Why is the Federal Reserve Raising Interest Rates?

In this article, you’ll learn:

• What the federal funds rate is
• How the federal funds rate affects the economy as a whole
• Why the Fed lowers or raises interest rates
• Why the federal funds rate is important to small business owners
• Best types of small business financing options in 2022
• Small business financing options to not rely on in 2022

The S&P 500 entered bear market territory (down more than 20% from its previous closing high) on June 13, 2022. The actions of the Federal Reserve have played a big part in the stock market losses – the central bank has increased its benchmark federal funds rate to a range of 1.5%-1.75%, and the rate could top 3% by the end of 2022.

In May, the Federal Reserve increased its benchmark interest rate by three-quarters of a percentage point. The 75 basis point increase was the biggest increase since 1994.

The federal funds rate doesn’t just impact Wall Street; it also matters to small business owners. Let’s start by looking at the federal funds rate at a high level, though.

What is the Federal Funds Rate?

The federal funds rate is the target rate set by the Federal Open Market Committee (FOMC) for commercial banks to borrow and lend their excess reserves to each other overnight. The banks are required by law to maintain reserves in an account at a Federal Reserve bank based on a percentage of their deposits.

It’s important to note that the Fed can’t force commercial banks to charge the exact federal funds rate. With that said, the central bank can adjust the money supply to influence rates in its intended direction.

The FOMC meets eight times a year to set the federal funds rate.

How Does the Federal Funds Rate Affect the Economy as a Whole?

The federal funds rate impacts the interest rates on other types of loans; a lower rate makes it cheaper to borrow money, and a higher rate leads to higher borrowing costs. The cost of borrowing is really important because there is a lot of debt across the U.S. economy:

A slight Fed rate hike may only cause a small decrease in purchases… but that small decrease in purchases may amount to hundreds of billions or trillions of dollars.

You can think of the federal funds rate as a gas pedal or brake – lowering the rate is like pressing the gas pedal, and increasing the rate is like hitting the brake.

Why Does the Fed Lower or Raise Interest Rates?

The Federal Reserve is tasked with maintaining maximum employment and stable prices. The federal funds rate is one of the main tools for accomplishing those goals. There is a positive correlation between the unemployment rate and interest rates, and there is a negative correlation between the inflation rate and interest rates. So, the Fed lowers or raises interest rates depending on employment and inflation numbers.

In a perfect world, there would be a low unemployment rate and low inflation rate all the time. But in reality, keeping both numbers in check isn’t easy. The economy booms and reaches maximum employment… but inflation rises above healthy levels. Or the economy contracts and inflation is low… but the unemployment rate rises and economic growth plummets.

While a “Goldilocks” zone of reasonably low unemployment and inflation is possible – and the Fed does everything in its power to get to and stay in this zone – there seems to be no way to keep the numbers at healthy levels forever.

So, Fed officials are constantly making tradeoffs between inflation and unemployment.

Why is the Fed Raising Interest Rates in 2022?

The Fed is raising interest rates in 2022 to combat high inflation. The consumer price index (CPI) experienced an 8.6% increase in May over the last year, a more than 40-year high. This is well above Fed policymakers’ 2% inflation target.

There was a widespread expectation that elevated inflation would be short-lived in the spring of 2021 when the inflation rate crossed the 4% level. But there are several things pushing prices higher across the economy, including shortages in the labor market, the Russia-Ukraine war, pandemic-related supply chain disruptions in China, and strong demand – some of which could persist into 2023.

So, the central bank is raising interest rates to discourage individuals and companies from making purchases, hopefully leading to price stability.

Why is the Federal Funds Rate Important to Small Business Owners?

The federal funds rate indirectly affects interest rates on small business loans.

Here’s how it works:

The federal funds rate impacts the prime rate. The prime rate is a starting point for interest rates on many small business loans.

Best Types of Small Business Financing Options in 2022

With the Fed likely to continue raising rates, you may want to get a product with a fixed interest rate if you need financing for your small business. By doing this, you lock in your interest rate on Day 1, and future market rate increases don’t affect your repayments. Here are a few of the best options:

Term Loan

A term loan is a loan product that traditional banks and online lenders offer. The borrower gets a lump sum and agrees to pay back the lender at regular intervals at a fixed or variable interest rate. This small business financing option can be used for several purposes, including real estate, equipment, inventory, and debt consolidation.

With Biz2Credit, term loans are customized to each small business. The loan amounts range from $25k to $500k, and payment plans are anywhere from 12 to 36 months. You typically need more than $250k in annual revenue, a 660 credit score, and 18 months in business to qualify for a term loan.

