Chart of the Week: Fed Funds Rate, Outbound Tender Volume Index – USA SONAR: FEDFUND.USA, OTVI.USA
The Fed raised interest rates another 75 basis points (0.75%) on Wednesday, which will more than likely support the continuing decline in trucking demand that started in early March. The national Outbound Tender Volume Index (OTVI), which measures requests from shippers for truckload capacity, has an inverse correlation with the federal funds rate — as one goes up, the other comes down. Truckload demand has been at its highest levels while interest rates have been close to zero. This correlation is somewhat coincidental but definitely not disconnected and predicts a sharper decline in volumes is yet to come.
The primary purpose of the Federal Reserve is to ensure economic stability by keeping prices stable and maximizing employment. Inflation has been above what the Fed views as acceptable — ~3% — since the start of the year, causing it to raise interest rates at a historic pace starting in March.
While stabilizing prices and maintaining full employment may be a mutually exclusive endeavor at the moment, the Fed views inflation as the priority.
The main purpose of raising interest rates is to subdue demand, primarily for goods. While the interest rate increase only directly influences the interbank rate or the rate at which banks borrow from each other to meet reserve requirements, it is also the basis for other interest rates that influence just about every other form of financing and savings account in the U.S.
Banks essentially use the funds rate as a cost basis for every other offering all the way down to personal loans and credit cards. The difference between the funds rate and the offered loan rate is how the banks fund their operation and make money. So when the interest rates increase, so do other rates in general.
The increasing cost of borrowing money means companies have to spend more on financing large purchases. Most companies do not carry large amounts of cash since their main purpose is to increase in value, which cash loses over time — thanks to inflation.
The bottom line for trucking
As financing costs increase, fewer purchases are made by businesses and consumers — meaning fewer goods are transported.
Here is where things get messy. While the Fed has clearly stated it means to fight inflation until the job is done, this message assumes it is the Fed’s job alone to fight inflation. The tools of the Fed are all demand-side influences — money supply, interest rates and a few other tools that encourage or discourage spending.
Anyone involved in supply chain management or transportation knows that most of the current inflation is supply side induced. Things like difficulty sourcing transportation capacity, production disruptions and cost of labor increases have all pushed the supply curve inward. Many of these items are in a state of correction as this article is written.
Trucking rates in correction
Looking at the OTVI, there was a 19% drop in truckload demand over the course of five weeks starting in March, before the Fed started raising interest rates. This drop has pushed truckload spot rates excluding fuel from a point where they were 63% higher than pre-COVID levels to a current value of 17% over September 2019.
Truckload contract rates take longer to move and have just started to drop over the past few months. The historic relationship between spot and contract rates suggests they will fall at least another 14% — if demand remains stable.
The problem is that interest rate changes take about 12 months to fully hit the economy, which means we are still six months away from the first rate increase being felt fully. Most trucking indicators and recent reports from companies like FedEx show that demand is already falling rapidly without the help of interest rate increases — suggesting that the Fed actions may show up at a time when the economy is in need of stimulation.
The Fed has admitted misunderstanding economic environment in recent years, drawing criticism from many experienced economists and former members. I know at least one economist who did not dismiss inflation as transitory last year and it was probably due to his immersion in supply chains and transportation.
The Fed of course has to look beyond near-term pain and individual sector interests to make the best decisions for the overriding health of the economy — no small ask — but recent history suggests its understanding of the current environment may be murky and trucking companies should brace for deeper drops in demand.
About the Chart of the Week
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