July 1, 2004

While business owners have come to fear rising interest rates, their reaction should be to greet them with anticipation and enthusiasm, not fear. The expected rise in rates during 2004 will have a positive impact on small to medium sized businesses—unless they allow fear and emotion to control their decisions. The recent comments by Federal Reserve Chairman Alan Greenspan trumpet the entry to a year of prosperity for small business fueled by increasing factory orders and retail sales.

After three years of continual reductions in interest rates to levels not seen since 1958, U.S. central bankers are poised to raise their target for short-term interest rates. The last rate cut occurred in June of 2003 when the Fed reduced short-term rates from 1.25% to 1%. Historically, well into the first year of the beginning of a tightening cycle the economy and business profits grow at a very rapid rate. The rise in the stock market has averaged in excess of 14% during tightening cycles since 1983. This cycle will be no different.

Thomson First Call reported that 454 companies in the S&P 500 have announced first-quarter results, and their earnings are up 27% over last year. For 2004, Wall Street analysts expect S&P 500 profits to rise 17% on average. This optimism is influenced by the recent overwhelming positive economic data, especially factory orders, retail sales, employment data, and an economy growing at a rate of four percent. The increase in nonfarm payrolls for March and April were well above the most optimistic forecasts, and the best back-to-back months in four years. “A rise in interest rates in the coming months is a clear sign of economic health and a growing economy. This trend will benefit small to medium-sized businesses in general, but particularly those poised to seize this once-in-a-cycle opportunity” said Steinberg.

It has been ten years since the Federal Reserve engaged in a program designed to raise interest rates. What differentiates 2004 from 1994 is that today inflation is much lower and productivity growth is much higher. During his recent testimony to the Joint Economic Committee, Federal Reserve Chairman Alan Greenspan told lawmakers, “When you have the benefit of a very significant increase in output per hour, it means that you can go in a much more measured pace (in raising rates) than you would be required to go in the past.” This bodes for a more gradual approach by the Fed, which translates into a more prolonged period of short-term prosperity than we have seen in past cycles.

The first rate hike by the Fed was announced after the conclusion of the June 29th Federal Open Market Committee meeting. As anticipated, it was one-quarter of a percent. This will probably be followed by a second one-quarter of a percent rise in mid August. The timing of the initial increase will be influenced by the rate at which reported economic numbers, particularly jobs and CPI, continue to increase. There are four remaining opportunities for increases in 2004. The Federal Open Market Committee meets August 10, September 21, November 10 and December 14. Over the next year and a half, I anticipate a series of small increases that could boost the fed funds rate to a minimum of 3.25 percent, up to a maximum of four percent, by the end of 2005. As of the June Fed meeting, there is a shift in policy to a tightening / inflation fighting bias.

During the past three years, Americans have become far more willing to acquire debts and banks are far more willing to allow this trend. Household debt increased at twice the pace of household incomes from the beginning of 2000 through 2003, according to data at the Federal Reserve. A series of small interest increases will have little, if any, impact on this consumer trend. Economic sectors such as basic materials, which are extraordinarily sensitive to the economy, are reporting accelerating profits, as are blue-chip technology and consumer-driven stock sectors. A rise in interest rates will reflect a change in focus by the Federal Reserve. Fed policy will shift its emphasis from economic stimulation to maintaining growth without significant inflation. The purchasing appetite of Americans is sustainable near-term, which translates into sustained profit trends for businesses near-term.

The benefits to small business owners of a moderate rise in interest rates over the next eight to twelve months include: