Over the past two years, small businesses have weathered a global pandemic, a supply chain crisis, labor shortages, and increasing costs due to inflation. Now, the next hurdle for small businesses lies ahead – a very possible recession.
The Current State of Monetary Tightening
After having been late to address inflation when it gained momentum last year, the Fed has slammed on the monetary policy brakes this year in a way not seen since the 1980s.
Federal Reserve Chairman Jerome Powell and most of his colleagues have decided that returning to low inflation is the top priority. Powell said in his Jackson Hole speech, “History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting.“
Multiple Fed officials have stated that the harm from ending anti-inflation efforts too soon would be much greater than the harm from going in the opposite direction. So during these uncertain circumstances, the Fed will keep monetary conditions tight.
Monetary tightening essentially runs through two channels and it usually takes time before the full effects are felt by the economy.
- First, higher interest rates stifle some economic activity – usually housing construction, car sales, and business capital spending.
- Second, the decline in demand lowers the incomes of people working in interest-sensitive sectors.
The Current Impact on the Economy
Not only has the Fed been raising interest rates at an unusually large 75 basis point steps each time, it has also started withdrawing $95 billion a month in market liquidity by not rolling over its bond holdings at maturity. These actions are putting significant downward pressure on the equity and bond markets and since the start of the year:
- The S&P 500 has lost approximately 20% of its value.
- Bond prices have declined by 15%.
- The larger/more popular cryptocurrencies have lost around 60% of their value.
In the housing sector, one of the first to feel the effects of a recession, mortgage rates, which are closely linked to the Fed’s interest rate hikes, have topped 7%, more than double what they were a year ago. In response, housing has become even less affordable and mortgage applications are plunging. Builder confidence is at new lows, housing starts have cut back sharply, and home prices are beginning to decline in at least 50 US cities.
The housing market distress, coupled with consumer confidence being sapped by high inflation and high-interest rates, has contributed to the virtual stagnation in the overall economy this year despite a modest economic bounce in the third quarter, which may be largely due to a strong US dollar.
Stagnation is leading to an abrupt decline in job openings, which could fall further if the economy enters a full recession next year. Filling open positions is still a problem, but a cooling labor market is what the Fed really wants, as it would reduce demand and subsequently inflation.
Is a Forthcoming Recession Likely?
The Treasury market actually offers a fairly accurate (historically speaking) prediction of what’s coming in the economy.
Treasury bonds are issued in varying maturities, and each signals expectations for a different period of time. Typically, the longer the horizon on a bond investment, the more investors expect to be paid in interest because there is more certainty about how things will go over the short term than a longer horizon.
The yield on a 10-year Treasury note is usually higher than the yield on one that matures in just a few months. These days, that’s not the case. Both the three-month and the two-year Treasury bills have yields higher than the 10-year note, creating an “inverted yield curve”. When this happens, it shows investors are more worried about the economy in the short term than the long term, AND this has been a reliable predictor of recessions.
Sometimes a recession doesn’t actually follow this kind of signal, and the rise in short-term yields doesn’t forecast exactly when a recession will start. But it certainly gets Wall Street’s attention because this pattern has preceded every U.S. recession for the last half-century.
How Are Small Businesses Doing Right Now?
According to a recent Nationwide Agency Forward survey:
- 6 in 10 small business owners say inflation and rising costs are negatively impacting them.
- 35% say they have been negatively impacted by interest rate hikes.
- Almost 4 in 10 (39%) say their business revenue has decreased over the past six months, with most declines being as high as 30%.
“Small businesses are struggling to maintain operations under current inflation and labor market trends,” said Eric Coleman, SVP of Small Business Insurance at Nationwide. “Getting back on track isn’t going to be easy if the predictions of a recession play out.”
Without even being in a recession, the current economic environment is beginning to take a toll on small businesses, with few seeing relief in the near term. 70% of small business owners expect a recession within the next 6 months, but significantly fewer feel prepared to weather it.
What Can Small Businesses Do Now To Prepare for a Recession?
Read our next post to learn what small businesses can do now to prepare for a recession.