Recent news reports are sounding the alarm that interest rates will be on the rise for 2004.
While many people fear rising interest rates, we should greet their rise not with fear but with
enthusiasm! A rise in interest rates in the coming months is a clear sign of economic health and
a growing economy which causes the Federal Reserve to shift its emphasis from economic stimulation
to maintaining growth without signifi cant infl ation.
We can’t lose sight where we are and where we have been. The current federal funds rate, which
banks charge each other for overnight lending, is just 1 percent. With an infl ation rate of just
1.8 percent, this equates to a negative rate of eight-tenths of 1 percent.
Let’s explore what this really means. If one were to
save $25,000 in a savings account at the current interest rate of 1 percent, one would have
$25,757.53 after 3 years. Let’s assume that the purpose of saving the $25,000 was to buy a piece of
property in 3 years. At the current rate of infl ation of 1.8%, the cost now for the property would
be $26,374.44. We would now be in a position where the interest we received was $616.91 less than the
amount of increase in the value of the property at the infl ation rate of 1.8%.
Let’s explore what this really means. If one were to
save $25,000 in a savings account at the current interest rate of 1 percent, one would have
$25,757.53 after 3 years. Let’s assume that the purpose of saving the $25,000 was to buy a piece of
property in 3 years. At the current rate of inflation of 1.8%, the cost now for the property would
be $26,374.44. We would now be in a position where the
interest we received was $616.91 less than the amount of increase in the value of the property at the
inflation rate of 1.8%.
What we need to do is
look at where we currently are and where we have been over the last 25 years. The federal funds rate
has never been 1% in the past 25 years. Nor has the prime rate been 4% in 25 years. A source at one
of the largest regional banks in the area stated that in his 21 years in the banking business interest
rates have never been lower and in the last 10 years of his experience the lowest the prime rate has
been was 5.5%, while the lowest for the federal funds rate was 2.5%.
What we are facing currently is the extremely high likelihood that the Federal Reserve will increase
the federal funds rate by a quarter percent very soon and in all likelihood 3 total increases of a
quarter point each by the end of the year. This would bring the federal funds rate to 1.75%, which
would still be dramatically less than the lowest rate previously experienced in the last 10 years.
Let’s explore the benefits of higher interest rates. Surprisingly, several benefi ts quickly come to
mind:
1) Increases in interest rates from the historically low rates of this past year mean that the US and
global economy are now recovering. This means more
businesses will invest in high tech spending which
drove the robust economic expansion in the 1990’s, raised overall productivity, and brought about a
higher standard living for the country as a whole;
2) Lenders will be much more willing to lend money to those who need it to purchase goods or to expand
business operations. The severe lack of liquidity, which has held back economic expansion over the last
2 years, will begin to evaporate so that lenders can do what they do best—lend money;
3) Higher interest rates will strengthen the dollar, making imported goods considerably less expensive
which will have a positive impact on reducing the federal trade deficit which has been at an all time high;
4) Higher interest rates will motivate more people to save, which benefits the economy over the long-term.
What incentive is there for people to save their money when 1 percent interest on $100,000 is about $80 a
month? Higher interest rates will increase savings for retirement and increase available capital to meet
both the needs of government and business to borrow needed money.
When seen in this larger context, the
current fear over rising interest rates causing people to lose sleep over the uncertainty about their
economic future is totally insane! If we were to experience 16 straight quarters of a quarter point rise
in interest rates, then we should become concerned. But even then the federal funds rate would be 5% and
the prime rate would be 8%. And much to the surprise of many, such a dramatic increase would merely bring
us close to the previous 10 year average for interest rates!
Now let’s take a look at how 3 one-quarter
point increases, which would bring the federal funds rate to 1.75 percent, will impact the average IPA
client. Let’s assume our client has $600,000 in debt with $200,000 in accounts payable and $400,000 for
which he is paying interest. The added interest expense from the expected rise in interest rates this year
would add only $3,000 to his interest costs for the entire year. In other words, the client would have to
find just an extra $57.69 per week to pay the added costs caused by rising interest rates.
The rise in
interest rates for 2004 will have virtually no impact on the business operations of our clients—unless they
let fear and emotion control their decisions.
John R. Burgess, Managing
Director since 1991