Fed Tightening May Be Just Starting to Hit Businesses (September 10, 2023)

A third of corporate debt may be at risk of default during this cycle of monetary tightening, Boston Fed economists find

By Lisa Beilfuss
September 10, 2023

Recent Federal Reserve research suggests there is significant economic pain in the pipeline–implying that any soft landing would be temporary.

Two recent papers out of regional Fed banks, taken together, undermine the notion that aggressive interest-rate increases won’t hinder U.S. economic growth. Already-implemented Fed tightening may have only just started to hit corporate balance sheets, meaning defaults are coming and significant job losses are more likely than an immaculate rebalancing of labor supply and demand.  

First, a paper published over the last week by Chicago Fed economists Stefania D’Amico and Thomas King received quite a bit of buzz. The pair estimates that about 65% and 75%, respectively, of the total tightening effect on the levels of real, or inflation-adjusted, gross domestic product and the consumer price index has already happened. What is left, they say, amounts to downward pressure of about 3 percentage points on real GDP over the next five quarters and 2.5 points on the CPI over the next 4 quarters.

On its face, the Chicago Fed paper’s conclusions for growth and inflation look like evidence that a soft landing is all but certain. The authors say Fed guidance shaped policy expectations, effectively speeding up the impact of rate hikes via longer-term private credit costs, expected future prices, and incomes. If they are right, CPI will fall below 2.3% by mid-2024 as real GDP growth remains positive.

But there is a wrinkle. D’Amico and King estimate that only 40% of the total impact of tightening has hit the labor market. Using hours worked as the proxy, they forecast a 6 percentage point hit coming over the next eight quarters.

That brings us to a separate paper published by Boston Fed economists at the end of August. In it, Falk Bräuning, Gustavo Joaquim and Hillary Stein focus on the transmission of monetary policy through the balance sheets of nonfinancial corporations. 

The team acknowledges that the corporate interest expense ratio–the amount of gross income that is being spent to pay the interest on borrowed money–is still at historically low levels. That is as the share of floating-rate debt is relatively small. Because firms issued a large volume of bonds during the COVID-19 pandemic and recovery, and because they refinanced en masse in 2020 and 2021 while rates were still low, companies increased the share of fixed-rate debt and extended the average maturity. Goldman Sachs says the share of corporate bonds maturing within the next two years is at the low end of its 15-year range–16% today versus 26% in 2007. 

Like households locked into low mortgage rates, many have assumed companies are largely immune to this cycle of rate increases. But the Boston Fed economists find that pass-through is gradual and peaks five quarters after the initial 1 percentage point increase in the Fed funds rate. That means that only the initial rate increase of 25 basis points in March 2022 may have fully passed through into the corporate interest expense ratio, they say. Said another way, firms have yet to see the impact of the subsequent 500 percentage points of rate hikes. The point is especially salient when you consider that it is businesses–not consumers–that usually lead downturns.

From there, the Boston researchers looked at implications for firms’ interest-coverage ratio, a measure of a company's ability to meet required interest expense payments. They note that the metric is crucial for debt and equity investors and is prevalent in debt contracts, often referenced in financial covenants included in most commercial loan agreements. 

Because an increase in interest expense can cause a violation of a financial covenant and effectively lead to default, firms tend to make adjustments to stay above their contractual ICR limit. That translates to less investment spending, less hiring and potentially more layoffs. Goldman says that for every additional dollar of interest expense, firms lower their capital expenditures by 10 cents and cut labor costs by 20 cents.

To estimate how much corporate debt is at risk of default, the Boston Fed economists took the recent monetary policy tightening and coupled it with various future corporate income scenarios. They then calculated the share of debt outstanding in firms that could have an ICR of less than 4 at the end of this year–what the researchers used as the threshold to capture firms that could violate their financial covenants and thus be at default risk.

Two main takeaways: Firms’ interest expenses are projected to grow about 23% by the end of 2023, and about a third of corporate debt is at risk of default during this cycle of monetary tightening. That share is roughly equivalent to the share at risk of default at the onset of the Covid-19 pandemic. For context, the share of company debt at risk of default coming out of the pandemic recession fell to a low of about 17%.

This brings us back to the Chicago Fed economists’ estimate that more than half of the already-announced Fed tightening has yet to hit the labor market. That estimate may wind up optimistic in light of the Boston Fed economists’ findings, in addition to a huge number of unprofitable U.S. firms. 

Economists at Goldman Sachs recently flagged the number of unprofitable firms as a reason to prepare for an outsized hit to economic activity from rising interest expenses. They say that the number of unprofitable firms has continued to proliferate, with nearly 50% of all publicly-listed companies unprofitable in 2022. 

What is more, the “exit rate” of unprofitable firms has declined since the start of the pandemic. That exit-rate decline is likely in part due to generous fiscal support that is no longer being provided, Goldman says, adding that unprofitable firms disproportionately cut back on employment and capex when faced with margin pressure. 

It may soon appear that the Fed has pulled off a soft, or softish, landing. But any victory by the Fed is likely to be transitory. Even if the hiking cycle is over, its impact on companies and the labor market seems far from finished.