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Rising Interest Rates And The Impact On AED Members

The U.S. Federal Reserve just announced an additional quarter-point increase in interest rates, bringing the borrowing rate to a range of 2.25 to 2.5 percent. This was the fourth hike in 2018, and Fed Chairman Jerome Powell has made it abundantly clear that the decision was data-driven and not influenced by politics.

In its December rate hike announcement, the Federal Open Market Committee (FOMC) gave its reasoning for the increase:

When determining the timing and size of future rate adjustments to the target range for the federal funds rate, the FOMC will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

So, on balance, inflation has not gone up significantly since the ’70s and shows no signs of rising, yet the Fed is raising rates. What gives? The Fed cites the historically low unemployment rate for the move, a reason that can be hard to swallow for members of heavy equipment dealerships who have yet to find the answer to the skilled labor shortage. 

As noted above, much of the Federal Open Market Committee’s decision-making process is based on forecasts rather than outcomes. The committee released its own projections with their September rate hike announcement. 

Despite this trend of rising interest rates, rates are still at historic lows. We have all enjoyed zero percent or close to zero percent interest rates since the Great Recession of 2008 through late 2015. These bargain rates were geared to encourage borrowing and growth and, to some extent, it worked. Moreover, the trend of increasing hikes is apparently slowing. The Fed chairman commented, “Despite this robust economic backdrop and our expectation for healthy growth, we have seen developments that may signal some softening.” Powell added that FOMC officials “now think it is more likely the economy will grow in a way that calls for two rate increases next year.” In previous rate hike announcements, the FOMC predicted three rate hikes for 2019, so this news came as a relief to many.

To say the economic prosperity that the nation has experienced in the last few years is a direct result of the Fed’s past low interest rate would be absurd; after all, the interest rate is a tool that artificially influences the organic operation of the economy and financial institutions. The real reason for our industry’s recent growth can more likely be attributed to the Trump administration and its business-friendly tax reform.

President Trump’s response to the September 2018 rate hike was critical, but understandably so. The president tweeted, “The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?”

Fed Chairman Jerome Powell seems to be taking the brunt of the president’s flak, despite being nominated by President Trump in late 2017. It should be noted that Powell has no formal background in economics and is by far the wealthiest person to hold the chair position, with a potential worth of over $112 million as of 2017. What’s more, Powell was first nominated to the Fed’s board of governors in 2012 by Obama.

Since the Fed is not technically a part of the government, firing Powell would be a tall order. Even for someone whose catch phrase is “You’re fired.” But deep in the Fed’s founding laws lies the previously unused section 10, which states, “Each member shall hold office for a term of fourteen years from the expiration of the term of his predecessor, unless sooner removed for cause by the President.” A political firestorm and a ding to the United States’ reputation for economic stability would surely ensue from the use of section 10. But who knows, President Trump might be up for it. 

RATE HIKE IMPACT ON DEALERSHIPS

But enough with the politics. When it comes down to it, AED members want to know what the hikes mean for their dealerships. This question has a lot of moving parts and will only truly be answered with time. Traditional logic suggests higher rates mean dealerships hold off on purchasing new equipment. And yes, going into the new year, the cost of financing will likely play a larger role in the decision-making process of dealer CFOs and purchasers. But are the rate hikes enough to turn the tide on the heavy equipment distribution industry’s current good fortune?

Again, only time will tell.

Jon Shilling, president and CEO of General Equipment & Supplies, commented on his company’s past experience with higher interest rates: “Interest rates were in the 4 to 8 percent range for years and we managed our inventory accordingly. With a higher interest rate environment, we buy inventory that is needed to service our customer base and do not get too wild and crazy about stocking unproven products or slow-moving products.” Shilling was quick to highlight how his company uses increased rates to their advantage:

The up side to the higher interest rates is that we still continue to make a margin on the interest rates we charge customers during rentals and potential rental buyouts. When the customer gets to the end of a work season and must decide whether he is going to purchase the machine he has been renting from us, the higher interest environment actually works somewhat to our benefit, as he can put the machine on a purchase contract with a lower interest rate than was charged to him during the rental. Conversion from rental to ownership then makes sense.

For now, dealership decision-makers will keep a close watch on economic indicators like the real estate cap ratio and the price of oil. After all, our success is dependent on the needs of the industries we serve.

John Crum, national sales manager at the Construction Group at Wells Fargo Equipment Finance, advised, “A lot of dealers are conscious about exposure to variable cost to an interest rate and look at debt floating, fixed, or some combination of the two. Dealers can protect themselves by having interest rate hedges or a fixed rate component.”

DEALERSHIPS IN STATES WITH GAS AND OIL MARKETS

Dealerships in states like North Dakota, Texas and Oklahoma who serve the needs of oil and gas producers are especially concerned with rate hikes, as oil producers tend to be very debt heavy. Shale fracking is a capital-intensive endeavor, and most oil companies sell a lot of debt in capital markets to raise the money for operations.

Rate hikes will make transacting in these capital markets more expensive, which may lead to a reduction in oil production, which in turn could lead to AED members servicing and selling fewer machines to said oil producers. Some economists are even predicting a major burst in the shale energy industry bubble, as the industry is highly dependent on low interest rates.

“On the topic of the interest rate in the oil industry,” said John Shilling, “I guess in North Dakota we have not experienced anything negative yet. Oil production rates are roughly 1.2 million barrels per day and have been for seven or eight years. They are becoming more efficient at drilling for oil and getting it to market, thus our ‘boom’ in the oil patch has become steady business and we all have adjusted accordingly.”

THE SILVER LINING

Interest rates are rising, but they are hardly skyrocketing. The Fed plans to raise the interest rate at an incremental pace, roughly a quarter of a percentage point per quarter. Such a measured approach should not drastically alter a dealership’s financial forecasting; after all, interest rates are still pretty low. In addition, more rate hikes will boost the purchasing power of the dollar compared to other currencies.

Before we get too worked up about rate hikes, let’s remember that it is the strong economy that got us here. For many dealerships, the economy’s strength will be enough to offset any foreseeable additions to the cost of borrowing. John Crum reminds dealers that we are all in this together: “Increases in rates happen across the board; rental rates for equipment have been low because the cost basis is low. If everyone is in the same boat, then everyone will have to raise equipment prices to remain competitive and to maintain profits.”

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