U.S. Federal interest rates are staying put for now; the U.S. Federal Reserve met this week and they maintained their target for the effective federal funds rate at 0.25–0.50%. This past December the target rate had been increased for the first time since January 2009, and there was initial speculation that it would be bumped up another step in March. This did not come to pass as the U.S. experienced lower than expected inflation (largely due to depressed oil prices), and therefore the Federal Reserve did not raise the rate.
While on its own today’s announcement is just one of eight made each year by the U.S. Fed, it is worth nothing that if interest rates are not raised in the next couple of announcements, the inaction will be a meaningful signal of a shudder in the U.S. recovery. This stall would be a broad confirmation of bad news for the world economy as whole, and for the power of central bankers.
The Effect of Central Bank Interest Rates on Credit
While the startup industry talks a lot about funding from venture-capital firms, angel investors, and other private equity sources, the fact is much of the funding for startups comes from personal lines of credit or small business loans. Those loans are usually variable rate loans. Therefore, for many, U.S. interest rates staying put is a good thing for obvious reasons; for the next few months at least, interest payments are not likely to increase.
However, if you are an entrepreneur considering obtaining a new credit facility, this may not be good news. Commercial banks make money on the spread between what they pay depositors (cost of funds) and what they charge for credit (loan rates). Depositors cannot be paid any less than zero % or they’ll keep their money under the mattress. Incredibly low central bank interest rates drive down what the commercial banks can reasonably charge for loans. For the last 24 straight quarters, the Senior Loan Officer Opinion Survey on Bank Lending Practices has reported decreasing spreads of loan rates over cost of funds. Banks have had to get leaner to survive and part of this tightening is evident in the far stricter regulations about who qualifies for credit, especially for non-mortgage loans. At the same time, low overall economic growth and low inflation is limiting what many small businesses can afford to pay on their loans. It may seem strange for someone to hope for higher interest rates so they can have easier access to credit, but in these strange times that seems to be the case.
What Interest Rates Staying Put Signals in the Economy
Interest rates staying put for now is generally bad for both entrepreneurs and investors because of what it signals about the economy. In this case, the signal sent is that the U.S. economy is not meeting expectations. The short-term blame has been attributed to the drop in oil prices. We should see better growth and inflation once the oil effect has worked its way out of the system, but for now, the situation is not ideal.
“[Inflation] continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.” –Board of Governors of the Federal Reserve System, March 16, 2016 Press Release
Central banks talk about inflation and not GDP growth because inflation is the one rate they have more control over. Both the U.S. and Canada targets are set at 2% inflation, (Canada does it officially and the U.S. unofficially), and interest rates are one of the key tools used to control inflation. By raising interest rates, the inflation rate lowers. By lowering interest rates, the inflation rate increases (at least in theory). 2% inflation is viewed as good because it is low enough to provide reasonable cost-certainty while being high enough to discourage banks and investors from holding onto cash.
However, the U.S. has been below the 2% inflation target since 2012, despite keeping central bank interest-rates at near-zero levels for many years and injecting tremendous amounts of new money into the system through mechanisms like Quantitative Easing (QE). Injecting money was supposed to drive prices up (and therefore inflation), but in reality this has not been as effective as central bankers would like. While the money supply has increased dramatically, the ‘velocity of money’ (how quickly money gets reinvested after being earned), has decreased. Two of the major components of the velocity of money are the rate at which banks lend out the money they receive in deposits and the rate at which major corporations reinvest their profits. Part of the slowdown can be ascribed to increased bank reserve requirements following the 2008 financial crisis, but as of today, both banks and major corporations are, on average, holding onto more reserves than central bankers would like. The velocity of money is approximately 75% of what it was in the early 2000s and is currently the lowest it has been in modern history. Essentially, what we are seeing is a sort of liquidity trap in which it does not matter how much money is poured into the economy because the institutions receiving the money are not spending it.
Why We May Be Less Concerned About Future Announcements
The Cover of February 20th‘s The Economist magazine sums up the general concern over announcements like this one: Are central banks “out of ammo”? The U.S. and its return to decent growth is supposed to be the poster-child for the combination of quantitative easing and low interest rates. However, if growth stalls again, there is little power left in those two tools. This is an almost self-fulfilling prophecy because so much of the power in interest rate announcements lies in the optimistic or pessimistic signals they send to the economy as a whole. If people view them any less powerful and stop taking interest rate announcements as seriously, they lose much of their economy controlling power and go back to just fine tuning the economy.
Focus on the Tangible Effects of Interest Rates
It’s best to stay focused on the tangible effects of all this – the interest payments on U.S. variable-rates of credit are probably staying the same for the next 6 weeks, until the next rate announcement. Over time, interest rates are expected to increase, but only when inflation improves. This will increase cost of capital for companies with significant amounts of variable-debt financing.
The rest is all part of the strange behavioural science of economics.