A new day, a new interest rate hike. The Federal Reserve has announced that they will do whatever it takes to tame inflation, and Wall Street is responding with a downturn in the markets. This begs the question: what is the actual connection between interest rates, startup capital, and valuations?
Understanding Modern Monetary Theory (MMT)
According to Modern Monetary Theory (MMT), the Fed is increasing interest rates to "cool the economy" and prevent further inflation. However, it’s not just about interest rates; the government response to inflation will have significant consequences for founders and the public.
Inflation: A Double-Edged Sword for Startups
Inflation affects your customers, providers (including employees), and capital in different ways. While startup literature focuses on cost-cutting measures, a better approach is to understand how price increases affect each of these factors.
- Customers: Will they have more purchasing power or will they be constrained by increased living costs? If you sell a consumer product or service, are your customers likely to benefit from inflation?
- Providers (including employees): When living costs increase, team members may pressure the company for salary increases. However, inflation affects different jobs and income levels in different ways.
- Capital: Inflation should improve capital availability as it incentivizes investment of money that would otherwise be losing value at an increased rate.
The Effect of Government Responses to Inflation on Startups
As monetary institutions try to tame inflation, they will reduce the supply of capital by increasing interest rates. Borrowing becomes more expensive, and saving becomes more attractive. This rebalances supply and demand, slowing price growth and economic growth.
However, this downturn or potential recession has significant consequences for startups:
- Customer impact: If your service is part of discretionary spending, you can expect lower demand.
- Provider (including employee) impact: Expect them to accept lower salaries and hourly rates, and sign more extended contracts.
- Capital impact: The situation is challenging to analyze, as capital is under inflationary pressure but invested with an expectation of future appreciation.
Conclusion
Each founder should look at their company, customers, suppliers, and capital needs to understand how they can best respond. The relationship between interest rates, startup capital, and valuations is complex, and each company will experience different consequences.
Related Topics
- Column
- EC Column
- EC Market Analysis
- Economy
- Inflation
- Macroeconomics
- Money
- Startups
- Venture Capital
About the Author
Daniel Faloppa is a contributor to TechCrunch and the founder of Equidam, a company that aims to make valuations less problematic for entrepreneurs and investors. He holds an M.Sc. in Finance and Investments from Rotterdam School of Management, Erasmus University.
