The good news is that your input costs may be low enough to offset some of your increased labor costs.
The bad news is that your sales could drop due to higher interest rates.
The Federal Reserve is expected to raise the federal funds rate from 0-0.25% to 1% by July 2022. That doesn’t sound like a big increase, and it isn’t. But, it’s fast.
The terminal rate is expected to be 2.5% in 2023. Even this rate is relatively low. However, the super cheap cost of money undermined the business environment as it allowed weak and failing businesses to operate.
A higher federal funds rate impacts other rates, such as mortgages, Wall Street Journal Prime, and lines of credit. Many lines of credit are re-evaluated monthly, so higher interest charges immediately impact the bottom line.
Some businesses operate from owner-occupied buildings, and those term loan payments could also adjust upwards. Higher interest rates affect your business’ cost of capital, reducing cash flow. You are mistaken if you think that higher interest rates will not affect you because you have no more debt. What impacts your customers, and the rest of the world, impacts you.
After the Japanese asset bubble collapsed in 1991, the government allowed banks to prop up so-called zombie companies by giving them enough cheap money to repay their loans. Two decades of easy money have created zombie companies here in the United States
There is no exact definition of “zombie companies”. Yet the Federal Reserve’s July 2021 report “US Zombie Firms: How Many and How Consequential?” notes that “it is generally accepted that these companies are not economically viable and manage to survive by appealing to banks and capital markets”.
Between 2015 and 2019, the Fed found that about 10% of public companies and 5% of private companies were zombies. Based on the peaks during the US recessions of 2001 and 2008, I would venture to assume that the numbers are double those reported for 2019 (and are even more dependent on easy money policies today).
The economic cycle has become linked to monetary policy. Marginal business practices were effective because the low cost of capital allowed for inefficiencies.
Despite these risks, the Fed intends to fight inflation by raising rates. According to the NFIB Research Foundation, the biggest problem facing small business owners is no longer labor shortages, it’s inflation. Inflation recently hit 7.5% over the past year, the highest consumer price index (CPI) measure since February 1982.
Since 1977, the Federal Reserve has fulfilled a dual mandate defined by Congress, to “effectively promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Fed’s target inflation rate is 2% (using a measure known as Personal Consumption Expenditure). His next dragon to slay is the High Price.
Supply chain issues partly explain the high inflation. The Fed cannot fix the supply chain issues that contributed to inflation. However, the Fed can slow down the economy. Interest rate hikes are a lever to induce your customers to buy less of what you sell. Falling demand for goods and services lowers prices.
When interest rates rise, consumers tend to save more and spend less. Higher interest rates mean higher debt servicing costs. This prevents households from spending on credit cards and taking out loans, which means your sales and profits could plummet.
The corporate sectors that will be hit first will be the most sensitive to interest rates. Mortgages will become more expensive. Auto loan repayments will be higher. Then it could spill over to the rest of the economy.
Higher debt service decreases profits and deters companies from starting new projects or expanding because they cannot afford credit as easily. This company may not be you, but the company or its employees could be your customers. It affects us. And once that starts, banks might become more reluctant to give you a business loan when you need it most.
You can take steps now to prepare for how higher interest rates could affect your business. You need to take action to control rising costs and defend your revenue.
If your lender allows you, change your adjustable rate loans to a fixed rate. This will lock in your low rate for the duration of your loan. If the lender does not allow refinancing, you can pay off your debt to avoid spending more at a higher interest rate. (However, you will need to account for the ratio of interest payments to principal in your amortization schedule.)
If you have excess cash, you can open a high-yield savings account to generate more interest income.
You can get an approved line of credit now. If your bank does not extend the credit, you could borrow from your investment portfolio. For example, Charles Schwab & Co. allows investors to take out a “pledged asset line” to “use for real estate investment, business start-up, or other expenses.” Suppose the economy slows down or your borrowing costs increase. In this case, it will be more difficult to obtain financing. Better to have it and not need it than to need it and not have it.
Finally, change the consumption habits of your customers. Pull some of your sales forward and make others recurring. This statement can (and has) been extended to entire books.
I understand it’s borderline flippant to suggest that it comes as easily as waving a magic wand. I also know that the reaction of business owners in all industries is, “We can’t do this; you don’t understand my industry. Well, I know business. And I know that owners of small boxes often find themselves. This box limits opportunities to cut costs or defend revenue. Let’s get out of this box.