Homebuyers, business owners and public officials are facing a new reality: If they want to put off large purchases or investments until borrowing becomes less expensive, it’s likely to be a long wait.
Governments are paying more to borrow money for new schools and parks. Developers have difficulty finding loans to buy lots and build homes. Companies, forced to refinance debt at sharply higher interest rates, are more likely to lay off employees, especially if they were already operating with little or no profit.
In recent weeks, investors have realized that even with the Federal Reserve nearing the end of its short-term interest rate hikes, market-based measures of long-term borrowing costs have continued to rise. In short, the economy may no longer be able to avoid a deeper slowdown.
“It’s a trickle-down effect for everyone,” said Mary Kay Bates, CEO of Bank Midwest in Spirit Lake, Iowa.
Small banks like Bates are at the epicenter of America’s credit crunch for small businesses. During the pandemic, with the Fed’s benchmark interest rate near zero and consumers piling up savings in bank accounts, it could have lent at 3-4%. He also invested money in safe securities, such as government bonds.
But when the Fed rate began to skyrocket, the value of Bank Midwest’s bond portfolio plummeted, meaning that if Ms. Bates sold the bonds to fund more loans, she would have faced a steep loss. Deposits were also falling, as consumers spent their savings and moved money into higher-yielding assets.
As a result, Ms. Bates makes loans by borrowing money from the Fed and other banks, which is more expensive. She is also paying customers higher rates on deposits.
For all these reasons, Ms. Bates is charging borrowers higher rates and is watching out for lenders.
“We don’t expect rates to drop anytime soon,” he said. “I really think we will watch closely and focus internally, not so much on innovating and entering new markets, but on taking care of the bank that we have.”
On the other side of this equation are people like Liz Field, who opened a bakery, Cheesecakery, out of her Cincinnati home, focusing on miniature cheesecakes, of which she has developed 200 flavors. She gradually built her business through catering and mobile food trucks until 2019, when she borrowed $30,000 to open a cafe.
In 2021, Ms Field was ready for the next step: purchasing a property including a building to use as a kitchen. She obtained a $434,000 loan, backed by the Small Business Administration, with an interest rate of 5.5 percent and a monthly payment of $2,400.
But in the second half of 2022, payments started to increase. Ms. Field realized that her interest was pegged to the “prime rate,” which moves up and down with the rate controlled by the Fed. Because of this, her monthly payments rose to $4,120. In addition to slowing cheesecake orders, she has been forced to reduce the working hours of her 25 employees and sell a food truck and a freezer van.
“It really hurts, because I could have one or two stores for that price,” Ms. Field said of her payments. “I won’t be able to open any more stores until I get this big loan under control.”
According to analysts at Goldman Sachs, interest payments for small businesses will rise to about 7% of revenues on average next year, from 5.8% in 2021. No one is sure when businesses will get some relief, although if the economy slows sharply enough, rates are likely to fall on their own.
For much of 2023, many investors, consumers and business leaders have been eagerly awaiting rate cuts next year, expecting the Fed to determine that it has finally defeated inflation.
Surprised by the persistence of price increases even after supply chains began to unravel, the Fed proceeded with its most aggressive campaign of interest rate hikes since the 1980s, raising rates by 5.25 percentage points in a year and a half.
Yet the economy continued to thrive, with job opportunities outpacing the supply of workers and freely spending consumers. Some categories that drive inflation have fallen rapidly, such as furniture and food, while others, such as energy, have rebounded.
In September, the central bank kept the rate unchanged, but signaled that it would remain higher for longer than the market expected. For many companies, this required changes.
“We found ourselves in an environment where the best strategy was to hold our breath and wait for the cost of capital to come back down,” said Gregory Daco, chief economist at consultancy EY-Parthenon. “What we’re starting to see is business leaders, and to some extent consumers, realizing they need to start swimming.”
For big businesses, that means making investments that are likely to pay off quickly, rather than spending on speculative bets. For start-ups, which have proliferated in recent years, the concern is whether their businesses will survive or fail.
Most entrepreneurs use their own savings and help from friends and family to start a business; only about 10% rely on bank loans. Luke Pardue, an economist at small business payroll company Gusto, said the pandemic generation of new businesses tended to have an advantage because they had lower costs and used business models suited to hybrid work.
But high costs and a shortage of capital could prevent them from growing, especially when their owners don’t have wealthy investors or homes to borrow against.
“We’ve spent three years patting ourselves on the back seeing this wave of entrepreneurship among women and people of color,” Pardue said. “Now, when things get bad and they start to struggle, we need to get into the next phase of that conversation, which is how do we support these new businesses.”
New businesses aren’t the only ones struggling. Older people are too, especially when the prices of their goods fall.
Take agriculture. Commodity prices fell, helping to reduce overall inflation, but this depressed farm income. At the same time, high interest rates have made purchasing new equipment more expensive.
Anne Schwagerl and her husband grow corn and soybeans on 1,100 acres in west-central Minnesota. They are gradually buying the land from his parents, on favorable terms that offset the high interest. But their line of credit carries an interest rate of 8%, which forces them to make difficult decisions, such as whether to invest in new equipment now or wait a year.
“It would be really nice to have another good grain wagon so we can keep the combine moving during the harvest season,” Ms. Schwagerl said. “Not being able to afford it because we’re putting off these types of financial decisions just means we’re less efficient on our farm.”
The stubbornly high cost of capital also hurts businesses that need it to build homes, when mortgage rates above 7% have put homebuying out of reach for many people.
Residential construction activity has taken a hit over the past year, with employment in the sector flattening while interest rates suppressed home sales. According to the National Association of Home Builders, builders who secured financing before the rate hike are offering discounts to get units sold or rented.
The real problem may come in a couple of years, when a new generation of renters starts looking for properties that were never built due to high financing costs.
Dave Rippe is a former Nebraska economic development chief who now spends some of his time renovating old buildings in Hastings, a city of 25,000 near the Kansas border, into apartments and commercial space. This was easier two years ago, when interest rates were half what they are today, even though material costs were higher.
“If you go around and talk to developers ‘Hey, what’s your next project?’ it’s crickets,” said Rippe, who is examining government programs that offer low-cost loans for affordable housing projects.
Despite all this, consumers continued to spend, even as they built up pandemic-era savings and began relying on expensive credit card debt. So far, this willingness to spend has been made possible by a strong job market. That could change, as the pace of wage growth slows.
Car dealers may feel this change soon. In recent years, retailers have made up for low supplies by raising prices. Automakers offered promotional interest deals, but the average interest rate on new four-year auto loans rose to 8.3%, the highest level since the early 2000s.
Liza Borches is the president of Carter Myers Automotive, a Virginia dealership that sells cars of many makes. She said automakers have churned out too many expensive trucks and sport utility vehicles and should shift to producing more of the affordable vehicles that many customers wanted.
“This adjustment needs to happen quickly,” Borches said.
Of course, interest rates aren’t a major factor for those with cash to buy a car outright, and Borches has seen more customers putting down more money to minimize financing costs. These clients can also get a good return by keeping cash in a high-yield savings account or money market fund.
The era of higher rates for a longer period of time is less beneficial for those who need to borrow for daily needs and also face rising real estate costs and subdued wage growth.
Kristin Pugh sees both types of people in her Atlanta practice as a financial advisor to wealthy individuals, who waives her fees for some low-income clients. She is a picture of divergent fortunes.
“Coupled with higher rents and stagnant wages, pro bono clients will not fare as well in higher interest rate environments,” Ms. Pugh said. “It’s just mathematically impossible.”