What do higher interest rates mean for my company?

Interest rates are on the rise and have been for a few years now. What does this mean for your company? If you're like most businesses, it means that you need to prepare for potentially higher borrowing costs in the coming months. Here's what you need to know about interest rate risk and how it could affect your business' cash flow and balance sheet:

Cash-flow friendly options

You can also look at your existing loans and see if you have any cash-flow friendly options. For example, if you have an interest-only loan or a repayment holiday period, you may be able to reduce your monthly repayments in the short term. You could also consider refinancing with another lender to get a better deal.
As interest rates rise, your existing capital might be worth less than it was before – but there are ways to offset this impact on your business. By looking at all of the factors involved and planning ahead, you can continue running a successful company as we head into 2020s!

Interest rate risk

The interest rate risk is the risk that the rate on your existing debt will change. If you have a fixed-rate loan, this means that your cash flow and finances are affected by changes in interest rates. For example, if your company has a $100 million bank loan with a 10% interest rate and then the interest rates increase to 15%, that means you'll have to pay 15% more every year on all of your outstanding debt, which could be very detrimental to your business.
It's important to manage this type of risk because higher interest rates can cause some borrowers (like businesses) who already struggle with cash flows problems even worse ones!
To manage this type of risk:
•    Make sure you understand what kind of loans/debts you have so that you know how much extra money will be going towards paying back those debts each month or year once rates increase;
•    Plan ahead for when rates are likely going up so that there aren't any surprises down the road;

Avg. duration of debt

The average duration of debt for a company is different than the average duration of debt for a household.
How do you calculate the average duration of debt?
You can use this formula to help you calculate the average duration of debt: (average maturity) / ((sum of cash flows)/(duration)).
The formula takes into account both interest rate risk and credit risk, so it’s important to consider both when managing your firm’s financial position.

Cost to borrow

Given the impact of higher interest rates on borrowing costs, it's important to consider whether there is a correlation between your company's credit rating and its cost of debt servicing.
If you are an established business with a strong financial track record, you may have access to lower interest rates than newer competitors that lack such credentials. That said, if your business has recently taken on large amounts of debt and secured it with assets that have declined in value since the loan was made, then your company may find itself paying more than expected in order to service its debt obligations.

The impact of higher rates

If you're a business owner, your company's interest rates will be affected by higher interest rates. That's because when rates rise, the amount of money you'll have to pay in interest increases as well.

This is important to keep in mind when working through your budget or making decisions about remodelling projects or other capital expenditures that require financing. You can make sure to account for higher-than-expected future costs by planning ahead and saving more now than you did before interest rates climbed.
You can manage potential interest rate increases
You have a number of options for managing the impact of higher interest rates on your business:
•    You can manage interest rate risk through hedging. This means you can reduce the probability that a change in market rates will negatively affect your business.
•    You can also manage the impact of higher rates by increasing your cash reserves, which are then used to pay off or refinance debt before it comes due. However, while this strategy may help prevent default on existing debt obligations and maintain an acceptable credit rating, it doesn't resolve all concerns related to higher borrowing costs over time (or at least as long as they remain high).
•    You should review your current portfolio and determine if there are ways for reducing its term length or overall duration—either by refinancing existing loans or by issuing new ones with shorter maturity periods than previously planned—then monitor how those changes impact both your finances now versus later down the road when rates finally go back down again (if ever).

How do higher interest rates bring down inflation?

What is inflation?

Inflation occurs when too much money only allows the purchase of too few goods. When people have lots of money, they often unknowingly bid up prices as means to park their cash. This can be seen with the current increase in housing and other asset prices.
By increasing interest rates, this increases the cost of borrowing and will disincentivize people taking out huge loans to buy property. This will not lower housing prices immediately due to the low supply of materials and labour shortages currently in this economy. After a recovery of these deficits, a lowering of house prices should be seen to properly reflect the increase in borrowing costs. 

Higher rates reduce demand

The Reserve Bank of Australia controls the federal funds rate, often referred to as its target rate.

