Interest Rates 101: What businesses may expect from a hike

Scott Anderson
Posted by Scott Anderson
Chief Economist

As the Federal Reserve prepares to start raising interest rates, perhaps by year’s end, Bank of the West Chief Economist Scott Anderson, PhD, answered questions from our editorial staff to help demystify rising rates. The resulting three-part “Interest Rates 101” series looks at what the rate-hike process — or “normalization” of interest rates — could mean for consumers, businesses, exporters, and the U.S. and global economies.

In this segment, Scott addresses the possible implications for businesses.

What will rising rates mean for businesses, both small and large?

African American woman crouching against a wall in office, staring thoughtfully at the whiteboard across from her that is filled with multi-colored notes.Businesses have been taking advantage of the lower rate environment more than consumers have. We’ve seen a lot of bond issuance at very low rates. Business credit has expanded at double-digit rates over the past several years. Businesses are taking advantage of these discount prices for money from the Fed because they know they won’t last forever.

There are going to be some implications for businesses as rates normalize. You’ll see business credit expansion slow a bit. There even may be some higher-risk businesses that will see their credit expenses rise even more. Looking at corporate bonds, we’re seeing some companies — especially those related to energy and the oil markets — having much higher costs of borrowing now than they did six months ago. As the Fed normalizes rates, those pressures could intensify.

It’s still going to be a very attractive environment for businesses to borrow by historical standards. If businesses are growing and sales are growing, the Fed normalizing interest rates shouldn’t be a huge impediment for them to continue to grow. They might have to look at other sources of financing than just borrowing. They might have to use some of their own capital and equity in their businesses — especially stocks given valuations. You might see a lot more stock M&A activity going on instead of people just borrowing from the banks.

How about those doing business overseas, in terms of currency moves and other issues?

It’s going to be harder for larger businesses. More of their sales are dependent on foreign demand — especially demand from China, for example. So we are seeing that they’re getting hit with a one-two punch right now because of the strong U.S. dollar and weak demand from abroad. The strong dollar makes the relative prices of U.S. exports more expensive than other countries. It makes U.S. manufacturers that are exporting less competitive globally, which could impact sales their and exports for some time.

The lag can be as much as a year or more, so this isn’t a problem that’s going to go away overnight. As long as the dollar remains strong or strengthens further, it’s going to continue to be a headwind for these businesses.

Thankfully, though, most U.S. growth is dependent on domestic demand, and in that regard the U.S. economy is golden with the consumer in a really good spot — better than I’ve seen in 30 years. Debt-to-income ratios, for example, are the lowest we’ve seen since 2002. Debt service burdens are the lowest since the 1980s. Incomes are rising. Inflation is low. The labor market is tightening up. Wealth effects are strong from both the stock market and housing. So there’s some momentum there for consumers to continue to drive growth.

Looking at previous cycles of rate increases, is this one comparable? Are there any trends you see aside from the Fed usually moving too quickly and driving the country into recession?

This will be a really interesting interest-rate tightening cycle. There are a bunch of new things going on. The last Federal Reserve chairman to raise interest rates was Alan Greenspan, and he pioneered the gradual tightening cycle. So every time the FOMC met, he would raise the Fed funds rate a quarter of a percentage point. That became his style, and he did that in several cycles.

Janet Yellen’s now at the helm of the Federal Reserve, which has communicated this is not going to be like the Greenspan era. It’s not going to be raising rates at every meeting.

The Fed is going to be very data-dependent even after the first rate hike. So we expect it will move at quarter-percentage-point increments, but over a longer timeframe. Usually the Fed raised rates over 12-18 months before they got back to normal. This time it’s likely to be three years or more before they get back to normal. So the Fed is really dragging this tightening cycle out a lot longer than what we’ve seen in past cycles.

The Fed’s leaders still see the economic expansion as somewhat fragile, and that’s part of the reason for their caution. They realize the global economy is in a whole different spot today than it was 10, 15, or 20 years ago. Inflation is pretty low around the globe, so there isn’t really the urgency that maybe we’ve seen in past cycles to normalize rates to head off inflation as aggressively. We have factors such as low global commodity prices and declining import prices that are continuing to put downward pressure on inflation, even as wages grow and consumers start to pick up their spending.

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