Inflation is declining, the jobs market is cooling and it looks pretty certain that the Federal Reserve will cut interest rates come September. But will lowering the federal funds rate – the interest rate the Fed charges to its member banks and an important tool for controlling money supply and inflation – have a significant effect on small businesses? Sorry to be the bearer of bad news but not really.
The Fed raised this rate 11 times over 16 months – an unprecedented run – and the subsequent impact has been significant. By combining this rate increase with a reduction in bond purchases, the central bank has managed to decrease its balance sheet by 20% over this period of time and also rein in the nation’s money supply after significant increases. There’s still some ways to go (the Fed’s balance sheet is still significantly higher than pre-pandemic levels) but no one can deny the results of the central bank’s actions.
The fiscal spending blowouts from government stimulus bills in 2021 and 2022 have been a big headwind in the Fed’s efforts to control inflation. Regardless, the consumer price index – which is the common metric for measuring inflation – peaked in 2022 at 9% and has since come down to 2.9%.
Consumers and businesses are still trying to catch up to the quick and significant jumps in some costs like insurance, rent and childcare and the rate is still above the Fed’s target of 2%. But it’s heading in the right direction. Unemployment has stayed relatively low and the economy has not fallen into a recession. The Fed chair, Jerome Powell, and the treasury secretary, Janet Yellen, may have mis-called the effects of inflation back in 2021 (remember: “it’s transitory”) but they’re doing a good job addressing the problem.
Some have paid the price for these actions, though. With a prime rate at 8.5% – the highest it’s been in decades – my small business clients are now paying as much as 12% for new financings. That’s when they can get the financing. Many have found this much harder as banks have increased their scrutiny on their clients’ abilities to service their loans in this higher-cost environment.
The nation’s real estate industry has also hit similar headwinds. Mortgage rates have hovered around 6-7% and many potential buyers have stayed away from the market, not wanting to replace their existing mortgage with a new one costing them three times as much. Supplies of existing homes have dwindled, house prices are at all-time highs and housing affordability has dropped to all-time lows. That not only affects builders but all the small businesses that directly and indirectly profit from housing transactions including realtors, mortgage brokers, home inspectors, title insurance providers, contractors and designers.
But if things stay on track, Powell will probably propose further small reductions in the fed funds rate. Will this save the day for small businesses? Not really. At least not right away.
A quarter-point reduction in the bank’s prime rate isn’t going make a big difference in a company’s loan repayment schedule or its ability to get approvals. A similar reduction in the average mortgage rate still means that rates remain at a level that’s multiple times above what many homeowners are currently paying. The stock market has already built in its expectations for a rate reduction so any bump in our retirement plans portfolio from rate-increase-ecstasy will mostly be short-lived.
No one’s complaining. A reduction in interest rates – no matter how small – is a step in the right direction. With fingers crossed, the hope is that the US economy (and the consumers underpinning it) will continue to hum along at least for enough time to absorb more interest rates decreases without heating up too much and triggering inflation again. A sub-5% mortgage rate environment will definitely unleash the pent-up demand for home buying and selling which will be a godsend for the real estate industry. Having the prime rate fall two points will free up more capital for small businesses and for a portion of the millions of newly minted entrepreneurs looking to grow.
Interest rates really do matter. In a capitalist economy, the cost of capital is one of the most significant factors underpinning investment and growth. Small, incremental decreases won’t be a gamechanger right away. But over time – and as long as they continue – we’ll all see the positive effects.
