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By: IBISWorld Analyst, Torsten Edstam
On March 15, the Federal Open Markets Committee (FOMC) raised the federal funds rate by 25 basis points – a decision that was primarily based on falling unemployment and strong wage growth. The month previous, the economy gained 235,000 jobs, bringing the unemployment rate down to 4.7% and marking 77 consecutive months of job growth. In addition, average hourly wages for all employees grew 2.8% in 2016, indicating that the economy has sufficient strength for a rate increase. Regarding the decision to raise rates, Fed Chair Janet Yellen remarked, “We have confidence in the robustness of the economy and its resilience to shocks.”
The FOMC met again this week and indicated that further rate hikes are imminent, despite slow economic growth so far this year. With the increase in March, the FOMC has now raised interest rates three times since the financial crisis in 2008, when rates were set at 0% to shore up the collapsing housing market. Short term interest rates currently stand at 0.75% to 1.00%, and the FOMC has indicated that it plans to begin raising rates at a faster pace to move closer to the goal of 2.0% inflation. As a result, two more rate increases of 25 basis points each are projected for June and September this year. IBISWorld expects these augmented rates to harm some businesses that have previously benefited from low interest rates. Fortunately, the increase in rates will also have a positive impact on other industries, especially those that generate a significant portion of their revenue from rate-sensitive investments.
Zero Percent Financing & Retailers
Because rising interest rates directly impact consumers, businesses in the retail sector will need to adjust their strategies for promoting sales. Since the recession, retailers have relied heavily on discounted rate offers, such as 0% financing, as a marketing strategy to encourage customers to make larger discretionary purchases, including cars, furniture, jewelry and appliances. However, due to continued increases in the federal funds rate, retailers that offer customers these deals will have to absorb greater interest costs for these loans, which are typically issued by a bank or finance firm.
Fortunately for retailers, the strong labor market and rising wages that prompted the FOMC’s decision will also push consumer spending upward, boosting sales growth. Therefore, rather than relying on 0% financing, businesses should begin investing in other strategies to drive sales, such as digital advertising campaigns and integrated advertising services. IBISWorld estimates that total advertising expenditure will reach $314.1 billion in 2017, as retailers and other businesses seek to increase their sales.
Business Financing Services
Rising interest rates will also impact businesses that take out loans to finance their operations. The prime rate, which is the interest rate that banks charge their most creditworthy customers, is typically set at three percentage points above the federal funds rate. Rising interest rates therefore make it more expensive for companies to borrow money for business development or acquisition and expansion. IBISWorld forecasts that the price of commercial lending will increase in line with the federal funds rate, growing by 0.2 percentage points in the next three years. Similarly, the average price of business credit cards is projected to rise by 0.5 percentage points, reaching an APR of 13.9% by 2020.
Due to the increasing costs of traditional lending options, more businesses are likely to turn to alternative sources of financing to increase their cash flow. For example, IBISWorld expects demand for invoice factoring to strengthen as interest rates trend upward. Unlike traditional lenders, invoice factors purchase current accounts receivable at a discount and then collect the outstanding debt, allowing businesses to increase their immediate cash flow without taking on loans. Because financing will become more expensive moving forward, businesses may benefit by locking in lower interest rates sooner rather than later.
While the rise in interest rates will increase financing costs for some businesses, it is expected to have a positive impact on the financial health of insurance companies. In general, there is a direct relationship between rate increases and revenue growth for companies in this industry. Insurance carriers invest a large percentage of the premiums they receive from customers in rate-sensitive vehicles, including Treasuries and corporate bonds, to generate the revenue necessary for covering the cost of claims. Some insurance carriers invest up to 75.0% of their portfolios in bonds, so that they have cash readily available to cover claims.
With interest rates at historical lows since 2008, insurance companies have had difficulty generating significant returns from these fixed maturity investments, which often represent the majority of their portfolios. However, as interest rates slowly increase, these fixed maturity investments will offer a higher rate of return, thus boosting insurance carriers’ investment revenue. Consequently, carriers that provide business insurance, such as professional indemnity insurance, building & contents insurance and business interruption insurance, will be more financially secure. This financial security will benefit their customers by reducing bankruptcy risk and potentially tempering growth in premiums. Even the minor rate increases that have already taken effect are expected to soon have a positive impact on some insurance carriers, pushing their investment revenue upward.
The Increasing Federal Funds Rate
Changes in the federal funds rate will have a ripple effect throughout much of the economy and impact sectors from retail to insurance. As rates reverse trends after years of stagnation, businesses will have to seriously consider how these changes will affect their operations. For instance, businesses that have relied on 0% financing offers should reevaluate their marketing strategies, while companies that expect to need financing would benefit from locking in rates in the nearer future. By adequately planning ahead for future interest rate increases, businesses can work toward minimizing negative outcomes.