Four Reasons Why High Interest Rates Hurt Small Businesses

For several months, Federal Reserve Chair Jerome Powell has hinted that the Federal Open Market Committee (FOMC) might lower interest rates sometime soon. Those hopes appear to be dashed as the U.S. inflation is on the rise and now stands at 3.5%, well above the Fed’s target inflation rate of 2%.

The Consumer Price Index rose 0.4% month-over-month in March, after increasing 0.4% in February, according to the latest report from the U.S. Bureau of Labor Statistics released on April 10, 2024. Housing costs and the price of gasoline both rose, accounting for much of the increase.

“The recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence,” Powell said at a Tuesday, April 17, press briefing in Washington.

The Fed chair indicated that although the central bank is not considering rate increases, we can expect interest rates to remain at their current level “as long as needed” if inflation does not recede. Last July, the FOMC raised rates last summer to a more than two-decade high and have kept them there ever since.

“We think policy is well positioned to handle the risks that we face,” Powell said. “Right now, given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work.”

Part of the disappointment in Powell’s most recent comments on interest rates is because at the end of 2023, he seemed to hint at a timetable for lowering them. In fact, economists, lenders and borrowers were anticipating when they might ease, rather than if they might ease. In fact, many experts had anticipated multiple rate cuts.

Officials expressed optimism until very recently that interest rate cuts could be happening soon. That no longer seems to be the case.

Powell said that the performance of the U.S. economy over the past year has been quite strong. The economy grew more than 3% last year as did employment, and inflation showed signs of decline. However, more recent data shows solid growth, along with continued strength in the labor market, which remains robust. The unemployment rate has been below 4% for 26 consecutive months, which hasn’t happened in more than a half a century, the Fed chair said.

While inflation declined significantly over the second half of last year, Powell reported “a lack of further progress on returning to the Fed’s 2% target inflation rate.” He added that that the FOMC will “need greater confidence that inflation is moving sustainably toward 2%” before it is appropriate to ease policy. Powell said recent indicates that it’s likely to take longer than expected to achieve that confidence.

Why high interest rates can pose challenges for small businesses

1. Increased borrowing costs. Many entrepreneurs owners rely on small business loans to fund their operations, manage cash flow, or invest in growth. When interest rates are high, the cost of capital increases, which can deter them from borrowing money. If they do secure financing, business thus have to allocate more of their money towards interest payments, thereby reducing their ability to invest in hiring or expansion.

2. Continued inflation and high borrowing costs tend also to reduce consumer spending, which results in a loss of revenue for non-essential goods and services, including restaurant dining, entertainment, fashion and grooming. With credit card interest rates in the mid to high 20 percent rage, consumers might think twice about going out to eat or buying a new pair of shoes. This change in mindset would hurt small business revenues.

3. Many small businesses frequently operate on tight margins. High interest rates can provide cash flow challenges by increasing the cost of financing short-term. This can strain liquidity and can make it more difficult for small businesses to meet their financial obligations on time.

4. Future growth is also curbed by high interest rates. Rising borrowing costs discourage expansion and investments in new ventures. Business owners may become hesitant to take on additional debt or invest in projects with uncertain returns when the cost of borrowing is high. This naturally can stifle innovation and growth within the small business sector.

Overall, high interest rates create a significant challenge for small businesses by limiting their access to capital, reducing consumer spending, hurting cash flow, and putting constraints on investment.

It seems that the only way for policy makers to approve a rate cut would be if the economy went into a steep decline. However, small business owners are unlikely to wish for an economic slowdown, no matter how high interest rates go.