Interest rates are at levels no one has seen since the mid-1950s. It may be time to lock those rates in since the inflation horizon may be changing.
The Federal Reserve Board (Fed) sets short-term interest rates. It has lowered them repeatedly during the last two years in an effort to stimulate spending and revive the economy.
There is little indication that the Fed plans to change its course and increase rates, but the likelihood of them dropping farther is slim. At press time, prime rate was at 4.25% and six-month treasury bills at 1.22%.
Even though the Fed has not indicated it may increase rates, there's still danger that long-term rates could spike. Keep in mind that the Fed doesn't set long-term rates, which are very dependent on anticipated inflation. The market establishes those rates.
Something occurred last December that may impact future inflation. The Commodity Research Bureau (CRB) is an index that we watch closely and comment on in each of our weekly market updates, and is a leading global indicator of industrial commodity prices. The CRB is made up of 17 commodity groups involving grain, energy, metals, etc. — anything that can be pumped, mined or produced from land.
In December, the index exceeded a monthly high made in October 2000. This index has been making lower highs and lower lows for the last 22 years. Subsequent monthly highs above current levels could indicate that commodities have ended more than two decades of deflation and are beginning to rise. (See chart.) During 2002, the CRB rose 19%.
If the CRB keeps rising, it will mean more inflation, and more inflation means high long-term interest rates. So I would evaluate decisions to fix intermediate-term and long-term debt, or roll down current rates if they are already fixed. One recommendation cannot fit all situations.
The ability to bear rate risk depends on your working capital position, profitability margin and overall debt structure. Some just sleep better at night knowing their cost of borrowing is known. If that's the case, lock in your rates.
Most lenders have a variety of options and products to allow you to design a product that fits your financial and psychological profile. It can involve fixing rates for 1, 5, 10, 15 and even 20 years.
This week I was working with a client who is borrowing a large amount of money on a facility he's building. He probably won't have the money or want to pay ahead on the mortgage. First of all, there will be little excess cash from the project. Second, at these rates you'd likely not want to prepay it anyway. He chose a fixed rate for 10 years with a prepayment restriction for seven years. This made the cash flow from the project better and reduced overall risk.
Unless you have very little debt and plan to pay it off soon, look at fixing rates this winter. Things could change quickly, especially with uncertainty in the Middle East and the potential cost impact of a variety of inputs — not only money, but also energy. The probability of rates going much lower is less than the risk of them going higher.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell previously spent 26 years with Farm Credit Services as a division president. For more risk management tips, check his Web site (www.russellconsulting.net) or call toll-free 877-333-6135.