As the Fed Works to Slow Economy, Small Businesses Feel the Squeeze

Now, having racked up debt that he says hovers in the six figures, Jackson’s challenge is two-fold. He’s trying to secure another line of credit that would allow him to expand into a second location, while figuring out how to afford soaring interest payments on the debt he already owes.

“We went from manageable to unmanageable very, very quickly, because the interest rates basically quadrupled,” Jackson told Barron’s from his Harlem-based restaurant.

Jackson, a seasoned restaurateur who once appeared on Iron Chef, is among millions of small business owners battling to stay afloat amid rising economic headwinds and slowing consumer demand. In less than four years, small firms—more vulnerable to economic whims than their larger counterparts—have been forced to navigate pandemic shutdowns and restrictions, supply-chain slowdowns, labor shortages and rising prices.

Now there’s a new challenge: tightening credit conditions, which have driven up interest-rate payments and made it difficult for entrepreneurs to secure the loans they need to expand. Roughly one in five small businesses view rising interest rates as the top challenge, and half of all small firms are delaying plans to expand because of those rates, says Tom Sullivan, vice president of small business policy with the U.S. Chamber of Commerce, citing survey data jointly collected by the chamber and
MetLife.

Access to financing is crucial for small businesses because it enables them to grow and hire additional workers, fueling a cycle that keeps the labor market expanding and the economy humming. Small firms are responsible for roughly two-thirds of all net new jobs and in recent years have accounted for 44% of all economic activity, so their resilience is key to the elusive soft landing Fed officials hope to achieve.

The headwinds dogging small businesses highlight the risks to the economy if the Fed keep rates too high for too long. Because monetary policy tightening filters through the economy with a lag, central bank officials are trying to determine whether the full impact of their efforts has yet to be felt or whether they have more work to do.

So far, data has largely suggested that the broader economy remains strong and steady: Unemployment is below 4%, household balance sheets are strong, and growth soared in the third quarter to a more than a 5% annual rate.

Many small businesses, in contrast, are offering sharp warning signs. The net share of business owners reporting higher sales in the past three months, compared to the prior period, just posted its lowest reading since July 2020, according to the October survey from the National Federation of Independent Business. The federation’s Optimism Index has also ticked lower for each of the past three months and is below where it stood in April 2020, in the depths of the coronavirus pandemic, staying there even as inflation has fallen by more than two-thirds. More than half of small business owners believe the U.S. is already in a recession.

And while securing financing is just one of many problems small businesses face, its prominence is rising. Five percent of owners listed it as their top business problem in the latest survey, up from the 1% to 2% level where it has stood for years, says Holly Wade, executive director of the federation’s research center. Owners are worried not only about being unable to access the capital they need, but also about how higher rates are impacting their customers’ ability to purchase the goods and services they are selling, she says.

“Nothing about this feels good,” Wade says.

Some economists warn that small business troubles could be an early indicator for where the broader economy is headed. “What might be happening is that small businesses, which are often at the forefront of the economy … might be seeing conditions on the ground deteriorate a little bit ahead of what the data is picking up,” says Charlie Dougherty, a senior economist with
Wells Fargo.

Fed officials have begun to air similar concerns. While the central bank wants to see some slowdown in economic activity and in the labor market, Fed Gov. Lisa Cook said in a November speech that she is “attuned to the risk of an unnecessarily sharp decline.” She highlighted tighter credit conditions among small firms as one element she is tracking, largely because small businesses borrow for shorter terms than larger firms and are therefore facing higher rates sooner as they roll over their loans.

“As we try to identify the full, lagged effects of monetary policy tightening,” Cook said, “I am considering whether small businesses, the housing sector, and low- and moderate-income households could be warning of broader stress ahead.”

Because of the reduced size of their balance sheets, small firms cannot absorb the costs of inflation and higher interest rates the way larger businesses can. Too much tightening could cut these firms off from the capital they need to grow, forcing them either to turn to more costly methods of financing—such as credit cards—or to postpone plans to expand.

In 2013, Samantha Snabes co-founded the Texas-based firm re:3D, a company that manufactures and sells 3-D printers that can use traditional pellets or plastic waste to print objects. As the 28-person team has grown, selling printers in more than 50 countries, it has pushed its main factory over capacity.

Snabes is now looking to relocate and purchase a new plant to help the company scale up. But the cost of financing has given her pause.

“We’re looking at lines of credit and other things, and the interest rates have just been insane,” Snabes told Barron’s. “So I’ve shied away from doing that.”

The data suggests she’s not alone. Small businesses are facing tighter lending conditions than large and mid-market firms when it comes to the maximum size of credit lines and collateralization requirements, the Fed’s most recent Senior Loan Officer Opinion Survey on bank lending practices shows. Demand from small firms for commercial and industrial loans is falling far more sharply than for their larger counterparts, according to the same survey: Nearly 53% of banks reported moderately or substantially weaker demand over the past three months for loans among small firms, compared with just over 40% reporting the same for large and middle-market firms.

At the same time,
Bank of America Institute
data shows credit card balances are rising among small businesses even as spending stays more or less flat, suggesting that more firms are using their cards as a source of financing. That points to “financial stress for certain firms,” even as overall loan-to-net worth ratios remain low, the Institute said in its latest Small Business Checkpoint.

Some 30% of small businesses are now using credit cards for financing, and overall credit-card debt levels for these firms are up 20% from the pre-pandemic years, according to the Intuit QuickBooks Small Business Index annual report.

That could indicate more small firms are facing trouble and growing more desperate for outside financing, says Ufuk Akcigit, a University of Chicago economics professor who led development of the QuickBooks index.

“The variable cost of financing through credit cards is very high—and that’s why normally it’s not the first means that people would use,” Akcigit says. “But of course, when things are tight, what will they do? They switch to credit cards.”

The saving grace for small businesses at the moment is the economy remains strong. Many firms, buoyed by strong consumer demand over the past couple of years, are armed with healthy balance sheets that can help provide some buffer even as interest costs grow more painful. And those that don’t hold debt or need credit aren’t feeling as much of a squeeze. 

Jeff Good, president of the Mangia Bene Restaurant Management Group, which operates three restaurants in Jackson, Miss., is debt-free. Two of his restaurants had their highest-ever revenue years in 2022. But as sales rose, so did costs for food and labor—so making a profit, Good says, has been more difficult.

His lack of debt means that he’s been largely shielded from the impact of higher rates, though he recognizes his customers could have smaller dining-out budgets as a result. “The tail of the tape will be, what’s consumer purchasing look like in the next year?” he says. “We all wait and see.”

There’s hope, then, that financing headwinds will have a limited impact: 
Goldman Sachs
economists estimate that the drag on GDP from small business borrowing costs will peak this year at just 0.1 percentage point, before moderating in 2024 and then rising again later in the decade as term loans are refinanced.

But Goldman acknowledges one risk to its outlook would be if small businesses have difficulty sourcing new banking relationships or accessing alternative sources of financing, both of which would leave them more sensitive to rising interest costs.

“Small businesses are like the children in the family,” Akcigit says. “When the weather gets cold, they are the first ones to get ill.”

Write to Megan Cassella at megan.cassella@dowjones.com