August 1, 2022 | Article | 5 min Business insights
As the Fed proceeds to raise interest rates and combat inflation, business leaders must keep a close eye on the market and make changes to retain profitability in 2022 and into 2023. Read more here as we discuss the path ahead for the Fed and interest rates—and explore what the current plan means for business and investments.
The Federal Reserve works to support three primary economic goals: promote maximum employment, maintain price stability, and offer reasonable short-term interest rates. All three work together to fight inflation—a battle the central bank wins when they keep inflation at or below 2% per year. At least, this was a battle the Fed was winning—until Covid-19 essentially threw everything off balance, causing record-high inflation in 2022 and raising new concerns for the Fed and interest rates.
The Fed’s traditional weapon against inflation is short-term borrowing rate increases for commercial banks. Banks pass those increased rates to borrowers looking to take out personal or commercial loans; borrowing money becomes more expensive, forcing companies to save before considering a significant move. The strategy pulls cash out of the economy and, ideally, decreases inflation. However, it comes with its own risks as well—as rumbling discussions of a recession on the horizon have shown.
Let's outline the path ahead for the Fed and interest rates and explore what the current plan means for business and investments.
A Quick Review: The Fed and Interest Rates
Before diving into the deep end, here’s a quick refresher of economics 101 to understand the relationship between the Fed and interest rates.
It begins with a problem: prices increase as people spend heavily on goods and services. In the context of the current round of inflation, this was exacerbated by pent-up stimulus income (although the alternative—not delivering any aid—could have been catastrophically worse). This money flooded the market when the world reopened, allowing companies to raise prices as they choose. At the same time, demand quickly sped past reasonable supply, straining the log-jammed global supply chains. Meanwhile, the current labor crisis further compounded the supply-side problem. All of this has led to one thing—inflation.
To combat inflation, the Fed raises the federal fund's target rate, thus raising the cost of credit across the economy. Borrowers pay more interest as these rates rise, forcing them to rethink their borrowing strategy. Some may determine that they can't afford the loan. Others will have to save or generate more cash flow to lower their risk. This ultimately reduces cash circulating in the economy and helps “cool” inflation when it's been “heating up.”
Of course, the “hotter” inflation gets, the more aggressive the Fed is with interest rates. In June, the Fed raised benchmark interest rates three-quarters of a percentage point, the most aggressive rate hike since the mid-1990s.
Fed Chair Jerome Powell touched on the aggressiveness of the move but assured that such increases wouldn't be the standard in the future. However, he did indicate that rate decisions will be a meeting-by-meeting situation, with additional 50-75 basis point increases not totally off the table.
Effects of Increasing Interest Rates on Your Customers
Rising interest rates trigger a domino effect throughout the economy. The Fed increases the federal funds rate, banks spend more to borrow money from each other, and borrowers and customers pay more in interest rates. As their money tightens, buyers spend less on commodities, thus easing inflationary pressures. So how do the Fed and interest rates affect your customers—and, therefore, your business?
Customers will see significant interest spikes on credit card debt. Most credit cards come with variable rates, drawing a direct line to the Fed's benchmark rate. Consumers can expect their annual percentage to increase within one or two billing cycles each time the Fed moves with interest rates.
Credit card rates could top 18.5% by the year's end, which would set a record. For those carrying hefty balances, now's probably the time to pay off high-interest cards before spending on more consumer goods. But when customers cut spending to pay off high-interest cards, they typically spend less on your products or services too!
Effects of Increasing Interest Rates on Your Business
As it becomes more expensive to borrow money, customers tend to be more frugal with their reserve cash. The decreased spending lowers demand—and when demand goes down, businesses reduce output. This output reduction leads to fewer sales, forcing companies to make cuts to save money, such as layoffs. Rising interest rates slow the economy, while decreasing interest rates have the opposite effect.
When the Fed manipulates interest rates, it also directly affects your investments—and thus, your business. While it takes roughly 12 months for increased rates to have the most widespread economic impact, the move could see changes in the stock market more rapidly. Understanding this dynamic is essential.
Rising rates can cause the stock market to fluctuate. The cost of doing business rises alongside borrowing money for public and private firms. As it takes time to get inflation under control through increased rates, public firms could see lower revenue and earnings, thus impacting their stock prices and growth rate.
For example, Dan Chan, a former PayPal employee and a Silicon Valley investor highlights that “the interest rate may be so high that many companies will not be able to afford to grow.” When borrowing money costs more, companies often minimize their CAPEX allocation towards growth.
The bond market is perhaps the most sensitive during inflationary periods and is impacted in the face of rising rates. As rates go up, market prices decline almost immediately. Why? Because new bonds will soon flood the market, offering investors higher interest payments. Lower interest bonds must lower their price points to be more appealing.
Top Business Considerations Amid Rising Interest Rates
Many business leaders grew accustomed to record-low interest rates over the past decade. They were free to borrow money and run incredibly cheap price points, thus growing their businesses. But in today's inflationary climate, interest rates have reversed course—and will only increase in the coming months.