SBA 7(a) Loan

The U.S. Small Business Administration (SBA) 7(a) loan program allows small business owners to borrow up to $5 million at a fixed or variable interest rate. The funds can be used for real estate, working capital, refinancing current business debt, and purchasing furniture, fixtures, and supplies.

The SBA guarantees a large portion of the loan, allowing lenders to offer borrowers below-market interest rates. In addition, the maximum maturity for an SBA loan is between 10 and 25 years, depending on the purpose of the loan proceeds. So, you may be able to get a long-term loan at a low, fixed interest rate, positioning you well if rates continue climbing over the next few years.

You have to meet several eligibility requirements to secure an SBA loan; it’s a good idea to carefully review these requirements before starting the loan application, which is time-consuming relative to other small business financing options. After applying, you may have to wait for months to get approval and funding, so you shouldn’t use an SBA loan for immediate business needs.

Merchant Cash Advance

A merchant cash advance (MCA)  provides a small business owner with upfront cash to be repaid through a percentage of estimated or actual future sales. With an MCA, the upfront cash is multiplied by a factor rate – usually between 1.2 and 1.5 – to determine the total amount to be repaid. So, if you borrow $100,000 and the factor rate is 1.4, you would have to repay $100,000 * 1.4 = $140,000.

The repayment period can be anywhere from three to 18 months; it depends on the agreement and the small business owner’s sales. If the repayments are based on a percentage of actual sales, higher sales will result in a shorter repayment period and vice versa for lower sales. If the repayments are based on a percentage of estimated sales, the actual sales will not impact the repayment period.

You may want to consider using an MCA in our current economic environment due to the fixed nature of the factor rate – it isn’t adjusted higher if market rates move higher. With that said, you effectively have to pay a lot of interest with a merchant cash advance; a factor rate of 1.2 to 1.5 works out to 20-50% paid to the company on top of the borrowed amount, and again, the 20-50% is usually applied over a short repayment period.

The good news with an MCA is that it’s not hard to qualify for this small business financing option, unlike the term loan and SBA 7(a) loan. You typically need a credit score of 525-550, $150,000-$200,000 in annual revenue, and 18-24 months in business.

Small Business Financing Options to Not Rely On in 2022

Let’s look at a couple of small business financing options that you don’t need to avoid flat-out, but that you shouldn’t rely on in 2022. With both of these options, you can’t lock in the interest rate on Day 1, but at the same time, you’re under no obligation to use them if rates continue moving higher.

Business Credit Card

A business credit card is a card specifically designed for business owners. Business credit cards work similarly to personal credit cards, but the credit limits and perks are structured with business owners in mind.

In 2022, there’s nothing wrong with using a business card… if you pay your bill in full each month. You don’t want to get used to carrying a balance, however, as credit card annual percentage rates (APRs) may move higher in the near future, in tandem with the federal funds rate.

You may be able to find a business credit card with a six-to-18-month 0% APR introductory period, though. If you go this route, you could carry a balance without worrying about rising interest rates, but it’s essential to be aware of when the 0% introductory period ends.

The eligibility requirements for business credit cards vary from card to card, but you need a credit score of 670+ to qualify for many of the best business credit cards.

Business Line of Credit

A business line of credit is a small business financing option that works similarly to a business credit card. You borrow what you need when the money is needed and only pay interest on what you borrow. There is a credit limit, and the available capital is reviewed yearly in many cases. While some small business financing options can only be used for a small number of purposes, a business line of credit can be used for a wide variety of business needs.

A business line of credit usually has a variable interest rate, so it’s hard to rely on this small business funding option with the Fed raising interest rates. With that said, you can consider getting a business line of credit for optional future purchases; this way, if rates continue moving higher, you aren’t forced to bite the bullet and take out a high-interest loan.

To qualify for a business line of credit from an online funder, you usually need a 580 or higher credit score, 12 months in business, and average monthly revenue of $10,000.

The Bottom Line

As a small business owner, you don’t need to have a deep understanding of macroeconomics, but it’s essential to have a general idea of the state of the economy. In 2022, the inflation rate is higher than it’s been in decades, and the Federal Reserve is raising interest rates in an effort to curb inflation.

In this economic environment, it’s essential to use the right small business funding option – you could otherwise be stuck paying more and more interest down the road.

In any economic environment, it’s essential to get funding as soon as possible, after you’ve identified a need for your small business. With Biz2Credit, you can get funded in a few business days. Dr. Ravindra Gautam, a California Doctor, applied and was funded $350,000 within 48 hours.

Learn how Biz2Credit can connect you with the right type of financing for your small business.