The good news is that your input costs might be going down enough to offset some of your rising labor costs.

The bad news is that your sales could be going down due to higher interest rates.

The Federal Reserve is expected to raise the federal funds rate from 0 to 0.25 percent to 1 percent by July 2022. That doesn’t sound like much of an increase, and it isn’t. But, it’s fast.

The terminal rate is expected to be 2.5 percent sometime in 2023. Even that rate is relatively low. However, the super-cheap cost of money has undermined the business environment because it allowed weak and failing companies to operate.

A higher federal funds rate impacts other rates, such as mortgages, the Wall Street Journal Prime and credit lines. Many lines of credit reprice monthly, so, higher interest expenses hit the bottom line immediately.

Some companies operate out of owner-occupied buildings, and those term loan payments could also adjust upward. Higher interest rates affect your business’ cost of capital, which drives down cash flow. You’re wrong if you think that higher interest rates won’t affect you because you are debt-free. What impacts your customers, and the rest of the world, impacts you.

After the Japanese asset bubble collapsed in 1991, the government allowed banks to prop up so-called zombie companies by giving them enough cheap money to make their loan payments. Two decades of easy money has created zombie companies here in the U.S.

There’s no exact definition of “zombie companies.” Still, the July 2021 Federal Reserve report “U.S. Zombie Firms: How Many and How Consequential?” notes that “it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets.”

Between 2015 and 2019, the Fed found that roughly 10 percent of public firms and 5 percent of private firms are zombies. Based on spikes during the U.S. recessions of 2001 and 2008, I’d venture an educated guess that the numbers are double those reported for 2019 (and are even more addicted to easy-money policies today).

The business cycle has become tied to monetary policy. Marginal business practices have been effective because the low capital cost has allowed for inefficiencies.

Despite those risks, the Fed intends to fight inflation by raising rates. According to the NFIB Research Foundation, the biggest problem facing small-business owners is no longer the labor shortage, it’s inflation. Inflation recently clocked in at 7.5 percent over the past year, the highest consumer price index (CPI) measure since February 1982.

Since 1977, the Federal Reserve has served a dual mandate defined by Congress, to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” The Fed’s target inflation rate is 2 percent (using a metric known as Personal Consumption Expenditures). Its next dragon to slay is high prices.

Part of the reason for high inflation is supply chain issues. The Fed cannot solve the supply chain issues that have contributed to inflation. However, the Fed can slow the economy. Interest rate hikes are a lever to make your customers buy less of what you sell. Reduced demand for goods and services drives prices lower.

When interest rates rise, consumers tend to save more and spend less. Increased interest rates mean higher debt service charges. This curtails households from spending on credit cards and taking out loans, which means that your sales and profits could fall.

The corporate sectors that will get hit first will be those most sensitive to interest rates. Mortgages will become more costly. Car loan payments will be higher. Then it could ripple across the rest of the economy.

Higher debt service decreases profits and dissuades companies from starting new projects or expanding because they can’t as easily afford to take out credit. Maybe that company isn’t you, but the affected company or its employees could be your customers. That trickles down to us. And once this starts, banks could become more reluctant to extend a business loan to you just when you need it most.

You can take steps now to prepare for how higher interest rates could affect your business. You should take action to control rising costs and defend your revenue.

If your lender will allow you, change your adjustable-rate loans to a fixed rate. This will lock in your low rate for the life of your loan. If the lender doesn’t allow for refinancing, you can pay off your debt to avoid spending more at a higher interest rate. (Although, you’ll want to consider the ratio of interest-to-principal payments on your amortization schedule.)

If you have excess cash, you can open a high-yielding savings account to generate more interest income.

You can get a line of credit approved now. If your bank doesn’t extend the credit, you could borrow against your investment portfolio. For example, Charles Schwab & Co. allows investors to take out a “Pledged Asset Line” to “use for a real estate investment, business startup, or other expense.” Suppose the economy turns down, or your borrowing costs go up. In that case, it will be more challenging to secure financing. It’s better to have it and not need it than need it and not have it.

Lastly, change your customer spending habits. Pull some of your sales forward and make others recurring. That statement can (and has) been stretched into entire books.

I understand that it’s bordering on flippant to suggest that doing so comes as easily as waving a magic wand. I also know that the reaction of business owners in every sector is, “We can’t do that; you don’t understand my industry.” Well, I do know business. And I know that tiny box owners often find themselves in. That box limits the possibilities to reduce costs or defend revenue. Let’s get outside of that box.

Allen Harris is the owner of Berkshire Money Management in Dalton. He can be reached at [email protected].

This article appeared originally in The Berkshire Eagle on February 26, 2022.