For the second time this year, the Federal Open Market Committee (FOMC) announced it will increase the benchmark federal funds rate by 25 basis points, bringing it to a target range of 1.00 to 1.25 percent. Today’s move was widely anticipated following the Fed’s comments at its May meeting. Previously, it was expected that there would be a total of three rate increases in 2017, with the next hike likely coming in September—but due to weaker than expected inflation readings, there is now some uncertainty in the market about when the Fed will make its next move.
Source: J.P. Morgan Markets, as of June 9, 2017
Q: Should we be concerned about rising interest rates?
A: The Fed held interest rates close to zero throughout the recovery in order to spur growth in the private sector. Seeing them rise for the second time in three months could spark fears in some investors’ minds. However, interest rate normalization is actually necessary in order to continue the already long period of expansion. As the economy has gained momentum, unemployment has dropped significantly and growth is likely to continue without the Fed’s help—which is a positive for commercial real estate investors.
It’s also important to keep in mind that the Fed has been very cautious about raising rates, only doing so when it’s confident the economy can withstand it. Today’s hike was only the third time in the past decade that it has moved to increase them; in past cycles we saw eight hikes in the space of one year.
Q: When will normalization likely end?
A: The FOMC and the markets are calling for interest rates to eventually reach a long-term target around 3 percent, but the process of getting there is expected to take place gradually over the next few years. Compared to the past, today’s 1.00 to 1.25 percent is low—historically, the “normal” range for the federal funds rate generally fell between 4.00 and 4.25 percent.
Notably, several factors—including demographic changes and an aging workforce—have slowed the US economy’s potential rate of growth, which could result in a lower range being considered the “new normal” for interest rates.
Q: What is the Fed going to do with its balance sheet?
A: When near-zero federal funds rates alone were unable to spur sufficient economic growth, the Fed stepped in with a quantitative easing program—a monetary policy in which the central bank purchases Treasurys and mortgage-backed securities—in an attempt to push more capital into the private sector by keeping medium- and long-term rates low. Quantitative easing was successful, but it left the Fed with an excess of $2 trillion in assets that will eventually need to decline.
The Fed has signaled that it might begin that process later this year by gradually reducing reinvestment of securities as they mature. Some might fear that the market will react abruptly once the Fed begins reducing its balance sheet. Although a negative reaction could occur, it is unlikely because the Fed has already indicated its intent to proceed slowly. Given the Fed’s power over short-term interest rates and its ability to adjust the pace of reduction if the market reacts adversely, the Fed should be able to limit any disruption to the economy.
Ultimately, the Fed’s goal is to keep unemployment near current levels and inflation near 2 percent over the medium term—both of which will keep the economy healthy. Today’s move to hike rates should signal to investors that the US economy is in a strong place, and when the broader economy is doing well—with expanding businesses, higher wages and extra discretionary income—commercial real estate investors do well.
In our view, an appropriate strategy for a potential rate increase is to build a 200 to 300 basis point (2 to 3 percent) cushion into your deal. And, today’s 25 basis point rate increase still leaves us with a rate environment that is historically low.
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