Navigating High-Interest Rates | Challenges and Solutions for Small Businesses

By MANAF SELLAK
Assistant Professor of Economics
Washburn University School of Business

Small businesses are the pillar of our economy, providing vast amounts of employment opportunities, contributing to innovation, and generating economic growth.

In a report released by the U.S. Small Business Administration, 99.9% of businesses across the U.S. are small businesses, employing 46.4% of all U.S. workforce.

In the State of Kansas, 99.1% of businesses are small, employing 50.5% of the private workforce, and 37.7% more new business applications were filed in 2022 than in 2019.

Small businesses operate on small profit margins compared to large corporations and have limited access to financial and non-financial resources, making them more vulnerable to recent economic fluctuations.

These fluctuations include, but are not limited to, supply chain shortages caused by the ongoing conflict in Ukraine and the persistent aggressive monetary policy in the form of high-interest rates, as well as sticky inflation.

In this short article, I will explore why the U.S. Federal Reserve Bank keeps raising interest rates, the impact it has on small businesses’ performance, and share potential solutions to help navigate the current challenges.

WHY DOES THE FED CONTINUE TO RAISE INTERNET RATES?

The role of the U.S. Federal Reserve Bank (Fed) is to maintain economic stability and keep the inflation rate at its lowest level by adjusting the federal funds rate, which is commonly known as the interest rate. This interest rate is a critical tool used by the Fed to influence economic conditions. To combat higher inflation, the Fed raises interest rates, which in turn increases the cost of borrowing money.

When interest rates are elevated, households and businesses face higher borrowing costs, including increased rates on their credit card balances. When borrowing costs become expensive, households and businesses tend to reduce aggregate demand for goods and services.

In reaction to a decrease in aggregate demand, firms start producing fewer goods and services, leading to less pressure on resources and a slowdown in price increases. This, in turn, can help bring down the inflation rate.

Now, back to why the Fed continues to raise interest rates. The answer is straightforward: the current inflation rate is still higher than the Fed’s target of 2% (see Figure 1). In other words, the Fed will continue to raise the interest rate until inflation returns to its desired level of 2%.

The events that caused higher inflation in the United States can be traced back to the beginning of the pandemic in March 2020. In reaction to the dire economic challenges, the government introduced a series of financial stimulus programs, and the Fed brought the federal funds rate (interest rate) close to zero from April 2020 until February 2022 (see Figure 1 on page 60).

The purpose of this collaborative effort between the government and the Fed was to provide financial assistance to businesses and households at a reduced borrowing cost.

These policy measures led to a rapid increase in household aggregate demand, fueled by multiple rounds of stimulus payments and low borrowing costs for two years. The excess consumer demand, the supply disruption caused by the pandemic, and the onset of war in Ukraine led to a persistent increase in inflation rates from 1.5% in March 2020 to 9.1% in June 2022.

However, as shown in Figure 1, when the Fed began to pursue a tighter monetary policy by raising interest rates multiple times beginning in March 2022, the inflation rate went down from 9.1% in June 2022 to 3.7% in August 2023.

The Fed’s policy has proven effective in reducing inflation over time, but at the cost of having an adverse effect on small businesses’ profitability and job creation.

Figure 1: Fed Funds Rate & Inflation Rate | Source of data: FRED (https://fred.stlouisfed.org/) and BLS (https://www.bls.gov/)

THE IMPACT OF HIGH-INTEREST RATES ON SMALL BUSINESS

While the Fed continues to raise its benchmark interest rate to bring inflation down to its desired rate of 2%, the negative impact is taking a toll on small businesses.

1. High-interest rates reduce small businesses’ ability to apply for new loans.

Small business loans are based on the prime rate, which is 3% higher than the benchmark rate set by the Fed. This rate is now 8.5% and pushing Small Business Administration (SBA) loans to an interest rate higher than 11.5%.

The increase in interest rate hinders the ability of small businesses to borrow new money to finance their spending, such as investing in new equipment, paying for marketing and growth initiatives, hiring new employees, and many more.

In a report released by the Fed this year, the percentage of small businesses applying for new loans has declined from 43% in 2019 to 34% in 2021.

A recent small business survey conducted by the Federal Reserve of Kansas City found that small business commercial and industrial lending declined sharply in the first quarter of 2023, decreasing 15.9% from the same period in 2022 and 6.8% from the previous quarter. This decline will likely continue as the Fed’s battle against inflation is not over yet.

2. High-interest rates reduce small business profitability.

The reduction in profitability can be attributed to increased business expenses and diminished sales revenues. On one hand, a high-interest rate increases the payments on outstanding credit card debts and loans.

Small businesses find themselves using a larger portion of their sales earnings to pay for their debts, leading to higher business expenses. On the other hand, high-interest rates reduce the ability of consumers to borrow money and purchase goods and services sold by small businesses, leading to lower business sales revenues.

The higher business costs and lower sales revenue induced by higher interest rates lead to a decline in the
overall profitability of small businesses.

3. High-interest rates make it difficult for small businesses to create jobs.

It may even lead to a workforce reduction, as well as a loss in income due to a decline in economic activity.

According to a recent report released by the U.S. Chamber of Commerce, 99.9% of businesses in the United States are small businesses. They employ almost 50% of the American workforce and generate 43.5% of the total nation’s income.

When borrowing becomes more expensive due to high-interest rates, small businesses find it difficult to invest in expanding. This slows economic growth and reduces job creation. Also, small businesses with lower profit margins limit their capacity to invest in new projects and introduce new products and services. This reduction in expansion and innovation reduces the chance to create new jobs.

Figure 2 illustrates the rise in the federal funds rate for the current year, climbing from 4.33% in January 2023 to 5.33% in August 2023. This increase caused the U.S. unemployment rate to move from 3.4% to 3.8%.

If the Fed continues to raise interest rates, workforce reduction may remain a priority for small businesses to cut their business costs to maintain sustainability in an environment characterized by severe competition and financial hardship.

ALTERNATE SOLUTIONS

To overcome the challenges posed by high-interest rates, small business owners will need to work with their financial advisors to create innovative financial solutions. They can also seek public programs at the U.S. Small Business Administration and the U.S. Department of Treasury that provide financial flexibility.

These solutions aim to reduce the impact of increased debt costs and find new sources to raise new capital. Small businesses can transition their existing credit card debts and loans to fixed interest rates. They can also negotiate with their lender’s alternatives to extend their repayment schedules. Refinancing may not be a practical option at this time since the Fed will likely raise the rate again to reach the desired 2% inflation rate.

Optimizing inventory levels, reducing unnecessary expenses, and exploring new markets will help small businesses enhance their profitability and create jobs in the economy. TK