Chairman Powell indicated that the Central Bank plans to hike interest rates through 2022. And while the Fed and interest rates don't directly impact what your firm will pay on loans, you can expect your lenders to follow the Fed's example. Don't get caught off guard. Here are a few actionable strategies to consider for your company's financial future.
Compare Fixed and Variable Rates
Variable and fixed-rate business loans may state the same nominal interest rate while costing you two different amounts—one considerably more expensive than the other. Understanding the difference is crucial to running a successful business in the current financial climate.
Fixed-rate loans come with a static interest rate that never changes. On the other hand, variable rates fluctuate with the market and are susceptible to change—both rising and falling. Given the Fed's plan to increase the federal funds rate, it may be wise to refinance any variable-rate business loans.
Many lenders will increase their rates for existing variable loans quickly after the Fed raises rates. Businesses with variable-rate loans will likely see their financial burdens increase compared to those with fixed-rate loans. By converting to fixed-rate loans in advance of additional rate hikes, you could shield your company from changes in the federal fund’s target rate and inflation.
Each type of business loan comes with its own pros and cons. For fixed-rate loans, you're getting a good deal when rates go up (as they are now). But when rates inevitably drop back down, you may end up paying more. Still, fixed-rate loans keep your payments consistent, allowing you to budget more effectively. Since long-term loans leave you more vulnerable to interest rate risk, fixed-rate loans can be more appealing for businesses that require financing over a longer period of time.
Evaluate CRE and Equipment Loans
When Fed manipulates interest rates to slow inflation, it can also create a balancing act for businesses that require commercial real estate (CRE) and equipment as part of their growth strategy. Purchasing or developing CRE can require a significant capital investment. As the cost of borrowing increases as rates go up, companies should reevaluate the value of renting versus owning.
As the cost of borrowing increases, it can make more sense than ever to lease equipment rather than buy it outright. Leased equipment typically doesn't require down payments (outside of a possible security deposit) and leaves cash available for more inflation-friendly investments. Leasing equipment can also be more cash-flow friendly with lower monthly payments to safeguard. This is especially true when compared to variable-rate loans to buy the equipment.
However, compared to equipment, real estate requires a different set of considerations. While equipment depreciates as soon as it leaves the lot, real estate fluctuates, making the “buy vs. rent” conversation more nuanced.
Buying CRE helps you build equity on an appreciating asset. Assuming the property becomes more valuable over time, you can sell it for a profit while recouping most (if not all) of the money you've invested thus far. On the other hand, renting CRE might be a better option for businesses that are filling a more short-term need.
While on the subject, if you own the property and only need a portion of the space for your own operations, you can diversify income streams by renting out the remaining space. You might occupy 51% of the building to qualify for the initial business loan, but then rent out the remaining 49% to a tenant. As interest rates increase, you can raise rent to keep pace.
But buying CRE also has downsides, especially when prices rise. Aside from the 10-40% down payment, rising rates could make your monthly repayments far more costly. You may lose money if the property doesn't appreciate as expected, given the higher interest payments.
Analyze the Impact on Your Cash Flow
Rising rates make everything more expensive, thus affecting your cash conversion cycle and cash flow. Understanding this impact is crucial to navigating inflationary periods. Don't think that just because you aren't carrying any debt you're impervious to rising rates. Your clients and customers may tailor spending to repay their own debts, ultimately affecting your own bottom line.
Sensitivity analysis is increasingly important as interest rates continue to rise. Understanding where your cash conversion cycle is impacted by rising rates helps you better determine how to optimize your AR/AP to keep cashflow healthy, and position you for preferred financing.
Mitigate Effects by Making Small Changes
Rising rates increase your operational costs, but you can navigate those expenses by examining your cost of goods sold (COGS) and passing increased costs to end-buyers. You can also take the necessary back-end steps to lower your COGS if increasing prices might hurt rather than help.
Make an effort to examine your current inventory when auditing your COGS. Determine which items would be considered “dead stock” and consider removing those items from production. Once you've removed this dead stock from the production line, you can pivot towards the raw materials used to make the products that do sell.
Can you make the same product with cheaper/less material? Are there processes along the production line you can cut to increase efficiency and decrease labor costs? You can also revisit production tech to see if newer, innovative, and automated technologies are worth the investment. Ultimately, reducing waste goes a long way in reducing your COGS and combating rising rates.
Guard Your Business Against Rising Rates Today
As the Fed proceeds to raise interest rates and combat inflation, business leaders must keep a close eye on the market and make changes to retain profitability in 2022 and into 2023. Rising rates weigh heavy on consumers and business owners alike, so preparing for potential threats today is essential to business success. While those preparations may seem daunting, they're made significantly easier with the help of a trusted financial partner such as New Mexico Bank & Trust.
Get in touch with New Mexico Bank & Trust today to speak with a commercial banker with local market insight. Together, you can form an actionable plan to navigate future possibilities in the face of rising interest rates and record-high inflation.