In early December, the Federal Reserve Bank (the Fed) increased the federal funds rate target from 0.5 percent to 0.75 percent.
The Federal Funds rate is the interest rate charged to banks for overnight loans to meet the Fed’s reserve requirements and usually is then reflected in the interest rates that banks charge to borrowers.
This is the first interest rate increase since 2015 and only the second since 2006. The Fed also signaled that it might increase interest rates up to three times in 2017.
In taking this action, the Fed cited that “the labor market has continued to strengthen and economic activity has been expanding at a moderate pace since mid-year.” In addition, it noted that the inflation rate had increased during the past year but continued to be below its long-run annual target of 2 percent. In addition, lower unemployment and rising wages were also cited as supporting potential inflation pressure in the future.
What are the implications?
In general, the bond markets anticipated the Fed’s action and priced that expectation into bond prices and interest rates. For example, the interest rate on 10-year government bonds increased from 2.15 percent in November to 2.59 percent in mid-December.
The Fed’s expectation is that higher interest rates generally reduce borrowing and reduce inflationary pressure.
In addition, higher interest rates also increase the value of the U.S. dollar if other countries do not respond by raising their interest rates.
As the rate of return on U.S. bonds and other debt instruments becomes more attractive to foreign investors, the demand for dollar-denominated assets (U.S. bonds and stocks) and the demand for U.S. dollars both increase.
As a result, the dollar appreciates, U.S. exports are more expensive for foreign buyers, and imports from foreign countries are cheaper for U.S. consumers.
During the last half of 2016, the U.S. dollar has appreciated by 10 percent or more against most European and Asian currencies in anticipation of the Fed’s December action.
Future Fed policy could have a greater impact on financial markets and the general economy in the future.
What might impact Fed policy?
Future Fed policy could have a greater impact on financial markets and the general economy in the future. First, it should be noted that interest rates remain very low by historical standards and the Fed may or may not increase interest rates in the near future.
Though the Fed announced its intention to increase interest rates up to three more times in 2017, it also made such an announcement in 2015 and then did not increase rates again because of continued disappointing GDP growth in early 2016.
GDP growth in the U.S. is estimated to be only two percent in 2016. As a result, the most important factor affecting interest rate increases will be the rate of inflation.
If inflation exceeds two percent per year, the Fed will be more likely to increase interest rates. Related to inflation is economic growth and unemployment, with a higher economic growth rate and lower rate on unemployment likely putting additional upward pressure on wages and prices and leading to a higher rate of inflation, and therefore higher interest rates.
Fiscal policy – government tax and spending policy – also impacts economic growth and the unemployment rate.
The incoming Trump administration has indicated an intention to reduce taxes and increase government spending, primarily for infrastructure.
Lower taxes and higher government spending both have the potential to increase economic output and reduce unemployment, which could also result in higher inflation. Higher budget deficits will also likely occur.
The Fed could respond to this by further increasing interest rates. It should be noted that higher interest rates will increase the cost of government borrowing, further increasing budget deficits.
The timing of such fiscal policy changes would also be important. If Congress and the administration move quickly on these proposals, interest rates would be more likely to increase in 2017; if action is delayed to late 2017, however, the effects on interest rates would be unlikely to occur until 2018.
The Fed may also consider the impacts of rising interest rates on the value of the dollar. If the value rises rapidly compared to the currencies of major trading partners and competitors, U.S. exports will decline and the competitiveness of the U.S. economy will be adversely affected.
The global economy remains stagnant and many foreign consumers of U.S. products such as Japan and the European Union; and competitors such as Brazil and Argentina are very unlikely to raise their interest rates.
Implications for Michigan
As noted earlier, the Fed’s December action has already been priced into bond markets. As a result, the interest rate on producers’ operating loans for 2017 are likely to reflect this increase. The impact beyond early 2017 will depend on the Fed’s next actions.
Interest rates will remain low unless the Fed continues to raise them in 2017. Higher Federal Funds rates will eventually work their way through the general economy, and the cost of borrowing money will increase.
The largest impact of higher interest rates may be on land values. Higher interest rates increase the total cost of buying land and this could reduce the value of land.
For example, interest rates on 30-year government bonds have also increased from 2.58 percent in early November to 3.06 percent in late December.
Lower land values will adversely impact farm balance sheets and increase debt-to-asset ratios making access to credit more difficult. Compounding this potential problem is the fact that low commodity prices make debt service more difficult.
A higher value of the dollar resulting from increased interest rates will make exporting to foreign countries more difficult. In addition, a higher value of the dollar will make the price of competitors’ agricultural commodities comparatively less expensive. Reduced access to export markets will put further downward pressure on commodity prices.
William Knudson and David B. Schweikhardt are agricultural economist with Michigan State University