by Home buyers, business owners and public officials face a new reality: If they want to postpone large purchases or investments until borrowing becomes less expensive, the wait will likely be long.
Governments are paying more to borrow money for new schools and parks. Developers are struggling to find loans to buy lots and build homes. Companies, forced to refinance debt at much higher interest rates, are more likely to lay off employees, especially if they were already operating with little or no profits.
In recent weeks, investors have realized that even as the Federal Reserve is about to end its short-term interest rate increases, market-based measures of long-term borrowing costs have continued to increase. In short, the economy may no longer be able to avoid a sharper slowdown.
“It’s a trickle-down effect for everyone,” said Mary Kay Bates, CEO of Bank Midwest in Spirit Lake, Iowa.
Small banks like Bates are at the epicenter of the credit crisis for small businesses in the United States. During the pandemic, with the Federal Reserve’s benchmark interest rate near zero and consumers piling up savings in bank accounts, she was able to make loans at 3 or 4 percent. She also invested money in safe securities, such as government bonds.
But when the Federal Reserve rate began to skyrocket, the value of Bank Midwest’s securities portfolio fell, meaning that if Bates sold the bonds to finance more loans, he would have to take a large loss. Deposits were also declining, as consumers spent their savings and moved money into higher-yielding assets.
As a result, Bates is making loans by borrowing money from the Federal Reserve and other banks, which is more expensive. It is also paying customers higher rates on deposits.
For all those reasons, Bates is charging borrowers higher rates and being careful about who it lends to.
“We don’t expect rates to go down anytime soon,” he said. “I really see us keeping a close eye and focusing internally, not so much on innovating and entering new markets but on taking care of the bank we have.”
On the other side of that equation are people like Liz Field, who opened a bakery, Cheesecakery, in her home in Cincinnati, focusing on miniature cheesecakes, of which she has developed 200 flavors. She slowly built her business through catering and mobile food trucks until 2019, when she borrowed $30,000 to open a coffee shop.
In 2021, Ms. Field was ready for the next step: purchasing a property that included a building to use as a commissary kitchen. She took out a $434,000 loan, backed by the Small Business Administration, with an interest rate of 5.5 percent and a monthly payment of $2,400.
But in the second half of 2022, payments began to increase. Field realized that his interest was tied to the “prime rate,” which rises and falls with the rate controlled by the Federal Reserve. Because of that, his monthly payments have increased to $4,120. In addition to decreasing cheesecake orders, she was forced to cut the hours of her 25 employees and sell a food truck and a freezer van.
“That really hurts, because I could have one or two stores for that price,” Field said of his payments. “I won’t be able to open any more stores until I get this big loan under control.”
According to analysts at Goldman Sachs, interest payments for small businesses will rise on average to about 7 percent of revenue next year, from 5.8 percent in 2021. No one is sure when companies will be able to get any relief, although if the economy slows enough, rates will likely fall on their own.
For much of 2023, many investors, consumers and corporate executives eagerly anticipated rate cuts next year, waiting for the Federal Reserve to determine that it had defeated inflation for good.
Surprised by the persistence of price increases even after supply chains began to unravel, the Federal Reserve proceeded with its most aggressive campaign of interest rate increases since the 1980s, raising rates by 5.25 points. percentages in a year and a half.
However, the economy continued to burn, job openings exceeded the supply of workers, and consumers spent freely. Some categories that drive inflation retreated quickly, such as furniture and food, while others, such as energy, have made a comeback.
In September, the central bank kept its rate steady but signaled it would stay high longer than the market had anticipated. For many companies, that has required changes.
“We’ve been in this environment where the best strategy has been to just hold your breath and wait for the cost of capital to come back down,” said Gregory Daco, chief economist at consulting firm EY-Parthenon. “What we’re starting to see is that business leaders, and to some extent consumers, realize that they have to start swimming.”
For large companies, that means making investments that are likely to pay off quickly, rather than spending on speculative bets. For startups, which have proliferated in recent years, the concern is the survival or failure of their businesses.
Most entrepreneurs use their savings and the help of friends and family to start businesses; only about 10 percent depend on bank loans. Luke Pardue, an economist at small business payroll provider Gusto, said the pandemic generation of startups tended to have an advantage because they had lower costs and used business models that accommodated hybrid work.
But the high cost and lack of capital could prevent them from growing, especially when their owners do not have wealthy investors or houses to borrow from.
“We spent three years patting ourselves on the back seeing this increase in entrepreneurship among women and people of color,” Pardue said. “Now, as the situation comes to a close and they start to struggle, we need to move on to the next phase of that conversation, which is how we can support these startups.”
Startups aren’t the only ones struggling. The older ones are too, especially when the prices of their products are falling.
Take agriculture as an example. Commodity prices have been falling, helping to reduce overall inflation, but that has depressed farm incomes. At the same timeHigh interest rates have made the purchase of new equipment more expensive.
Anne Schwagerl and her husband grow corn and soybeans on 1,100 acres in west central Minnesota. Little by little they are buying the land from their parents, with favorable conditions that compensate for the high interests. But their line of credit has an 8 percent interest rate, forcing them to make tough decisions, whether to invest in new equipment now or wait a year.
“It would be really nice to have another good grain cart so we can keep the combine moving during harvest season,” Ms. Schwagerl said. “Not being able to afford that because we’re putting off those types of financial decisions just means we’re less efficient on our farm.”
The stubbornly high cost of capital also hurts companies that need it to build homes, when mortgage rates above 7 percent have put home buying out of reach for many people.
Residential construction activity has received a blow during the past year, with employment in the industry Flatten as interest rates slowed home sales. Builders who obtained financing before rates increased are offering discounts to sell or rent units, according to the National Association of Home Builders.
The real problem may come in a couple of years, when a new generation of renters starts looking at properties that were never built because of high borrowing costs.
Dave Rippe is a former Nebraska economic development chief who now spends part of his time rehabbing old buildings in Hastings, a city of 25,000 near the Kansas border, into apartments and commercial space. That was easier two years ago, when interest rates were half what they are now, even though material costs were higher.
“If you go and talk to developers about ‘Hey, what’s your next project?’ they’re crickets,” said Rippe, who is researching government programs that offer low-cost loans for affordable housing projects.
Through all of this, consumers have continued spending, even as they have exhausted pandemic-era savings and begun to rely on costly credit card debt. Until now, that willingness to spend has been made possible by a strong labor market. That could change, as the pace of wage increases slows.
Auto dealers could feel that shift soon. In recent years, distributors have compensated for low inventory by raising prices. Automakers have been offering promotional interest deals, but the average interest rate on new four-year auto loans has risen to 8.3 percent, the highest level since the early 2000s.
Liza Borches is the president of Carter Myers Automotive, a Virginia dealership that sells cars of many brands. She said automakers had been producing too many expensive trucks and sport utility vehicles and should shift to making more affordable vehicles that many customers wanted.
“This adjustment must be made quickly,” Borches said.
Of course, interest rates aren’t a factor for those with the cash to buy cars outright, and Borches has seen more customers put down more money to minimize financing costs. Those clients can also earn a good return by holding cash in a high-yield savings account or money market fund.
The era of higher rates for longer is less advantageous for those who have to borrow for daily needs and also face rising housing costs and moderate wage growth.
Kristin Pugh sees both types of people in her Atlanta practice as a financial advisor to wealthy people, who waives her fees for some low-income clients. She is a picture of divergent fortunes.
“Coupled with higher rents and stagnant wages, pro bono clients will not fare as well in higher interest rate environments,” Ms. Pugh said. “It’s just mathematically impossible.”
