What’s the big deal with interest rates rising?
“Interest Rates are Like Gravity”
– Warren Buffet
The Federal Reserve is on the move to continue interest rate hikes. The overnight bank interest rate has been close to zero since the economic calamity of 2008 in an effort to stimulate growth in our economy. Lower rates mean cheaper money, which encourages consumer spending, investment in businesses, overall expansion, and increased employment opportunities.
The fact that the Fed is thinking that it is time to raise rates is good news as it indicates they feel our economy is growing. The U.S. economy has in fact enjoyed a 2.1% growth rate since the 2009 recession. Our labor market numbers indicate unemployment rate is low meaning that anyone who wants to work and can work is working. When employment is high then we begin to anticipate inflation (rising prices) and in order to control inflation the Fed raises interest rates.
So the Federal Reserve has been keen on watching our rate of inflation, as this informs as to when it is an appropriate time to raise interest rates. Today our core inflation (inflation excluded for food and energy) is running close to that benchmark.
The big question is: Will the Federal Reserve continue to raise interest rates?
Here at home we are experiencing positive signs of expansion in the job market, falling gas prices, increased home real estate sales, and retail sales. In addition, the commercial real estate market is on steroids and is actually positioned as a giant bubble just waiting to burst. (Won’t that be fun – anyone recall the bubble that burst in 2008?)
And, then there is the global impact.
We are a global economy and outside of the U.S. there are some serious concerns. China thought it was a good idea for their currency, the yuan, to be valued closer to market so they let it depreciate. So they say. Market value or not, this devalue of the yuan will make their exports more competitive and is an indicator of just how much of a concern the slowing Chinese economy is. To compound matters the weak Chinese market negatively impacts the other emerging markets (Brazil, Russia, and Indonesia) that supply China with raw materials, which now puts those markets at recessionary risk.
It is all complicated and creates a domino effect. China is responsible for 15% of world economic output. So if there is a rumble in China the global economy reacts as we have seen with our own U.S. stock market “corrections”.
On our own turf, our U.S. dollar has become stronger which has the impact of our exports slipping as our exported goods become more expensive, which in turn could eventually constrain our growth. Then there is the Greece bail out debacle, the Swiss franc untethering from the Euro and a myriad of other influencers on the global market.
So, the questions remain: Why is the Federal Reserve intent on raising rates? When will the interest rates begin to move upward? And, will our economy take a hit if the Federal Reserve tightens credit? What impact will an interest rate increase have on your business?
Well, lets drill down the impact to you the consumer and owner of a privately held business.
When the Federal Reserve raises the overnight federal funds rate (the rate banks charge each other to borrow federal funds) your bank rates will increase accordingly.
Why do they adjust rates? The Federal Reserve uses interest rate adjustments as a tool to stimulate the economy when we are headed toward troubled waters by lowering rates or to hinder inflation by increasing rates.
The reality is that our rates have been historically low since 2009 and can’t get any lower. When our economy begins to stagger again, without the ability to use interest rates to control inflation and stimulate the economy, the Federal Reserve have to resort to unconventional tools like we did in 2008 when the U.S. instituted quantitative easing (the bond buying program that pumped trillions of new dollars into our economy), which comes with its own set of long-term negative consequences. Now we are on the precipice of the Federal Reserve deleveraging their balance sheet. I’ll talk about that in another blog! Bottom line – the Federal Reserve wants the use of manipulating interest rates back in their toolbox and they think the time is here.
I speak in the mergers & acquisition arena regularly and projecting the impact of interest rate increases is a favorite topic of discussion.
So how does a rate increase impact you?
Shrinking Profit Margins: The raise in the federal funds rate will trickle down to short-term rates like your business line of credit, credit cards, and on a personal level an adjustable mortgage rate will increase. The short and sweet of it is that an increase in interest rate raises the cost of capital and when money is expensive business growth is limited.
The cost of your business line of credit increases which ultimately squeezes your bottom-line.
When personal loans such as credit card debt or home mortgage become more expensive consumers have less discretionary income and they stop spending ultimately hitting business profitability.
Industry Market Volatility: Many markets will be hindered. For example: If you are in an industry related to the housing market an increase in interest rates would cause consumers to think twice about investing in their home with improvements. This will impact architects, builders, mortgage lenders. etc. A rate increase will lead to a decline in home prices as the cost of borrowing goes up. If your business success is contingent upon exchange rates the volatility in currencies can upset your apple cart.
Business Value Loss: If you are considering becoming liquid by selling your business an increase in interest rates will increase the cost of capital that buyers will need to leverage the purchase of your business, thereby decreasing the price you will garner with the sale of your business. Another contributing factor to the decrease in the value of your business is that with an increase in interest, a buyer’s expected return-on-investment (ROI) increases, thereby decreasing the value of your business.
As interest rates go up the value of your business goes down.
Warren Buffet was right when he said, “Interest rates are like gravity.” Interest rates are always affecting different sectors of the economy. So as you review your business strategy keep in mind that you don’t control interest rates or the timing of an increase—Janet Yellen and the Federal Reserve does. What you do control is the strategy you develop to counter market conditions and the timing of your execution.
If the future looks like your costs are going to go up due to a higher cost of your line of credit the natural thought is how much of the increase can you pass onto your customers. Now is a good time to analyze your whether your business will allow for increased prices to reflect the increased interest rate. If you are in the market for capital purchases now may be a time to execute purchases and lock in a lower interest rate to finance.
If your business profitability is contingent upon exchange rates now may be the time to lock in contracts.
If you are looking to sell you business, now is the time to execute that strategy if you are to garner the highest return on your investment in your business. Now is the time… before interest rates go up and the value of your business goes down.
Bottom line — market conditions are dynamic on a global basis, which impacts your success, so think long and hard when formulating and executing a strategy that will help you realize your financial goals. Be proactive!