For the past few years, the availability of qualified workers has been the top business problem for small firms, trumping taxes and government regulations, historically popular choices. Today, the No. 1 issue is inflation. The Federal Reserve says it has the tools to bring inflation back down to 2%, which, by the way, is not “price stability,” one of the Fed’s two goals (the other is full employment).
The Fed’s policy posture has changed dramatically, from patiently waiting for inflation to go away while maintaining near-zero interest rates and heavy purchases of bonds, to an end to bond buying and prospects of accelerated increases in interest rates. The Fed Funds rate could go from zero to 3% in a matter of months. This, in conjunction with the withdrawal of the Fed from the bond market, could raise the yield on the 10-year bond to 5% or more. The strategy is to slow spending in the economy, reduce growth and, with less pressure from spending, cause prices to fall, all without a recession.
The yield on the 10-year bond is an important rate, often the base for determining mortgage rates (which have already risen in anticipation of Fed actions). But the cost of loans for small businesses has always been closely related to the 10-year yield. Since 1973, the National Federation of Independent Businesses has asked a random sample of its member firms what rate they paid on their most recent short-term loans. Historically, those rates have been several percentage point above the yield of the 10-year, rising and falling in sync with it.
If Fed policy takes the fed funds rate to 3%, the 10-year will likely increase to about 5%. In that case, one might anticipate average rates charged to small businesses could rise to the 8% range, well above what firms report paying now. This will be the inevitable outcome of the Fed’s fight against inflation. Small businesses already see this coming. Many borrowers with variable-rate indexed loans are asking their lender banks to convert to fixed rates loans at the rates they currently have. The banks, of course, don’t fall for it, as they read the news too.
As interest rates rise, the profitability of more and more projects financed with debt falls, so capital spending and associated jobs are lost. Housing is negatively impacted, with higher mortgage rates. That’s how the Fed fights inflation. With softer demand, the pressure on prices (of everything) eases and fewer price hikes occur. Indeed, the prices of many things will fall. At this point, the economy is usually in a recession historically. There are few “soft landings” with deflation but no surge in unemployment.
The problem today is that the Fed is behind the curve; it should have started raising rates at least a year ago. Now, it will have to hurry up and raise rates by big chunks, harder for economic agents to quickly adjust to. Financial markets are likely to respond negatively, with further declines in stock prices. The Fed is leading the economy into recession — an expensive way to conquer inflation. But the longer the Fed delays, the more difficult the process will be for both the Fed and businesses and consumers throughout the economy.
