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Sunday, September 8, 2013

Fed Tapering and Interest Rates

If Past is Prologue

Ruggles AFN September 2013

Federal Reserve Chairman Ben Bernanke let it slip a couple of months ago that the Fed might begin to “taper its asset purchases” this fall. “Asset purchases” in this case is a euphemism for the Federal Reserve buying our own U.S. Government debt. The Fed has been buying about $85 billion in U.S. Government bonds each month for quite some time, representing about 60% of total U. S. debt purchases. Yes, they do this by “printing money,” another euphemism.

Markets didn’t like the sound of Bernanke’s comment and immediately retreated, the Dow from a record high of over 15,000. Certainly, markets hang on every word Bernanke speaks, reacting to the actual words as well as to what they think he means. Bernanke says the Feds future actions will be “data driven.” Analysts believe the Fed could begin their “taper” as soon as September if data for August looks favorable.

Mortgage interest rates have risen a full percent this year. Despite this, home prices have advanced remarkably. The “Sequester Spending Cuts” are still in effect, adversely impacting GDP numbers, yet the economy marches forward showing surprising growth under the circumstances. The specter of another debt ceiling fight, as Republicans threaten to hold the debt ceiling hostage in an attempt to renegotiate ObamaCare, hangs like a pall over the economy while fears of a Syrian/Middle East engagement raises fears of a sudden spike on global oil prices putting the world economy in jeopardy. Still, the U.S. economy marches on. Many analysts believe this is a product of incredible built up demand in the U. S. economy.

Normally, “money printing” of this magnitude weakens a country’s currency, which occurred initially to the U. S.dollar. That had many folks upset, but resulted in an export boom led by refined fuels as dollar denominated trade became less expensive to foreign buyers. Another effect of a weaker dollar was that Chinese goods became more expensive here, resulting in the loss of about 10,000,000 jobs in China. Surprisingly the dollar has recently strengthened. Now Japanese and Korean auto manufacturers are feeling price pressure on exports to the U.S. while making them grateful they have manufacturing in the U.S.

But the Fed has vowed to take away the punch bowl before the party really gets started to mitigate the risk of market bubbles and destructive inflation, while calling it “tapering.” At some point, we ARE going to have to find out the real “cost” of money. Many fear the “rubber band” effect of releasing the lid on something that should have been freed long ago. Corrections rarely go directly to the point of equilibrium and most often overshot the mark before eventually finding the balance point.

So what is the “real" interest rate if we no longer had an artificially low Prime Rate and say 2.5% measured inflation? I’ve read analyst estimates of 4.5% to 5.5% once the rate is allowed to find its own level. If this is correct let’s hope we don’t have to endure a period of “rubber band effect” after the interest is allowed to “float” before the natural equilibrium is achieved.

Flash back to 1970, the year I entered the auto business. The Prime Rate was about 7% compared to the current 3.25%. A mortgage cost about 7.75% for a 20 year mortgage compared to the current 30 year 4.5%. But a 36 month car loan was 12% compared to the current Tier 1 rate of about 3% for a 72 month car loan. There were no credit tiers in 1970, with only the local finance loan company to charge a higher rate for higher perceived risk for certain borrowers. Perhaps the much higher spread at the time was how lenders accommodated those with less than perfect, but not awful credit, thereby charging the best borrowers “too much” while the less credit worthy buyers caught a break? I didn’t know any different as I had no other basis of comparison. At the time I thought things had always been this way.

The car loan rate stayed around 12% until it went higher, much higher around 1978. By then we were decrying 48 month car loans and complaining about “stagflation,” a weak economy along with inflation.

Paul Volcker, Fed Chairman at the time, appointed by President Jimmie Carter, fixed all of that. But this remedy was not without considerable pain. Many of us who have been in the auto industry for some time recall vividly when interest rates were allowed to keep pace with inflation after the wage and price controls of the 1970s were lifted. The horror of 20% floor plan interest and 16% interest rate car loans will never be forgotten by those of us who lived it.

Today’s auto dealers pencil out projections of what a doubling of their floor plan rate would mean to their business, as well as a 2 – 3% increase in Tier 1 finance rates. And OEMs roll on as if none of this could happen, pushing dealers to spend more and more on their facilities while the Internet puts ever higher pressure on gross profit margins.