Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The 3.63 Fed Funds Rate Is Squeezing Small Business Lending
Transcript
- Lucas: So the federal funds rate has been sitting at 3.63 percent for about six weeks now, and we've spent a lot of time talking about what that means for inflation, for the bond market, for big corporate borrowers. But I think there is a quieter story here that's actually hitting closer to home for a lot of listeners. Luna: Which is what? The consumer side? Lucas: Small business lending. The Fed's Senior Loan Officer Opinion Survey — the one they release quarterly — just came out with its May data, and it shows that banks are tightening credit standards for small firms at the fastest pace since the second quarter of 2020. I'm talking about commercial and industrial loans under one million dollars. Luna: Right, because the prime rate is directly tied to the fed funds rate. So if the funds rate is at 3.63, prime is around 6.63, and then you add a spread for small business risk. Lucas: Exactly. The average rate on a variable-rate small business loan is now close to 8 percent. Maybe 7.8, 7.9. And look, these aren't Fortune 500 companies with access to the bond market. These are the local manufacturers, the independent retailers, the construction subcontractors. When their cost of capital goes up by 500 basis points relative to where it was in early 2022, it changes investment decisions. Luna: And we just saw GDP growth come in at 1.6 percent annualized for the first quarter. That's better than the 0.5 percent we saw at the end of last year, but it's still below trend. Lucas: It is. And part of that below-trend growth is exactly this channel. Small businesses typically account for about 44 percent of U.S. economic activity. If they can't get affordable credit, they can't expand, they can't hire. And the weird thing is, job openings actually surged to 7.6 million in April, up from 6.9 million in March. So there's demand for workers, but hiring itself stayed sluggish. Luna: So businesses want to hire but they can't afford the capital to make the expansion happen? Or they're worried about the outlook? Lucas: Probably both. The loan officer survey also asks about demand. And demand for small business loans is weakening — not because businesses don't want to borrow, but because the terms are too punitive. Banks are also tightening standards on commercial real estate loans, which is a whole other can of worms. But for the small business side, the mechanism is pretty clear: higher fed funds rate means higher prime, means higher loan rates, means fewer projects get the green light. Luna: And the yield curve inversion doesn't help. The 2-year Treasury is at 4.22 percent, the 10-year at 4.45 percent. That's a pretty flat curve, actually — not deeply inverted like last year. But still, banks make money borrowing short and lending long. When that spread is thin, they have less incentive to lend. Lucas: That's a great point. The 2s10s spread is only about 23 basis points. For context, it was inverted by more than 100 basis points at the peak in 2023. So the inversion has mostly resolved, but the level of rates is what matters for borrowers. The average small business owner doesn't care about the shape of the yield curve — they care about their monthly payment. Luna: And the monthly payment today is roughly double what it was in 2021. Lucas: Roughly double. So what does this mean for the Fed? Kevin Warsh just had his first FOMC meeting as chairman. The statement was largely unchanged. They're still data dependent. But if credit conditions for small businesses continue to tighten, that's going to show up in payrolls eventually. And we already saw nonfarm payrolls tick up to 159 million in May, but the pace of gains has been slowing. Luna: The unemployment rate is at 4.3 percent. Still low historically, but it's been creeping up from 3.4 percent in early 2023. Lucas: Right. And the core PCE price index — the Fed's preferred inflation gauge — is at 129.6, up from 129.32 a month earlier. That's still running above the 2 percent target. So the Fed is stuck: inflation isn't low enough to cut, but the real economy is showing signs of strain. And small business lending is the canary. Luna: I actually talked to a small business owner in Ohio last week who runs a metal fabrication shop. He said his line of credit renewal came through at 8.5 percent. He used to pay 4.25. He's not taking on any new projects until rates come down. Lucas: That's exactly the kind of anecdote that the loan officer survey is capturing in aggregate. The net percentage of banks tightening standards for small firms jumped to 34 percent in the latest survey. That's up from 22 percent in the previous quarter. And it's the highest reading since the pandemic lockdowns. Luna: Is there any silver lining? I mean, the breakeven inflation rate on the 10-year TIPS is at 2.25 percent. That's down a bit. Market expectations for inflation are moderating. Lucas: That is a silver lining. The 10-year breakeven was at 2.26 percent last week, now 2.25. It's been trending down since April. So the bond market is pricing in a gradual easing of inflation pressures. That gives the Fed some room to eventually cut, but not yet. The real question is how much damage gets done to Main Street in the meantime. Luna: And if the Fed waits too long, they might have to cut more aggressively later. That's the classic delayed-recession risk. Lucas: Exactly. And you can see that in the inversion of the 5-year and 30-year — the 5-year is at 4.22, the 30-year at 4.90. That's still a steep curve out there, but the front end is anchored by the fed funds rate. So the market is saying, 'We think rates will come down, just not right now.' Luna: If walking through the economy with us has made something click — maybe you better understand why your local hardware store isn't expanding, or why your own credit card rate hasn't budged — then we want to mention something. Lucas: Yeah. Fexingo is completely ad-free, and that's possible because some listeners choose to support the show directly. If you find these daily conversations useful, you can buy us a coffee — just go to buy me a coffee dot com slash fexingo. One-time, no subscription, no pressure. Luna: And it genuinely helps us keep doing this without sponsors or commercials. So thank you to anyone who's already done that. Lucas: Back to the data: we mentioned that job openings jumped to 7.6 million. That's a big increase from 6.9 million. But the hires rate barely moved. So the labor market is in this weird place where demand for workers is there, but the matching process is broken. Part of that is skills mismatch. But part of it is that small businesses — which hire a huge share of workers — can't afford to add headcount because their borrowing costs are too high. Luna: And the JOLTS data is for April. So we're seeing a lag. The tightening in lending standards in the loan officer survey is for the second quarter. That might show up in the July or August jobs reports. Lucas: Exactly. So the Fed is watching these numbers closely. Warsh said in his post-meeting press conference that the committee is 'attentive to financial conditions' — that's code for 'we know lending is tightening.' But they can't ease until inflation gives them cover. Luna: So the real action is in the data between now and the September meeting. The July meeting is still possible for a cut, but the market is pricing that probability at around 30 percent. Lucas: And the terminal rate — where the fed funds will peak — is still uncertain. But if small business lending continues to contract, the Fed might find itself behind the curve. That's the tension at the heart of this whole macro moment.