Interest rates impact the economy in many ways. For businesses, they signal potentially higher borrowing costs and reduced cash flow as the availability of cheap credit runs dry.
As it turns out, all those headlines you’ve been reading about the Federal Reserve could have a major impact on your business.
Federal Funds Rate Rises
On March 15, the Federal Reserve voted to raise the target for the federal funds rate by a quarter point to 0.75% to 1.00%. That was the second interest rate hike in two months. The decision, which surprised no-one, came in response to rising inflation and a gradually improving economy – two ingredients that give the central bank the justification it needs to raise borrowing costs.
With the March move, the Fed has raised interest rates only three times since the recession. At 1.00%, the federal funds rate is still very low by historical standards, but is widely expected to rise at an even faster pace over the next two years as inflation runs hotter. Rising interest rates cause a ripple effect on borrowing costs for businesses seeking access to credit. Understanding interest rates is therefore seen as an everyday part of business planning.
How Banks Borrow from One Another
To understand how interest rates impact business planning, it’s important to reflect on how banks borrow from one another.
The federal funds rate is essentially the interest rate banks pay to borrow reserves from one another. When rates are low, banks pass the lower cost of debt to consumers and businesses. When rates are high, they pass on the extra costs to the same end users. When the central bank raises the federal funds rate, banks pay more to borrow from one another. These costs eventually trickle down to consumers and businesses looking for credit. This is especially the case for variable-rate loans, which are the first to feel the impact of higher Fed rates.
Auto loans and mortgage rates aren’t directly impacted by a Fed rate hike, but tend to move higher as lenders pass on costs to consumers.
That’s why businesses carefully monitor Federal Reserve meetings. Businesses, consumers and investors have a vested interest in monitoring the pace and timing of Fed interest rate moves. The Fed meets eight times each year. You can check out their schedule here.
For the latest news about the Fed, interest rates and how these dynamic forces impact your business, be sure to check out the Red Door Blog. It features key stories and resources that can help you stay informed.
How the Federal Funds Rate Impacts Business
Rising interest rates affect business owners in three ways:
- Access to credit
- Cash flow
- Consumer behavior
Access to Credit
Higher interest rates make access to credit more restrictive, which could impact an owner’s ability to grow their business. In other words, banks charge more for business loans when the federal funds rate rises.
If you’re a small business owner enjoying a fixed rate loan, a rate hike might not impact you right away. But if you have a variable rate loan, paying down your debt may get a little harder. Of course, higher loan payments could eat into your profit margin.
It’s generally understood that business profits decline when rates rise (unless you’re a bank, in which case profitability tends to increase). That’s because the cost of capital to expand your business tends to go higher when rates rise. In this environment, you’ll have to be extra picky about your capital expenditure.
Access to credit is a challenge many business owners face. Red Door offers specialty financing and other solutions to help you meet your funding goals. Click here to learn more.
If you’re an entrepreneur or small business owner, there’s a good chance you’re dealing with limited cash flow. When interest rates rise, even more of your cash will be diverted to repaying loans.
Rising interest rates also mean that lending is generally more restrictive. Short-term loans that boost cash flow may be harder to qualify for (and probably more expensive) in this environment. Expect banks and other traditional lenders to scrutinize your loan application much more carefully in tougher lending environments.
Interest rates have a major impact on consumer expectations and overall spending patterns. When rates are low, consumers enjoy easier access to credit and are more likely to spend on big-ticket items. When consumers pay higher interest rates on loans, they have less disposable income to buy your products and services.
In other words, you can expect consumer spending to decline (or at least moderate) in a rising rate environment. Remember, the Fed rate impacts things like credit cards much more directly. As the cost of borrowing rises, so too does the cost of servicing debt.
Understanding and anticipating consumer behavior is important for small businesses and entrepreneurs. Red Door Capital has developed custom cash management and merchant service solutions that can help you manage all stages of the business cycle.
Preparing for an Uncertain Future
Rising interest rates aren’t the end of the world. The Fed raises rates only when it is confident that the economy is on the right track and that jobs are plentiful. A robust economy generally means that consumers and businesses are better positioned to absorb rising interest rates.
Most economic data seem to indicate that the American economy is improving. Jobs are plentiful, wages are rising and more people are buying homes. For the Fed, these forces will offset any potential negatives of higher interest rates. This changing economic landscape is sure to impact your company’s growth and expansion. Find out how to increase your funding solutions in a rebounding economy by clicking here.
Although it’s almost impossible to accurately predict the future, understanding how interest rates impact the broader economy is essential for business planning. Now you have the context to make more informed decisions.
If you’re on the fence about how interest rates will affect your business, check out our cash flow solutions. We can help you with accounts receivable, payroll and credit and debit card payments.