How to Prepare for Rising Interest Rates
November 29, 2021 |
The C2FO Team
Ushered in by the pandemic, will the prolonged era of near-zero interest rates subside?
Now standard and expected by borrowers, interest charged by lenders was long ago considered taboo if not unethical. As early as 5000 BC, interest charges as we know them today were largely prohibited, often seen as a form of greed or exploitation related to uncontrollable events like bad harvests, a workplace fire or the fact that no physical output resulted from their incurrence. The idea of not charging interest was supported by many religious faiths of the time and is selectively practiced today. Charging exorbitant or usurious interest rates is especially frowned upon in some faiths.
Fast-forward to 2021, and having developed over several centuries, interest is the price routinely paid to borrow funds from banks or other lenders. Interest charges are determined by the amount borrowed, the applicable percentage rate and the loan’s duration.
Determination of target US interest rates often begins with the Federal Reserve, commonly known as the Fed, and is largely implemented by banks or credit unions. Interest rates impact how much money a consumer can borrow for a home or auto loan and can have a make-or-break influence on the decision to borrow. For business borrowers, interest rate changes by lenders can immediately impact their cost of capital, and later, profit or loss.
Where rates are now
Whereas the Fed formerly changed interest rates almost quarterly, the current Federal Reserve interest rate range of 0%-0.25% has been in place since March 16, 2020.
With a robust economy from mid-2016 to 2018 due to a combination of low unemployment, high profitability, multisector productivity and inflation contained at less than 3%, the Fed consistently and gradually raised the interest rate range from 0.50%-0.75% to 2.25%-2.50% to keep the expansion in check. Then amid signs of slowed economic growth due in part to tariffs on imports and fears related to strained US-China relations, the Fed lowered rates through 2019 to 1.50%-1.75% to maintain some economic momentum.
When the pandemic hit in March 2020, the Fed acted aggressively and decisively along with other countries’ central banks to halt a full economic slowdown. Unusually, the interest rate range was lowered by a half-point twice in two weeks — a full one-point reduction — to the current 0%-0.25%. This contrasted sharply with prior quarter-point changes approximately every calendar quarter.
Effects of low interest rates
With interest rates low, and in concert with other economic relief measures taken via the CARES Act during the pandemic, businesses borrowed for growth and consumers spent aggressively. In a September 2021 Bankrate survey, 42% of respondents reported higher consumer credit card balances since March 2020. The continued flow of money and the ongoing pandemic has led to labor shortages, supply chain issues and October’s 30-year high of 6.2% year-over-year inflation.
Again to rein in spending and curtail further inflation, the Fed is now considering raising interest rates, as has occurred in England, Canada, Norway, Australia and elsewhere.
With two to three interest rate raises by the Fed being discussed for 2022, business borrowers have time to plan for the anticipated higher borrowing costs.
What you can do to offset higher interest rates
Time offers several opportunities to review how the cost of borrowing affects your business and to mitigate the increased borrowing expense:
Assess your situation.
Start by viewing the “interest expense” line item on your income statement, then trace it back to the principal owed and current rates on lenders’ monthly statements. By varying the interest rate even a quarter-point at a time, you can calculate how the expense (or even profit and loss) would differ based on the Fed’s anticipated actions or to what extent margin compression may result.
Understand why you’re borrowing.
Is it for subsidizing cash flow expenses like payroll or utilities, for example, or are you paying for equipment or other capital expense items?
Review financing options.
The thought of rising rates, especially those tied to benchmarks, can spur you to seek alternative sources for capital. These can include a new or additional lender, accelerating collections of accounts receivable, expanding or extending current lines of credit, transferring balances or converting variable-cost balances to fixed-rate instruments.
Reduce the impacts of controllable and uncontrollable costs.
Reviewing your income statement line by line, can you:
- Prepay or level-pay known monthly costs like utilities or insurance premiums?
- Renegotiate credit or debit card fees, or even freight carriers’ discounts?
- Extend suppliers’ payment terms or seek buy-ahead incentives for inventory purchases?
Any of the above, and others, can be performed before rate increases impact everything from daily or monthly cash flow to business valuations. Digital platforms like C2FO Early Payment offer immediate and ongoing opportunities to convert select accounts receivable to cash on-hand, strengthening your balance sheet.
When rates will change
It’s anyone’s guess when rates will change. And much like “knowing” a stock’s closing price on any given day, if you knew, you’d certainly act.
Accordingly, officials and others who follow rates closely or have influence are noncommittal on timeline specifics. Kansas City Federal Reserve Bank CEO and President Esther George recently said to a Women in Global Leadership Conference audience, “Interest rates will probably stay near 0 until the labor market gets back to what we might consider maximum employment and inflation looks like it will stabilize at 2%.”
Sentiments are shifting for perhaps multiple rate hikes in 2022, and up to a target range of 1.0%-1.25% in 2023. Bankrate recently reported that of 18 Fed policymakers, nine in September 2021 preferred a rate hike in 2022, up from seven in June.
In a pre-Thanksgiving announcement, President Joe Biden nominated Jerome Powell for a second four-year term as Federal Reserve chairman, a post he began in 2018, signaling confidence in Powell’s handling of the economy and an approach of balanced stability to recovery.
Though interest rate changes are beyond your control, preparations are not. Much like diversifying in advance to protect an investment portfolio from a market downturn, a wise defense against the potentially adverse results of rising interest rates is to stick to the fundamentals: be proactive, assess your current situation, know your options and make necessary changes sooner rather than later, before conditions worsen.