From the pages of In Business magazine.
When the Federal Open Market Committee, the branch of the Federal Reserve Board that determines the direction of monetary policy, met Oct. 29 and 30 in Washington, D.C., financial experts were at odds over whether it would cut interest rates for a third consecutive meeting.
While many pundits expected another rate cut given the Fed’s silence in the weeks leading up the meeting, there was less certainty about why the Fed would feel it necessary to cut rates once more in this economically strong year.
A July rate cut, the Fed’s first downward rate move in more than a decade, was followed in September by a second cut. These moves were widely viewed as designed to sustain the economy’s continued expansion by protecting against what the Fed believed to be downside risks to the economy, including muted inflation pressures, the ongoing trade battle with China, slower global growth, and weaker U.S. manufacturing due to global uncertainties and the trade war itself.
At best, given the overall strength of the U.S. economy, the October rate cut was seen as unnecessary by many experts. At worst, it weakened the Fed’s ability to make moves to bolster the economy should a recession take hold in 2020. Nevertheless, the FOMC voted 8–2 in favor of a third rate cut in as many meetings, this one a quarter-point reduction to a target range of between 1.5 to 1.75 percent, while not offering any clues as to whether or not it will cut rates further at its final meeting of the year, Dec. 10 and 11.
So, what does this relatively unprecedented rate-cut move mean for the larger economy and the effect interest rates have on business lending? While the FOMC was meeting in October to announce a third cut in interest rates, we spoke with three local finance experts: Dennis Haefer, vice president at State Bank of Cross Plains; Jim Hartlieb, president of First Business Bank in Madison; and Kevin O’Driscoll, executive vice president of commercial real estate for Old National Bank. They provided their takes on what another rate cut could mean for lending in Greater Madison and the overall strength of the local economy.
Questioning the Fed
The trade challenges are one of several headwinds that prompted the Fed to cut rates twice earlier this year, notes Haefer. “Polls showed a greater than 50 percent chance that we’d see another quarter-point cut [in October], although a year ago the experts were predicting multiple rate increases in 2019 and they were completely wrong,” he states.
Haefer says he wouldn’t have been surprised to see the Fed pause and not do anything for the rest of this year, but right now it’s harder than ever to be a predictor of where rates move, if at all.
“The rate increases from 2016–2018 gave the Fed some room to maneuver, so yes, the Fed could lower rates several more times in the coming year or two, if needed,” Haefer explains.
But with unemployment superbly low, and inflation clearly under control, Haefer was expecting the Fed to hit the pause button on a third rate decrease.
Hartlieb says the concern with reducing interest rates based on issues like the trade war, tariffs, or impeachment is that the Fed could “use up its bullets” and not be able to stimulate the economy through rate adjustments if there is an economic slowdown next year.
“We see a relatively strong economy through our clients’ performance, so these cuts seem a bit premature,” notes Hartlieb. “[However,] we see this as the final cut based on today’s economic data. It appears the Fed ‘overtightened’ last year, responding to above-average economic growth that was largely a result of tax reform and underappreciating the deleterious impact of the trade war. The Fed had room to cut on Oct. 31 in light of the flat yield curve and absence of inflation, but after this cut we hope and expect a holding pattern until economic data suggests otherwise.”
The Fed denies that White House pressure had anything to do with the most recent rate cut, but whatever its motivation, O’Driscoll is blunt about the Fed overstepping with its October interest rate reduction. “We are at historic highs in the stock market, historic lows in interest rates, and we are at full employment, so why would the Fed continue to lower interest rates?” O’Driscoll asks. “I think the average person is confused by the ‘propping up the economy,’ as the economy on many levels is the best it has ever been, particularly for those who have real estate and marketable securities.”
According to O’Driscoll, the Fed can’t do much more to boost the economy right now, and like Hartlieb he warns against the body using up its options before they’re needed.
“We do have to look to Europe and ask ourselves, are the negative rates coming our way?” he says. “It sure seems so based on the Fed’s continued willingness to cut rates. We also have more uncertainty at the ‘top of the house’ than we have had in recent memory. We have a president who can be a bit unpredictable, a president who may be impeached, and a president up for reelection. That type of uncertainty causes business investors to question their outlook for 2020.
