The reality of interest rate hikes
The Federal Reserve raised the federal funds interest rate by 25 basis points in March 2022, and further increases are expected. The Fed is expected to raise rates by 50 basis points, or half a percentage point, at each of its next two meetings in May and June. What is the reality of rate increases for business owners?
First, here are the 101s behind the Fed’s rate hikes. The federal funds rate is the interest rate that banks charge each other for overnight loans. The Federal Reserve’s Open Market Committee determines the federal funds rate. Fed rate hikes increase banks’ cost of funds. Ultimately, banks pass the increases on to their customers through all types of loans, including home, auto and business loans.
Given the current economic climate and the level of inflation, the Fed is in a position to use a key tool – interest rate hikes – to fight inflation. It is a lever that the Fed has used successfully in the past to control inflation or deflation. In the 1980s, the federal funds rate peaked at 20% to fight double-digit inflation. Decades later, the Fed cut the rate twice within a range of 0% to 0.25% to control deflation. The first time was during the 2008 financial crisis. The Fed only raised rates in December 2015 and then March 2020 when the Covid pandemic began.
The current discussions on interest rates have been going on for several months given the signs of inflation in our economy. The Russian-Ukrainian conflict has added a layer of complexity to strategic discussions and tariff decision. During a meeting with the Congressional Committee on Banking in early March, Fed Chairman Pro Tempore Powell told lawmakers: “The short-term effects on the U.S. economy of the invasion of Ukraine , the ongoing war, sanctions and future events, remain highly uncertain. Given the current situation, we must proceed with caution.
Second, let’s take a look at what rate increases mean for business owners – starting by setting the baseline for owners unfamiliar with the term. It represents the smallest unit of measurement for interest rates and other financial instruments. One basis point is equal to one hundredth of a percent, or 0.01, which means that 100 basis points is equal to 1%.
The Federal Reserve Board raised the rate by 25 basis points on March 16, meaning the federal funds rate fell from 0.25% to 0.5%. Interest rates were at historic lows. Chairman Powell said the Fed would be “humble and nimble” in managing the situation and the risks while using data and communicating transparently. Raising the fed funds rate by 25 basis points had an immediate effect.
To put things into perspective, apply the increase to a $250,000 10-year loan. Increasing the interest rate from 3.25% to 3.5% increases the monthly payment from $2,339.73 to $2,356.75, or $17.02 more per payment, or 2,042, $40 additional interest over the life of the loan.
Owners with long-term growth plans shouldn’t stop acquisitions and expansions. Examining the decades of history related to interest rates shows that since the 1980s rates have generally declined and been supportive of the corporate sector. The economic climate remains robust and healthy.
- Owners need to keep pushing the business strategy forward. The economy remains robust with low unemployment. Discuss financing related to your business plan with your lending partner. Navigate decisions based on thoughtful long-term forecasts. Take advantage of this historically low rate environment.
- Weigh the options of a variable or fixed rate loan. A short-term loan shouldn’t be as worrying as considering a long-term loan. Remember, refinancing in the future is always an option.
- Match your liabilities with your assets. As a general rule, long-term assets should be funded by long-term liabilities. Current assets must be funded by current liabilities. Assess your ability to absorb future interest rate increases and your ability to pass on price increases.
- Talk to lenders in your business and assess market dynamics to consider how it might be affected by the overall market, not just rate increases. For example, our team works with travel insurance companies. It’s been a tough business for the past two years. Financing decisions are very different for these clients than traditional insurance agents who cover auto, home, renters and other lines.
Today’s economic market is in a historically unprecedented space. A global pandemic, supply chain challenges, the Great Resignation and the Russia-Ukraine escalation are beyond our control. Use the recommendations above to control what you can to pursue the strategic, performance-driven expansion and growth of your business.
Rick Dennen is the Founder, President and CEO of Oak Street Funding, based in Indianapolis, a First Financial Bank company with lending products and services for specialty industries, including chartered accountants, registered investment advisers and insurance agents nationwide.