Small Matters: Fed actions are little help to small businesses

Posted: December 26, 2011

The deputy governor of Sweden's central bank recently urged the U.S. Federal Reserve to find ways to push borrowing costs lower, this even though we have the lowest nominal interest rates in decades.

Really?

Would lowering mortgage rates another 20 basis points from their recent historic lows suddenly trigger more demand for mortgages to buy a house? Get small-business owners to rush out and buy equipment or expand their businesses? Real interest rates are already negative in many instances.

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, observed: "I am skeptical that further asset purchases will produce much gain in terms of increased economic activity."

Lockhart's is a more accurate assessment of the Fed's ability to bring about real economic activity on Main Street. Certainly, announcing programs such as "Operation Twist" or more purchases of mortgage-backed securities will create activity on Wall Street, but the Fed is "out of bullets" when it comes to reducing the unemployment rate and inducing job creation.

The National Federation of Independent Business has surveyed its member firms (350,000 of them) since 1980 about credit-market conditions and the rates they pay on short-term loans (12-month maturity or less). The average rate reported has been stuck between 6 percent and 6.5 percent since January 2009. This has occurred despite massive Fed intervention in the form of liquidity-providing purchases of assets (mostly Treasurys and mortgage-backed securities).

The spread between the one-year Treasury yield and reported rates paid by business owners for loans has rarely been as large as it has been since 2008 and never for as prolonged a period of time. With the Fed maintaining a virtual zero-rate target, it is hard to see how the agency could drive borrowing rates for small firms any lower.

The cost of funds for community banks is not driven by just the federal funds rate. Their business model is built around "relationship lending" and information that is not contained in a credit report, such as the quality of the management team or prospects for growth in the geographic area.

This kind of scrutiny is labor-intensive, but one that provides a service that is valued by borrowers and apparently not available from larger financial institutions.

Most if not all community and regional banks have put floors on the rates they will offer on business loans and equity lines of credit that reflect these cost differences. When market rates are at historic lows, it is risky for small banks to make longer-term loans at historically low fixed rates. If rates rise, as most observers expect, the value of low-rate loans on the banks' balance sheets will not perform well and earnings will be impaired.

So besides periodic "resets," floor rates are in place and it will be difficult if not impossible for Fed policy to push longer-term loan rates below those floors. That said, loan rates are historically low, and the cost of funds is not preventing firms from borrowing.

It is the lack of good uses for borrowed funds that is depressing loan demand. Loans must be repaid and so must be used in ways that at least return the principal amount of the loan - and those business opportunities are few in this weak economy. Most firms see little or no improvement in the economy in the coming year, so no need to borrow to invest or hire. It will take time and an election to change this.


Bill Dunkelberg is a professor of economics at Temple University and a nationally recognized expert on small business. Contact him at dunk@temple.edu.

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