Furthermore, sweeping changes in international trade and tariffs have immediate and unintended consequences, O’Driscoll adds. “Every single developer and contractor tells us about how plywood, steel, drywall, or countertops have increased in price dramatically and almost overnight, even when there’s a hard bid in the contract,” he explains. “A trade breakthrough is needed as further interest rate reductions are providing diminishing returns. We don’t need lower rates. We need more certainty from a political standpoint.”
Loss of credibility?
The Fed has not hit its 2 percent target inflation rate for nearly eight years — it currently sits about 1.3 percent — and a higher expected inflation rate allows the Fed to help the economy during recessions because it gives them more of a cushion to cut interest rates. With inflation so low, could that hurt the Fed’s credibility and present more problems down the road?
Hartlieb doesn’t think so, but he and O’Driscoll are firm in their stance that the Fed should tread lightly moving forward with respect to further rate cuts.
“[The] third rate cut in October could be justified by weak economic data, a flat yield curve, and absent inflation,” Hartlieb explains. “While the Fed has not hit its ‘target’ of 2 percent inflation, 1–1.5 percent inflation is not a problem for the economy, and we have not had deflation. The bigger issue, as I mentioned before, is if the Fed does cut rates two or three more times now, it could reduce its ability to stimulate the economy should there be an economic slowdown in 2020 or beyond.”
The Fed doesn’t have a lot of tools to manage inflation, and it’s on a path to exhaust rate cuts as an option, agrees O’Driscoll. “If you look back over the last five years at the prediction for year-end, short-term, and 10-year treasury rates, the prediction has been wrong every single time,” he states.
“With respect to inflation, I think that it is almost a meaningless number, and I don’t think it is low. Inflation is a calculation of a ‘basket of goods,’” O’Driscoll explains. “That basket of goods does not include housing costs, which makes up somewhere between 25 percent and 50 percent of a household’s income. The trend is that more and more of a household’s dollar is going to housing, either because rent is increasing or housing prices are increasing. In both cases, the rise in housing cost has been dramatic. In my opinion, if the basket of goods doesn’t include the highest expense in a household, it is not meaningful.”
Haefer notes his comfort level is more about the local economy and all that is going on in Dane County, and the biggest area of inflation here is related to construction costs.
“Lower interest rates will certainly help lower the financing costs related to local new construction projects,” acknowledges Haefer. “From a more macro perspective, factors that influence inflation are more than ever related to global trade and supply-and-demand balances or imbalances, thus the Fed’s influence on inflation is increasingly muted. Technology and the efficiencies that we are constantly gaining from continued advances also play a role in the inflation rate.”
For example, the ‘Amazon effect’ and the price transparencies that we all enjoy now online have helped to keep inflation in check, further reducing the impact the Fed has on inflation, Haefer notes. “Overall, the media and business reporting outlets give the Fed probably more credit than deserved. The economy has changed so much over the past 15 years, making it so difficult to ascertain the impact the Fed does or doesn’t have on the economy,” he states. “The Fed’s credibility and influence is declining, related to global influence. The banking industry, however, is always concerned about rate cuts and the impact that has on our net interest margin.”
(Continued)
‘Best day to be a borrower’
In light of recent interest rate cuts, business lending has been a bit of a mixed bag for our local bankers.
“Today is the best day to be a borrower, as interest rates are at absolute historic lows,” remarks O’Driscoll. “If a client is expanding, now is the best time to borrow ever from an interest-cost perspective. There has been a boom in refinancing as borrowers with existing buildings work to capture today’s low interest rates.
“Unfortunately, new loans to our commercial and industrial clients are constrained by labor and the inability to hire more workers. I think it is interesting that we talk about Foxconn and 10,000 new jobs in southeastern Wisconsin, but at full employment I’m not sure how those jobs would ever get filled.”
