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Fed Repeats: Low Interest Rates Into 2013
At its regular policy meeting today, the Federal Reserve Open Market Committee re-affirmed its pledge to keep interest rates low through mid-2013. The committee first made that unprecedented statement at its regular Aug. 9 meeting.
It’s unprecedented, say Fed watchers, because the committee tries to avoid such specific language. Instead, it typically says that it will leave rates low merely for “an extended period.”
Like the Aug. 9 statement, today’s Fed announcement says that economic conditions are likely to warrant “exceptionally low” rates through “at least” mid-2013. Both statements were approved on a 7-3 vote. In August, three members favored the less definite “extended period” language. Today, three members did not support “additional policy accommodation at this time.”
That additional policy accommodation is significant because the Fed voted today to try to keep long-term interest rates low, not just short-term rates. It’s well known that the market, not the Fed sets long-term rates. But today, the Fed announced steps that the committee hopes will keep long-term rates low.
The Fed hopes to pressure long-term interest rates lower by buying long-term bonds. Over the next nine months, it plans to sell short-term securities (under three years in maturity) and use the proceeds to buy long-term Treasuries (6 to 30 years in maturity).
The committee also plans to increase its purchases of mortgage securities, again aimed at keeping long rates low.
On short-term rates, the Fed kept its target rate for “Fed funds” at 0 to 0.25 percent.
The Fed has been in this stance since the housing/financial collapse of 2008-09, and farmers have reaped the benefit through lower borrowing costs.
Many farmers are locking in these low rates, both by converting their loans to lower rates, and by extending maturities on existing loans. For example, the four-state Farm Credit Services of America says it has converted more than $3 billion in loans so far this year.
Many of these refinancing farmers look at the Fed’s mid-2013 promise as something less than rock-solid.
“The Fed’s promise to keep interest rates low for two years is about as valid as me saying I’m going to have 200-bushel corn for the next two years. Nobody can predict in advance,” says central Illinois farmer Tim Seifert.
“The world is changing every day, with events around the world and politics in Washington. A lot can happen before 2013.”
Seifert, who says he was aware of the Aug. 9 announcement, typically gets a phone call or e-mail from his lender when rates fall enough to make refinancing profitable. And he’s already converted some of his loans this year.
Interest rates, both long and short, will eventually rise. With rates currently low, by default the next move is up. Advisers suggest being ready for it.
For several years now, retired economics professor Edmond Seifried has been traveling the country to warn farmers of higher rates. But on Aug. 9 he had to moderate those warnings when the Fed announced its 2013 target.
"It was a two-year reprieve for farmers," says Seifried, a partner in the Pennsylvania bank consulting firm Seifreid & Brew. "I call Aug. 9 'Farm Freedom Day'."
The Fed's Aug. 9 statement came just one day after the stock market suffered a sharp one-day loss. The message was meant to soothe jittery markets and instill confidence in the economy.
"The announcement basically lifted the burden of worrying about a sharp rate increase that's surely coming in the future," says Seifried. "Rates can't stay this low forever, and farmers should not get used to these low levels."
In about 150 speeches a year to farm groups, Seifried warns that interest rates will eventually have to return to "where they should be." He calls this natural rate "equilibrium." An equilibrium level, says the former econ prof, would be determined by free-market forces, without the artificial influence of the Federal Reserve.
Seifried warns farmers that the natural equilibrium rate for farm loans should be about 3.5 to 4.5 percentage points higher than currently. He points out several reasons: First, savers won't deposit their money for nothing; they want to be paid. Seifried suggests 2-3 percent as a minimum market-based rate for rewarding savers.
Second, because loans are repaid in the future with cheaper dollars, interest rates have to account for inflation. That adds another 2-4 percent. Finally, you have to add the lender's profit and overhead -- staff, office rent, electric bill, etc.
He figures it all adds up to about 8-9 percent by the time it's lent to farmers. Currently, ag loans are running around 3.4 to 5.3 percent, depending on the term and whether the rate is variable or fixed. About 4-5 years ago, rates were closer to 7 percent.
With the Fed's Aug. 9 announcement, it looks like rates will stay low for a while. But Purdue University ag economist Mike Boehlje warns that the Fed is not obligated to stick to its announcement. The Fed could raise rates at any time if employment and economic activity start to pick up. In fact, says Boehlje, the Fed would like nothing better than to raise rates, as that would be a sign of an improved economy.
"Interest rates will go up eventually," says Boehlje. "Farmers should take advantage of this window of opportunity to lock in long-term debt at low fixed rates."
Northwest Indiana farmer Brian Putt doesn't want to bet his farm's future on whether the Fed keeps its word through mid-2013. So in September, when his lender sent him an e-mail outlining the benefits of refinancing, he did. He locked up his machinery loan for seven years at 4.5 percent. And he got a lower rate on his long-term land loan by agreeing not to refinance for five years."I do't see how rates can go much lower," he says.
And although mid-2013 seems far away, strategists for the four-state Farm Credit Services of America are already preparing for it. "It's definitely on our radar," says Mark Hancock, vice president for finance.
In recent months, the Farm Credit System (FCS) has been actively notifying farmers to convert to lower rates, then securing the money for those loans in the wholesale capital markets. With crop prices high, Wall Street bankers see reduced risk in farm loans, and that means lenders can obtain large loan pools at lower rates.
At the farm level, locking in interest costs and refinancing to a lower rate is easiest for long-term loans on land, machinery and equipment. In contrast, protecting against a rate rise on short-term operating loans is more difficult. One approach is to use a variable-interest line of credit with a "cap," or limit, to how high the rate can rise over the life of the loan.
For example, earlier this year (before the Fed’s Aug. 9 announcement), farmers in Hancock’s region of Indiana, Kentucky, Ohio and Tennessee could choose from a range of rate caps.
You start with a variable-rate loan, and for a fee of $70 per $100,000, your interest rate would never go up more than 1 percentage point over the next year. It’s an upfront fee that’s based on every $100,000 in your credit line.
If you wanted to extend that same protection out to two years, it would cost $880 for each $100,000 covered. Your interest rate would not rise more than 1 percentage point, but it’s free to drift lower if market rates fall.
Allowing your interest rate to drift up by 2 percentage points instead of 1 is cheaper. One-year protection in this example cost just $20 per $100,000. Two-year protection cost $460. Three-year protection, which extends beyond the Fed's 2013 commitment, cost $1,630 to $2700 for every $100,000 covered. These fees change daily, and are just an example from before the Fed’s Aug. 9 announcement.
If the general interest-rate market looks like it's going to stay low, that will be reflected in a cheaper overall fee structure.
But if it looks like the rate trend has changed to a rising environment, the entire fee structure could be raised to reflect the increased risk. That's important to know, because most borrowers would choose this protection only in a rising-rate environment.
"Most of our customers are fairly confident that rates won’t increase more than 50 basis points (one-half percentage point) over the next year or so," says Hancock, based in Louisville, Kentucky.
Still, he says, the customer can get "the best of both worlds" with this approach -- a lower initial rate, plus a cap. And if market rates go lower still, so does your rate.
Editor's Note: Freelancer Andre Stephenson contributed this report.