At a high level, it is easy to understand what the Federal Reserve is attempting to do by raising interest rates. Inflation has skyrocketed and the Fed’s decision to raise interest rates should cool demand from consumers, ideally bringing inflation under control without pulling the economy into a recession.
But there is a lot that happens in the economy in between the decision to hike rates – by 0.25% in March, 0.5% in May, 0.75% in June and potentially even more in July and beyond – and the actual outcome the Fed is trying to achieve.
While the housing market may be the most obvious place where higher rates shape economic activity, there are plenty of other areas, from credit cards and car loans to lines of credit and equipment financing.
Take We Energies, for example, which had to update its rate increase request with regulators to account for nearly $12 million in additional borrowing costs brought on by rising interest rates since it initially filed the case in April.
Gus Faucher, chief economist at PNC Financial Services, said higher rates do make some business projects less feasible, but there is still reason to expect that companies will continue to invest.
“Businesses are still facing strong demand, and they’re still having difficulty in hiring, so they can still undertake investments that make their existing workforces more productive,” Faucher said, adding while PNC’s base case does not call for a recession, if there is a downturn, it would likely be short and mild.
Still, he expects businesses would be more likely to invest in things with a quicker return on investment.
“It’s one thing to invest in an information technology project, it’s another thing to buy big pieces of machinery,” Faucher said.[caption id="attachment_552849" align="alignright" width="300"] Oswald Poels[/caption]
Rose Oswald Poels, president and chief executive officer of the Wisconsin Bankers Association, said that increasing rates will translate to higher costs for lines of credit and operating loans.
“I think most businesses have operating lines of credit frankly as a prudent measure of managing their cash flow, and then it just is a matter of how dependent is the business on the loan versus being able to manage some of that through their own cash flow,” Oswald Poels said.
Some businesses may have come through the pandemic in good shape and can manage, others may have been hit by supply chain issues and have been forced to tie up cash by holding more inventory than normal, she said.
“You’ve got a higher debt service ratio and if you’re a company that may have cyclicality in their earnings or if you may have earnings challenges and your earnings slow down, you could definitely start to see cash flow tighten, and I think that’s often the concern when rates go up,” said Andy Keller, Wisconsin market manager at J.P. Morgan Private Bank.[caption id="attachment_552847" align="alignright" width="300"] Keller[/caption]
Around 70% of Keller’s private bank clients are current or former business owners and, combined with conversations with colleagues in commercial banking, he said there doesn’t seem to be a drop in loan demand.
“If rates continue to surge the way they have, you might expect to see a decline in demand for longer-term loans like real estate … and then maybe large capital raises for M&A-type activity,” Keller said.
The expectation that the Fed will continue to raise rates might be helping fuel continued loan demand. If borrowing is going to be more expensive in the future, it might be prudent to do it now.
“I do think you’re seeing business owners in particular borrowing money now and they’re trying to do so ahead of further interest rate increases,” Oswald Poels said.
For banks themselves, rising rates do have some benefit as net interest margin – the difference between revenue generated from interest on loans and money paid out for deposits – grows.
Oswald Poels said banks are seeing improved profitability, but many are also putting more money into loan loss reserves, not because they are seeing higher defaults now, but because they’re anticipating a downturn in the future.[caption id="attachment_552848" align="alignright" width="300"] McKenna[/caption]
Jay McKenna, president of North Shore Bank, said community banks in particular have been squeezed by the low interest rate environment in recent years. Refinancing mortgages helped offset the pressure, but that business has slowed with rising rates.
On the deposit side, banks have plenty of liquidity, so even with rising rates there isn’t as much of a need to increase what they pay out, but Oswald Poels noted banks are hearing from customers who want a better return or they will take deposits elsewhere.
“There’s some market competition that is always obviously in play,” she said.
McKenna said he tries not to get too excited one way or another when it comes to interest rate movements, knowing they swing both ways at any time. Still, he is expecting the Fed to continue making fighting inflation a priority. The central bank has a dual mandate to control inflation and maximize employment and the latter is under control with low unemployment rates.
“I think that gives them a lot of freedom to work on the other side of their dual mandate, which is price stability,” McKenna said.