Interest Rates and Their Effect on Small Businesses

Predicting future interest rate movements is not only important for traders who invest in financial markets. Instead, it is also important for regular business people. It is important for small businesses because the increase and decrease in demand is related to interest rates which the central bank sets.

The problem is that most central banks around the world do not announce their intentions clearly. Consider the case of the Fed which is America’s central bank and probably the most important one in the world. In 2013, Fed had lowered its interest rate to almost zero there were talks about going into negative territory. However, that never happened. Fed did not raise on lower their interest rates significantly for the next few years. Only in 2017, did Fed make an aggressive move towards increasing interest rates. Now, in 2018, the Fed is expected to keep raising interest rates.

The problem is that these benchmark rates set by the Fed impact everybody including small businesses. This is the reason why small business owners need to be more aware of the situation. In this article, we will explain how the boom-bust cycle may be connected to the interest rate manipulation done by central banks.

Central Banks and Business Cycles

It needs to be understood that there were very few if any, business cycles prior to the establishment of central banks. When the interest rates were set by the market, booms and busts were not considered to be common. Ever since the creation of the Federal Reserve in 1913, the world has been under the grip of boom-bust cycles. Longer periods of boom mean that the bust will be equally hard to get through. The impact has been devastating in human terms with lower incomes becoming the norm and unemployment going through the roof.

How Interest Rates Cause Business Cycles?

The problem is that the small businessman thinks that they only need to be careful during the bust period. When the economy is in a boom period, they tend to get carried away by the optimism and end up making rash decisions. In reality, every boom within itself carries the seed of a bust.

This is because, during the boom period, the interest rates are artificially lowered by the central bank. As a result, projects which were earlier not viable start appearing viable to small business owners. This is when they borrow money in order to expand their business. These interest rates are always taken at low-interest rates. However, these low-interest rate loans reset periodically according to the prevailing market rates. For some time, businesses make money because of the low-interest rate. Expanding businesses provide more revenue which in turn leads to increased profits.

The amount of debt on the balance sheet of small businesses keeps on increasing at a constant pace. At some point in time in the future, the central bank reverses the trend of low-interest rates being offered. This leads to increase in the cost of debt for most small-scale businesses. Many times businesses are not able to tackle this increased cost of debt. This destroys their cash flow and over a period of time leads to bankruptcy.

The problem is this case did not really occur when the interest rates rose. In reality, the problem occurred when the interest rates were first lowered artificially. This is when the projects that were unviable in the first place suddenly started appearing viable. Hence, it is important for small business owners to factor in the effect of interest rate sensitivity on their budget. They should only take loans if they are relatively sure that they will be able to service the debt even if the interest rate increases.

The Herd Effect

The next question that arises is, “why can’t businesses anticipate interest rate hikes by the bank?” The answer to this lies in behavioral finance. Human beings tend to copy the behavior of one another. When interest rates are first lowered, some risky business owners borrow money and end up earning huge sums because of it. This creates a fear of missing out amongst other people. As a result, more and more people start borrowing money and investing in unviable projects. By the end of the boom phase, even the staunchest opponents of debt decide to borrow money since it seems like a profitable decision. Hence, peer pressure plays an important role in getting a large number of business owners indebted.

Timing the Market

Lastly, some businessmen are aware that the banks will raise interest rates at some point in time in the future. However, they believe that they will be able to time the market and pay off their debt before the interest rates rise. The problem is that some of them are able to pull this off sometimes. However, in most cases, timing the market is not really a viable strategy and leads to colossal failure in the long run.

To sum it up, it is important that small businesses pay attention to the interest rates at which they are borrowing. It is also important that they conduct sensitivity analysis and assume that the demand will fall and the interest rates will rise. They should borrow money to invest only if they are sure that their project is strong enough to wither such storms.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.