The Economic Outlook For Federal Reserve Policy

The Federal Reserve is in the spotlight again this week with another interest rate hike to try and squash the inflation beast. Prices are rising just over 8% year-over-year, while wages are rising at a 5% annual rate, a losing proposition for workers and consumers. The Fed has been raising interest rates this year to slow spending. These rate hikes have resulted in higher mortgage rates, but general consumer spending remains solid and that’s a problem. The 10 Year Treasury Bond now yields 4%, the cost of financing the federal debt is rising. The cost of small business loans has tracked that rate for 48 years. Historically low now due to the 0% rate policy which is being abandoned, owners paid an average of 19% for their short-term loans in the early 1980s. Now the rates are 4%-5%, but rising as the Fed raises its rate. So far, the percent of owners complaining that they didn’t get all the credit they wanted and the percent reporting credit as their top business problem are historically low. But that is likely to change as rates rise and the Fed stops buying Treasury bonds.

Small business owners aren’t very confident that these issues will be successfully resolved anytime soon. Asked about business conditions six months out, only 8% said “better”, while 56% said “worse”, among the weakest readings in survey history (48 years). Expected sales are similarly glum, with 20% expected higher real sales volumes, 40% expecting lower. Only 4% thought that the current period was a good time to expand substantially. In 2018, as high as 36% thought so. Recalling that small businesses produce about half of our GDP and employ about as large a share of our workforce, this is not very promising for the rest of the year.

From an investor perspective, if one can earn 4% with no risk of default by lending money to the government, lending money to finance small business expansion must provide a much higher return to compensate for a higher risk of a default on the loan (and similar loans). And, an investment project must provide a much higher return on the money invested (cost reductions, higher sales, etc.). A project that yielded a 5% return might be worth financing with a 4% bank loan, but not a 6% loan. Higher interest rates reduce the number of profitable investment options. And for consumers, the cost of financing large purchases (cars, houses, etc.) also rises, slowing spending.

So, inflation is the top business problem faced by small businesses today. Close second goes to the shortage of qualified workers, as job openings and hiring plans are still historically high (consumer spending has not collapsed). Fed policy raising interest rates will cool spending in many sectors, and consumer spending will fall (that’s the goal), especially as unemployment begins to rise. That’s the economic outlook for the next 12 months.

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