How will Main Street react to higher interest rates?

Small town USA
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While small-business optimism is holding steady by a variety of indicators, that increased outlook hasn't translated to more borrowing on Main Street. And if small businesses aren't interested in loans when rates are low, will they change their tune with a rate hike on the horizon?

The answer is mixed. Historically low interest rates haven't pushed small businesses to borrow from banks, as noted by Fed Chair Janet Yellen during her congressional testimony in February. Experts cite a disconnect between the Fed and Main Street, as borrowing is often driven by cash flow and opportunities to derive returns rather than interest rates alone.

The timing of a rate hike is also uncertain, giving Main Street an unclear message. Yellen said in March that a rate hike may be warranted "later this year," but then at the same speech she seemingly struck a dovish tone, saying an increase was "likely to be gradual."

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On Monday, New York Fed President William Dudley, the first to comment publicly after a weak jobs report for March with 126,000 jobs added, missing estimates of 245,000, said the Fed would monitor future reports to see if the jobs data were a sign of greater economic weakness. The market read this as a signal that the rate hike would not be fast-tracked.

"I suspect if the Fed were to move aggressively to raise rates, that might prompt small business owners to move faster," says Stuart Hoffman, chief economist of PNC Bank's Financial Services Group, whose own small-business optimism survey finds small business owners are as optimistic as they were in 2007. "But we still have over one-third of businesses citing weak demand, and while that is a shrinking number, an improvement in outlook for sales and profitability is what will prompt borrowing."

Better Cash Flows

The same optimism levels that are holding strong are also driven from better cash flows, which are part of the low-loan-demand puzzle. According to Dun + Bradstreet Credibility Corp.'s Q1 2015 Pepperdine Private Capital Index, 65 percent of small businesses surveyed said they have enough cash flow, and 33 percent said they have sufficient funding in place. What's more, the index finds that over the past 12 quarters, demand for capital is down 12 percent.

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This is echoed in the National Federation of Independent Business' latest report on optimism for February, demand for credit remained historically low, with optimism holding fairly steady. Only 3 percent said their reported credit needs were not met, while 33 percent said their needs were met and 53 percent said explicitly that they do not want a loan.

Despite the fact that optimism has held steady, and plans to hire and spend in the past four months have increased, a trigger in borrowing has not been noted in the report, the NFIB says. The latest reading is due out next week.

The upside of a rate hike, which could potentially drive lending, is the fact that the status quo is changing, signaling a stronger economy, said Jeff Stibel, CEO of Dun + Bradstreet Credibility Corp.

"For small businesses, there is a weird paradox where an increase in interest rates can actually fuel lending," Stibel said. "We've been living in a time of historic uncertainty, and a lot of small businesses don't fear bad times, they fear not knowing. If the Fed doesn't raise rates, things are bad, and if they do raise rates small businesses may feel things are going well."