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    The Economic Outlook for Federal Reserve Policy

    The Federal Reserve is back in the spotlight this week with another rate hike to try and squash the inflation beast. Prices are rising at just over 8% year-on-year, while wages are increasing at 5% year-on-year, a loss-making proposition for workers and consumers. The Fed has raised interest rates this year to slow spending. These rate hikes have led to higher mortgage rates, but overall 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 been tracking that rate for 48 years. Now historically low due to the abandonment of the 0% interest rate policy, owners paid an average of 19% for their short-term loans in the early 1980s. Now rates are 4%-5%, but are rising as the Fed raises its rate. So far, the percentage of owners who complain that they didn’t get all the credit they wanted, and the percentage who report credit as their main business problem, is at an all-time low. But that is likely to change if interest rates rise and the Fed stops buying government bonds.

    Small business owners are not very confident that these problems will be solved successfully in the short term. When asked about business conditions six months later, only 8% said “better”, while 56% said “worse”, one of the weakest measures in survey history (48 years). Expected sales are also bleak, with 20% projected higher real sales volumes, and 40% expected lower. Only 4% thought the current period was a good time to expand significantly. In 2018, no less than 36% thought so. Considering that small businesses produce about half of our GDP and employ the same proportion of our workforce, this doesn’t look very promising for the rest of the year.

    From an investor’s perspective, if one can earn 4% without risk of default by borrowing money to the government, then lending money to finance small business expansion must yield a much higher return in order to increase the risk of to compensate for default of the loan (and similar loans). And an investment project should yield a much higher return on the money invested (cost reduction, increased turnover, etc.). A project that yielded a 5% return might be worth financing with a 4% bank loan, but not with a 6% loan. Higher interest rates reduce the number of profitable investment options. And for consumers, the cost of financing large purchases (cars, homes, etc.) is also rising, slowing down spending.

    Thus, inflation is the biggest business problem facing small businesses today. Second is the shortage of qualified workers, as job openings and hiring plans are still at an all-time high (consumer spending hasn’t collapsed). Fed policies that raise interest rates will cool spending in many sectors and lower consumer spending (that’s the goal), especially as unemployment starts to rise. Those are the economic prospects for the next 12 months.

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