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Outlook 2006: Interest Rates

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The Challenge Just a couple of years ago, interest rates were enticingly low. From June 2003 to June 2004, businesses delighted as the federal-funds rate (what the Fed charges on overnight loans between banks) stayed at an unheard-of 1%. Using debt to finance a business was a savvy choice.

Since that June, though, the Fed has raised interest rates at every meeting, and the federal-funds rate is up to 4%. Alan Greenspan has indicated that will continue, as has his expected successor, Ben Bernanke, who has pledged to "maintain continuity with the policies and policy strategies established during the Greenspan years." Bernanke's first Fed meeting will be in March (pending Senate approval).

That continuity means, presumably, tempering economic growth and inflation worries through still higher interest rates. Macroeconomic Advisers' Prakken predicts that the economy's slight dip after the hurricanes will reverberate into fast growth in the first part of 2006. The employment rate will rise as Katrina victims find work, and reconstruction activity will boost GDP growth (everything that was destroyed in Katrina will be counted as new contributions to the economy as it is rebuilt). Plus, outside of the Gulf devastation, the economy is pretty strong, with good production growth and consumption. "Before these storms, we were telling clients the fed-funds rate would be up to 4.5% by spring," says Prakken. "Now, we're saying 4.75%."

The high interest rates may be good economic policy, but businesses are groaning. "My biggest concern is the change in interest rates," says Irene Cohen, CEO of FlexCorp Systems, a $48 million company that manages temporary workers for large corporations. "As far as I'm concerned, it's out of control. And we know that it keeps coming."

What You Can Do In a service business like Cohen's, higher interest rates necessitate being careful with cash flow--"We watch it practically hourly," she says. In businesses with higher fixed costs, though, stronger cautions are necessary. Those that have been hedging the prices of raw materials by stocking up on them are stopping. And the low-inventory, just-in-time approach, which has traditionally been popular in high interest rate years, should prove popular once again. "The name of the game is low inventory, low carrying costs, more of a just-in-time environment with regard to raw materials," says logistics company CEO Jarrett. Businesses should also be wary of applying for loans and refinancing debt, and of buying new assets, since the cost of capital is rising.

Another way to hedge against interest rates is by outsourcing, offshore or domestically. "I think rising interest rates can cause some interesting things to happen in the U.S.," says Jim Franke, president of eTelecare Global Solutions, a $101 million call center company based in Monrovia, Calif. "I think that could further increase the amount of outsourcing that's done in total. If a company wants to hire a bookkeeper, for example, that would mean investing in a computer, desk space, and salary. But when interest rates rise, the cost of financing that investment rises--so it might be more attractive to outsource that function and just pay for the hours used."

Outsourcing converts fixed costs--the computer, the salary--into variable costs. If fixed costs are high, then even if sales plummet, companies are stuck with them. Changing some of that to variable costs means companies are less likely to get slammed by sales fluctuations.

What Insiders Watch

  • The Federal Reserve's fed-funds rate. It's announced after each Fed board meeting.
    www.federalreserve.gov
  • The Chicago Board of Trade fed-funds futures contracts, which are insiders' bets on where the Fed will move rates at its next meeting
    www.cbot.com
  • The yield curve for government bonds, which are examined as indicators of future rate changes and economic vitality (most financial sites track this, including stockcharts.com/charts/YieldCurve.html)



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