With respect to how interest rates affect the bank, O’Driscoll says the bank earns money on interest income, so interest revenue continues to decline as rates continue to get lowered by the Fed. On the other hand, low rates have led to a bit of a residential refinancing boom that has allowed bank earnings to offset the loss of interest revenue.
“In the middle of this year, rates declined steadily for a period of almost four months,” notes Haefer. “Pricing new construction loans, for example, became tricky during this timeframe. Currently, the rate curve has ‘bottomed out’ somewhat and the 10-2 spread has increased slightly in recent weeks.
“For sure, these lower rates have helped new construction projects get off the ground quicker and we expect this to carry over into the first half of 2020.”
Lower interest rates have had very little effect on First Business Bank’s business lending over the last 12 months, says Hartlieb. “Generally speaking, there are bigger issues — i.e., what is the ROI on the capital investment? — that business owners are considering when deciding whether to borrow funds. For example, for a $1 million loan, a half-percent decrease in rates only decreases the monthly payment by approximately $250 per month, whereas investing in the wrong people or equipment could cost the business tens of thousands of dollars per month.”
Still, Hartlieb says the business lending environment is good right now due to the profitability that banking clients are generating. “Many are in need of capital for capital expenditures or working capital. While the trade war has an effect on some of our clients, the decision makers at the clients we serve are dynamic leaders who are able to navigate through issues like tariffs and trade wars.”
Haefer concurs that the lending environment remains healthy and strong in Dane County, “but for sure some companies have become a little more cautious because of economic uncertainties and also the uber-low employment rate in Dane County. Buying a new piece of equipment makes no sense, of course, if you can’t find someone to operate it efficiently.”
According to O’Driscoll, some of the large national banks have started to slow down their lending in commercial real estate, but Madison is very well banked by regional and community banks that are lending in a diverse economy. The wait and-see approach is driven by tight labor and increased material costs, and the double whammy has caused some developers to pause as construction costs outstrip the ability to obtain the investment return needed to justify new construction.
“You can’t simply pass all the cost on to the renter or new home buyer,” O’Driscoll adds. “The market dictates rent, as does household income. Back to my comment about inflation, we have seen staggering inflation in the real-estate sector, and this fact is not picked up in the basket of goods used to calculate inflation.”
Parting thoughts
On the heels of the most recent interest rate cut and lingering uncertainty over the trade war with China, even with a recent thaw that suggests a deal is near, the real possibility of a presidential impeachment and the belief among many pundits that a recession is not out of the question sometime in 2020 mean that our experts aren’t breaking out the crystal ball when advising their business banking clients.
“More than ever, we are trying to stay out of the rate-predictor business,” says Haefer. “If it makes sense to refinance now, we want to help our clients accomplish this. What happens to rates in 2020 is anyone’s guess.”
“We never predict rates,” says O’Driscoll. “We ask our client: ‘Is the fixed rate you are being offered today among the lowest rate you have seen? If the answer is yes, fix the rate.’ However, in the declining rate environment, rates have dropped every year, so in hindsight the borrower should have waited. Regardless, the certainty of a very low fixed rate allows the borrower and lender to sleep well.”
With the flat yield curve, First Business is talking to clients about the option of fixing rates for a longer period of time or converting from a floating rate to a fixed rate, says Hartlieb. “As an example, the historical average spread between the two-year Treasury and the 10-year Treasury rate is approximately 1 percent,” he explains. “That spread is approximately 0.15 percent currently. So, the client has the opportunity to fix a rate for a longer period of time at lower rates than they could historically, thus eliminating one expense variable in their operating structure.
“Beyond that issue, we are focused with our clients on things like finding and retaining good people, how to navigate the growth cycle and, in the event there is a downturn in the economy, how to identify costs that could be right-sized should revenues flatten out or decline,” Hartlieb adds. “Again, in the big scheme of things, interest rates represent a relatively small part of their overall profitability.”
Click here to sign up for the free IB ezine — your twice-weekly resource for local business news, analysis, voices, and the names you need to know. If you are not already a subscriber to In Business magazine, be sure to sign up for our monthly print edition here.
