut legislation which will result in less tax revenue.

The next Fed meeting is May 1-2. The futures market currently projects a less than 5% chance of a rate hike at this meeting and but is projecting a more than 80% chance of a rate hike during the June 28-29 FOMC meeting. At present time, the market is anticipating three total quarter-point increases by year-end with a small probability (30%) of a fourth hike in December this year.

Updated Economic Projections

The Federal Reserve Board members released their quarterly economic projections at the March meeting. There were some changes from December projections with real gross domestic product growth increased to 2.70% for 2018 – from 2.5% in December – and tapering down to a long-run growth rate of 1.80%. This year, the Fed projects a rise in the federal funds rate by an additional 0.50% (in two quarter point increments), three quarter point increases in 2019, and two more quarter point increases in 2020 to reach 3.40%  – a 0.30% increase from December projections.

However, the FOMC continues to project a long-run federal funds rate of 2.80-3.00% – a forecast below the rate projected for 2020. Today, the federal funds rate is 1.75%. If the Fed projections are correct, we are about half-way through this tightening cycle.

Impact on Interest Rates – Don’t be a Frog in a Pot of Slowly Warming Water

You’ve heard the metaphor that a frog placed in a pot of water that is slowly warmed to the point of boiling will not perceive the danger and will eventually be cooked. While biologists may dispute the accuracy of this fable, don’t become the frog in the metaphorical story by sleeping on opportunities.

Variable rate loans have increased along with the federal funds rate. The Wall Street Journal prime rate is now at 4.75%. However, the market for longer-term loans has not increased as much as expected with the increases in short-term rates. This has kept long-term loan rates such as home mortgages and fixed-rate farm real estate loans much lower than anticipated. How much longer this phenomenon will last continues to be an INTERESTing question.

This was the sixth increase during this interest rate tightening cycle and the fed funds rate is now 1.50% higher than it was before the Fed began increasing rates. On a $1 million loan, that translates into an additional $15,000 of annual interest expense. Is the slow increase in interest expense making you feel like a frog in a pot? While you may not be able to do much to mitigate this risk on operating loans, you do have options to fix rates on term loans. Explore them before the water gets too hot!

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