Is a 2.5% Fed Funds Rate a Sign of Health or Distress?

Updated: May 17, 2020

The Story

Several years ago the Federal Reserve embarked on a path that most accepted as the right medicine for an economy in recession.

The Fed Funds Rate was lowered to an unprecedented 0-0.25% range (effectively zero) in December of 2008 in an attempt to stimulate an ailing economy. Then after keeping the rate at effectively zero from 2008 to 2015, the Fed began a series of rate hikes to bring the rate up to a December 2018 level of 2.5%. This was largely perceived by financial commentators in the media as a sign of a healthy economy. In fact we’ve heard for years now from almost all media outlets that the economy has been strong. We continue to read headlines that while we’ve had significant market volatility, the fundamentals are still solid.

This would be a good time to put some things in perspective by taking a look at the larger timeline of Fed Funds Rate changes.

After years of low interest rates as a response to the 2001 recession, the fed funds rate was raised to a max of 5.25% in 2006 as the housing bubble became evident. By September of 2007 the fed was lowering rates to 4.75% “in a bold acknowledgement that the central bank is concerned the mortgage meltdown plaguing Wall Street and Main Street could hurt the economy.” Sept 18, 2007

And then in January of 2008 the Fed “slashed a key interest rate by a hefty three-quarters of a percentage point, the biggest cut in more than 23 years, after a two-day global stocks rout sparked by fears of a U.S. recession.” Jan 22, 20018 The cut that triggered that dramatic statement brought the rate down to only 3.5%.

There are numerous other dramatic statements that continued to emphasize the urgent nature of our ailing economy and the stimulus needed to rescue it. The point is that if we take a wider view of the timeline, we see that rates such as 4.75%, 3.5%, and everything between 3.5% and zero were considered stimulative to an ailing economy. And each lower rate was an increasingly more extreme measure. Today we’ve made it back up to 2.5%. This might not be a rate reflective of a healthy economy, but, much different than most voices proclaim today, it is a rate that not that long ago was considered stimulus to an ailing economy.

The Economics Lesson

Interest rates are a reflection of society’s preference for present consumption over future consumption. The more people prefer to consume now, the more they must be rewarded today (by an interest payment) for deferring their ability to consumer into the future (by placing their money into savings which are then lent out by banks). When people strongly prefer future consumption, interest rates rise which makes long-term capital-intensive projects more expensive and thus serves as a signal to businesses to invest in shorter-term projects. Whatever consumers' preferences, there is a natural rate of interest which naturally clears the market of individual savings and funds available for business to borrow and grow. When we artificially manipulate this natural rate, we confuse businesses’ investment decisions. An artificially low interest rate set by the Federal Reserve will lead a business to invest in a long-term capital-intensive project when that isn’t the resource society actually wants. Capital becomes mis-allocated across the economy into uses that aren’t its highest and best use and bubbles start to get air blown into them.

Guidance for owners and managers of lower middle market businesses

We’ll be able to give more complete advice after our next post on the Fiscal Deficit, but here are some things to consider now.

For the last couple of years businesses were locking in interest rates by pursuing fixed rate debt or by entering into swap agreements to effectively convert their variable rate debt into fixed rate debt. Banks had a field day charging fees to sell variable rate debt and then charging more fees to arrange a swap. Many of those earlier swap agreements are now in the money (the borrowers are now better off because their fixed rates are now lower than what they could find in the economy today). This made a lot of sense a couple of years ago. We’ve advised some organizations we’ve worked with recently to hold off for now (or at least carefully examine) any new swap agreements. The Fed has now signaled that it will be slowing its pace of rate increases as almost every one of its recent increases has resulted in a market decline. It may also be up against a wall of fiscal deficit that may prevent it from raising rates much further anyway. While the long-term fundamentals point to saliently higher rates in the future, we may see a near-term period of mild increases or even rate decreases first.