When will interest rates go down? If businesses are considering an expansion or if a person is buying their first home, second home or home away from home, this question remains top-of-mind for many consumers and commercial clients.

The interest rate benchmark, set by the Federal Reserve, is called the fed funds rate. Most investment and borrowing rates are based upon this benchmark. For example, the prime rate, a base for setting lending rates, is usually 3% above the fed funds rate. A fed funds rate of 5.5% equates to a prime rate of 8.5%.

Because the fed funds rate is so important, pundits may speculate as to when it will drop. I have a few theories on why there is so much discrepancy.

First, let’s look at the age of our workforce. Nearly 60% of our current workforce started in or after the year 2000, according to Statista. In May of that year, the fed funds rate hit 6.5%, the highest in the last 25 years. Since that time, rates have largely declined, hitting 0% during the Great Recession, and staying at or near that level until last year. During that period, there were a couple of interest rate blips, but when those happened, rates quickly fell back to about 0%, according to the Federal Reserve. We will call this period, the “zero rate environment.” Most of our workforce and population only knows a zero rate environment.

Now that the fed funds rate is 5.5%, the logical expectation is a rapid decline back to zero.

Second, when I hear experts espouse a rapid decline, I look to the industry they represent and how rate movement benefits them. Take for example, Wall Street investment firms. They want low rates so people invest in stocks and not money market depository accounts or certificates of deposit. Or private equity funds that have built their business models on a zero rate environment. They need it back so they can make money.

Then there are the developers who have large downtown projects with high vacancy rates. These projects were financed at low rates and cash flowed at high occupancy rates. You can only imagine the effect of refinancing a loan rate from 4.5% to 8.5%. Then, add lower cash flow from fewer tenants and a major problem spreads industry-wide.

Another theory espoused is that rates will decline because it is an election year. Ironically, during the zero rate environment, rates did tend to decline around elections. However, if you dig deeper into the timing, the head of the Federal Reserve was also up for appointment by the president during those time periods.

This fall, Chairman Jerome Powell is not up for reappointment. Maybe, if rates decline at that time, it will be based upon the data, and not politics.

Finally, let’s talk more about the Federal Reserve. They are in quite a quandary. They have a mandate to fight inflation and keep employment high. While inflation has reduced, it still remains stubborn and is dropping slowly. Consumers are still spending and employment remains robust. Until spending or employment drops, the Federal Reserve will most likely hold rates at this level.

But here is the more complicated quandary: The Federal Reserve has concerns over its own financial situation, along with the large level of the federal government debt. On Jan. 24, a Wall Street Journal article said the Fed posted its largest-ever annual operating loss of $114.3 billion. The reason is that their investment income on their U.S. Treasuries is less than what they have to pay to banks at the fed funds rate. Additionally, the federal government debt has ballooned by a third since Covid-19. As a country, more of our federal budget is spent on interest costs, according to the Wall Street Journal. This contributes to tremendous inflationary pressure. However, the Federal Reserve needs to keep rates high to fight inflation, but lower rates to reduce their losses and interest rate costs on the federal debt. This is quite a predicament.

So, what does all this mean? Perhaps this is the cost of a “soft landing” and not another recession. While $114 billion a year sounds like a lot of money, it is not compared to the trillions of dollars of national debt. As a nation, we can afford to hold this course for a while and allow our society to become used to the higher rate environment, which is near the 100-year average rate environment. Due to the financial pressure on the Federal Reserve and our national debt, the pundits may also be correct that interest rates will decline. As for the timing, only the Federal Reserve knows.

While none of us locally can always have a say on national level decisions, it’s in our communities where we see the health of our economy on display daily. Independence Bank is committed to the local businesses and families around Kentucky where we serve.

As we navigate the changing rate environment together, we invite you to stop in and see us today. You can find us at our St. Matthews location at 3901 Shelbyville Road or online at 1776bank.com.

Originally published
Louisville Business First
Louis Straub, President
March 1, 2024