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The Fed Makes Its Move

After cutting short-term interest rates 13 times, the Federal Reserve did something on the last day of June that it hadn't done in nearly four years. In a move that had been expected for months, the Fed raised the federal funds rate a quarter point to 1.25 percent. This is the first of what is likely to be many increases. Over the next year, we should see the federal funds rate rise to 2.5 to 3 percent. In anticipation of the Fed's move, long-term interest rates have been rising for nearly a year.

Rising interest rates reflect an improving economy. They also reflect the Fed's fear of rising prices. The question that many retailers and their suppliers are asking is: So what does this really mean to me?

The credit markets have a stellar record of forecasting the economy, if you know how to read what they are saying. When short-term interest rates rise above long-term rates, as they did in 1989 and again in 2000, the credit markets are warning of a recession. When there is a wide variance between long- and short-term rates, as there is now and as there was back in 1993, the credit markets are forecasting a booming economy.

A wide spread between short- and long-term rates means that bank margins are very large and, hence, banks have an incentive to lend. Money is what makes the mare run and nothing creates money like bank lending. Since the rate increase in June, long-term interest rates have actually fallen. The increase in short-term rates and the drop in long-term rates narrows that spread, reducing the growth of bank lending and the economy.

For retailers, a slowdown in bank lending will translate into a slightly slower pace of real-estate development and perhaps more stringent lending on inventories. On balance, the rise in short-term interest rates will translate into slower growth and less inflation for the economy as a whole in the months ahead.

Rising inflation is generally a mild positive for retail profitability. Rising prices allow most retailers to pad margins and add to inventory profits. At the very least, rising prices add to the top line and take some of the pressure off of the need for more productivity growth as a booster to profitability. With rising interest rates, that top-line pressure is going to intensify.

For suppliers, rising interest rates represent an increase in the cost of doing business. As retailers force suppliers to hold a greater proportion of the inventory in the supply chain, the cost of financing this inventory rises with short-term interest rates.

The stock market generally reacts poorly to rising interest rates. Stock prices are discounted cash flow and a rise in interest rates increases the rate of discount and reduces the value of future cash flow as well as stock prices. Raising capital in the stock market becomes more difficult.

Some consumer credit-card rates are tied to short-term interest rates and the rates they charge on credit balances will rise. Consumers, however, have never shown themselves to be very sensitive to small changes in credit-card interest rates, particularly for small-ticket purchases.

The Effect on Convenience Stores

In raising interest rates, the Fed's press release commented, "Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors."

That is Fed-speak meaning that rising gasoline prices are only temporary. While declining gas prices will hurt the top line for many gas-oriented convenience stores, it will leave c-store shoppers with a little more cash in their pockets to spend on non-gas related items in the store. The challenge convenience stores face is in converting these gas buyers into non-gas merchandise buyers.

Auto sales tend to suffer when interest rates rise, increasing the monthly payment for new cars. When auto sales slow, however, sales of auto repair and accessory items tend to do better.
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