By Steven Jones; Dir. Investment Strategy & Walker Wilkerson , Managing Partner;

CliftonLarsonAllen

The tightening cycle has begun

For the past two years, labor shortages and disruptions in the supply chain have become part of everyday business management. Now businesses must add high inflation to the list of challenges and try to figure out how the Fed’s response may impact their decision-making process.

To help ease inflationary pressures, the Fed ended its quantitative easing program in March and raised the key federal funds rate by 0.25% in March and 0.50% in May. (Federal Reserve) Thus, 2022 marks the start of another “Fed tightening cycle.” As with all Fed tightening cycles, the key questions are:

• How far will the Fed need to raise interest rates to bring inflation back down to its 2% target?
• Will raising interest rates eventually cause the economy to slip into a recession, or can the Fed engineer an economic “soft landing”?

The short answer is, no one knows, not even the Fed. The U.S. economy is dynamic and complex, and the Fed is “data driven.” That is, the Fed’s future actions will be based on data that stems from the decisions of millions of consumers, investors, and business owners. Still, there are some insights we can gain from past Fed tightening cycles.

Act with caution — all is not as it may seem

The beginning of a Fed tightening cycle can be marked by the opposite of what the Fed intends. Specifically, the Fed is trying to slow down the economy, but rational consumers understand that it’s cheaper to borrow and buy now, before interest rates go up and residual inflationary pressures drive prices even higher.

The net effect is that demand is pulled forward and the economy may appear stronger than it otherwise would. On the flip side, future demand is now lessened, thus opening the possibility of a sharper slowdown in the future. All of this helps to explain why economists believe it is difficult for the Fed to engineer a “soft landing.”

Stress-test your business metrics

There is no “one-size-fits-all” approach. Instead, every organization needs to understand how a Fed tightening cycle may specifically impact them.

For example, nondiscretionary consumer purchases are less likely to be impacted than discretionary capital expenditures. Consider the elasticity of client demand relative to rising interest rates and a slowing economy — and then examine the results of a stress test to understand how it may impact revenue and cost structure.

How will this impact your business?

As the Fed tightening cycle continues to drain liquidity from the economy, cash management could become paramount. If the Fed drains too little liquidity, inflation will persist. If the Fed overshoots and drains too much liquidity, a “liquidity squeeze” will occur.

Therefore, carefully consider how much cash is appropriate to hold on your balance sheet. Too much cash will drag down earnings or sustainability, while too little cash could result in a “cash crunch” or even insolvency. Increased borrowings will impact your balance sheet health. How will interest rates impact your pricing or future expansion efforts? And ultimately, how will the future economic environment impact consumer demand and ability to pay?

How we can help

Whether you are looking to grow or trying to understand how each of these elements will impact your profitability or sustainability, CLA can help. We bring deep industry knowledge and experience to each conversation in order to know you and to help you.