Business valuations, expansion plans, and investment income can all be dependent on the prevailing interest rates. That’s why leaders need to be aware of factors that can affect market interest rates and, in turn, their cost of borrowing. One of the most important factors is the federal funds rate.
The FOMC has recently signaled tighter monetary policy that includes higher interest rates in 2022 but has not formally announced a timeline for these rate hikes. However, futures and bond markets provide signals that could help business leaders forecast where rates are headed. By understanding this data, managers can tailor their business decisions to make the most of the rising rate environment.
Current State of the Economy and Interest Rates
The COVID-19 pandemic and subsequent recession led to widespread unemployment and dampened economic growth. In April 2020, the Fed lowered the federal funds rate to the lower bound, a target rate between 0% and 0.25%, in order to promote recovery. FOMC members have stated that they will maintain interest rates at the lower bound until both employment and the economy have recovered.
When measuring economic output, Gross Domestic Product [GDP] is one of the most common yardsticks. Currently, GDP is exceeding the pre-pandemic level. In the fourth quarter of 2021, GDP was 11.7% higher than the level in the first quarter of 2020. When taking inflation into account, Real GDP was up about 4.5% over the same timeframe.
Employment has also strengthened. Prior to the pandemic, the unemployment rate was very low, at just 3.5%. In the midst of the pandemic in April 2020, unemployment spiked to 14.8%. As of January, unemployment was down to 4.0%. While unemployment has not reached its pre-pandemic level, the current rate remains historically low.
In addition to key economic indicators, FOMC members must also consider the current inflation environment when determining the appropriate policy rate. As of January, the Consumer Price Index [CPI] was up 7.5%, the largest 12-month increase since 1982. Together, the recovery in employment, expansion of GDP, and rapid pace of inflation signal tightening monetary policy ahead.
Guidance from the Fed on Interest Rates in 2022
During the pandemic, the Fed began buying bonds in a process called quantitative easing. This program added liquidity to markets and helped to speed the recovery. When the economy displayed signs of strengthening, the Fed began reducing asset purchases. The latest round of quantitative easing will conclude in March, a milestone that is typically viewed as a precursor to raising rates.
The FOMC has given other signals that interest rates are on their way up. At December’s meeting, FOMC members submitted updated economic projections. Among these projections was an outlook for the Fed funds rate in 2022. The committee’s projection for their benchmark rate at end of 2022 was elevated to 0.9%, indicating that members forecast at least three rate hikes in 2022.
The projections do not include a timeline for rate hikes, and FOMC members have not issued specific guidance on when to expect the first increase. However, in January, a statement from the FOMC said “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.” This statement, along with the scheduled end of the quantitative easing program, has led many to believe that a hike will occur at the next FOMC meeting in March.
Market Projections for Interest Rates in 2022
Financial markets are also signaling that a rate hike is likely at the March meeting. In fact, futures traders predict the first increase will be announced at the March meeting, with near certainty. Throughout the rest of the year, markets predict at least three more rate hikes, including a 94% probability that rates will reach 1% at or before December’s meeting.
Bond traders also anticipate higher rates this year and short-term yields have risen in response. In January, the 2-year Treasury yield, commonly considered a gauge of future Fed funds rates, exceeded 1% for the first time since January 2020.
As investors flock to short term securities, the yield curve has shown signs of flattening. The spread between the 2-year and 10-year Treasuries shrank to its smallest level since November 2020. A flatter yield curve typically indicates investor expectations for higher rates in the future.
Impact of the Fed Funds Rate on Businesses
If the Fed funds rate increases as anticipated, businesses could see significant impacts. Depending on the industry, debt levels, cash reserve levels, and other characteristics of a particular company, higher rates could be a windfall or serious complication.
Higher rates mean businesses with large cash reserves can earn higher rates of return.
One area where higher interest rates can have a positive impact on business results is investment returns. Business cash reserves are typically invested in an account(s) that provides safety, the needed level of liquidity, and a competitive return. When the Fed raises rates, the interest rate on these types of accounts typically follows. This means that businesses could earn more on their cash reserves as interest rates rise.
Higher rates help banks earn healthier profits.
Banks generate revenue through lending activity. So, when interest rates are higher, banks bring in more income from the loans that they issue. This increase in revenue can be partially offset by higher expenses for deposit interest, but, in general, bank profitability increases as interest rates rise. In 2022, bank leaders could expect higher profit margins as their loan revenue increases.
Higher interest rates can change consumer behavior.
When interest rates increase, consumers may shift their focus from spending to saving to take advantage of higher interest rates on their savings accounts. Additionally, higher borrowing costs could dampen consumer demand for high-dollar items. However, the global economy is expected to continue to grow in 2022, with consumer demand expected to remain strong throughout the year.
Higher rates could increase borrowing costs for businesses.
For businesses, expansion often comes with a steep cost. Buying a new building, an expensive piece of equipment, or employing additional people is expensive. When businesses finance these costs, higher interest rates can make these activities more expensive. But, when businesses maintain cash reserves, and these cash reserves grow alongside interest rates, expansionary activities can be more manageable.
While higher rates can create challenges for businesses, they can also create opportunities. With accurate projections and careful planning, leaders can adjust their decisions to make the most of the rising rate environment. One way that businesses can excel in a rising rate environment is by maximizing their returns on cash reserves. That’s where our company, the American Deposit Management Co. [ADM], can help.
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