Pay Attention to Interest Rates

By North, Daniel C. | Business Credit, June 2005 | Go to article overview

Pay Attention to Interest Rates


North, Daniel C., Business Credit


2004 proved to be a year of strong growth, low inflation and low interest rates, despite a wobbly labor market and political uncertainty. For 2005, we expect to see continued favorable conditions overall, but a somewhat slower growth rate. Consensus estimates are that GDP will grow at 3.5 percent to 4 percent this year, compared with 4.4 percent last year. Even so, if the year continues as expected, it will represent positive growth for 17 consecutive quarters.

We expect interest rates and inflation to rise modestly, with the 10-year Treasury note going from 4.5 percent to 5 percent at the end of the year, the Fed Funds rate going from 2.75 percent in March to 3.5 percent by the end of the year, and inflation going from the current 3.2 percent to 3.5 percent by the end of the year. We also expect that several major macroeconomic issues will occupy center stage for quite some time. These issues include the swirling debate around Social Security, the federal budget deficit, the current account deficit and its effect on the U.S. dollar, and rising oil prices.

A Common Denominator

Of course, all of these issues are interrelated, but a closer look at interest rates ties them together. Interest rates affect consumers personally on their mortgage rates and credit card debts, and they affect businesses on revolving lines of credit or other types of financing. However, the impact of interest rates on business success or failure is just as direct and dramatic from a macro level.

Chart A, on page 12, illustrates how interest rates directly correlate with the total number of bankruptcies in the United States. A more careful examination of this chart and the data behind it suggest that interest rates actually lead bankruptcy activity by several quarters. Given the recent path of interest rates, then, the chart could suggest a modest increase in bankruptcies going forward. A further look at interest rates is revealing.

Inflation Creeps Back

Interest rates are driven by several variables, including inflation. White inflation has been relatively quiet for years, a few signs point to its reappearance. The most common measure of inflation is the Consumer Price Index (CPI), which measures the cost of a typical basket of goods and services the consumer purchases. Broadly speaking, the cost of producing those goods is comprised of about one-third materials and two-thirds labor. Last year, prices for oil, gasoline, and other materials spiked sharply, yet the CPI rose only modestly because the more heavily weighted tabor costs were actually shrinking.

Commodities prices are on the rise again this year. [See Chart B] Gasoline prices have broken last year's records, and there is market speculation that crude oil could reach $60 a barrel this year. And now, unlike last year, labor prices are also rising. Unit labor costs, which are the costs to make one unit of production, have actually been shrinking for two years. But in this post-recessionary environment, employers must hire new workers who are, almost by definition, less productive than current employees, therefore raising unit labor costs. These higher labor costs are being passed on to the consumer because, as noted in the Fed's March "Beige Book" report, businesses are now able to make consumer price increases stick.

A Tool Of The Fed

Interest rates, of course, are also influenced by the Federal Reserve Bank. The Fed uses the short-term Fed Funds interest rate as a monetary policy tool to help manage the economy. If the Fed Funds rate is too low, the economy could grow rapidly, but it could also get overstimulated and result in inflation. If the Fed Funds rate is too high, inflation might be tamed, but the economy could slow too much and fall into recession. Thus the level and direction of the Fed Funds rate strongly influences growth, inflation and other interest rates throughout our economy.

For example, last year the Fed started raising the Fed Funds rate in a bid to stem incipient inflation. …

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