This is the interest rate that banks use to make overnight loans to each other. Banks borrow money – sometimes from each other – to make loans to consumers and businesses. So when the Fed raises its target rate, it raises the cost of borrowing for banks that need funds to lend out or meet their regulatory requirements.
Banks naturally pass on these higher costs to consumers and businesses. This means that if the central bank raises its federal funds rate by 25 basis points, or 0.25 percentage point, consumers and businesses will also have to pay more to borrow money – just how much more depends on many factors, including the maturity of the loan and how much profit the bank wants to make.

This higher cost of borrowing in turn dampens demand and economic activity. For example, if a car loan becomes more expensive, maybe you’ll decide now is not the right time to buy that new convertible or pickup truck you had your eye on. Or perhaps a business will become less likely to invest in a new factory – and hire additional workers – if the interest it would pay on a loan to finance it goes up.
This is the cost to the economy when the RBA raises interest rates.

And reduced demand lowers inflation

At the same time, this is exactly what slows the pace of inflation. Prices for goods and services typically go up when demand for them rises. But when it becomes more expensive to borrow, there’s less demand for goods and services throughout the economy. Prices may not necessarily go down, but their rate of inflation will usually decline.

To see an example of how this works, consider a used car dealership, where the pace of inflation has been exceptionally high throughout the pandemic. Let’s assume for the moment that the dealer has a fixed inventory of 100 cars on its lot. If the overall cost of buying one of those cars goes up – because the interest rate on the loan needed to finance one rises – then demand will drop as fewer consumers show up on the lot. In order to sell more cars, the dealer will likely have to cut prices to entice buyers.

In addition, the dealer faces higher borrowing costs, not to mention tighter profit margins after reducing prices, which means perhaps it couldn’t afford to hire all the workers it had planned to, or even has to lay off some employees. As a result, fewer people may be able to even afford the deposit, further reducing demand for cars.
Now imagine it’s not just one dealer seeing a drop in demand but an entire US$24 trillion economy. Even small increases in interest rates can have ripple effects that significantly slow down economic activity, limiting the ability of companies to raise prices.

The risks of raising rates too quickly

But our example assumes a fixed supply. As we’ve seen, the global economy has been dealing with massive supply chain disruptions and shortages. And these problems have driven up production costs in other parts of the world.

If high inflation stems mainly from these higher production costs and low inventories, then the RBA might have to raise interest rates by a great deal to contain inflation. And the higher and faster the Fed has to raise rates, the more harmful it will be to the economy.

In keeping with our car example, if the price of computer chips – a critical input in cars these days – is increasing sharply primarily because of new pandemic-related lockdowns in Asia, then carmakers will have to pass on these higher prices to consumers in the form of higher car prices, regardless of interest rates

In this case, the RBA might then have to dramatically raise interest rates and reduce demand substantially to slow the pace of inflation. At this point, no one really knows how high interest rates might need to climb in order to get inflation back down to around 2-3% in line with the economic goal.

Governor, Philip Lowe had a lot to say regarding inflation in his recent speech to the American Chamber of Commerce in Australia (AMCHAM). He mentioned that a major component of the increase in prices seen by Australians has been as a result of the ‘tragic events in Ukraine’. This has seen increases in both food and energy prices. He mentioned that it’s a global phenomenon which has affected virtually every country.

“Australia is no exception to the general trend, although inflation here remains below that of most other advanced economies. In headline terms, inflation in Australia was 5.1 per cent over the year to the March quarter, which is the highest rate in many years (Graph 2). In underlying terms, the inflation rate was 3.7 per cent, which is higher than it has been in recent years, but still lower than it was during the resources boom. In both headline and underlying terms, inflation is much higher than we had earlier expected.

The fact that inflation is higher everywhere tells us that there are powerful global factors at work. During the pandemic, supply chains were interrupted around the world, delivery times were pushed out and firms' costs of production rose. The inevitable result has been higher prices. And on top of this, Russia's invasion of Ukraine has caused major disruptions to the global markets for energy and food. As a result, oil prices have increased by 28 per cent since February and global food prices, including the prices of wheat and vegetable oils, have increased sharply (Graph 3). There has also been strong growth in demand globally, supported by stimulatory fiscal and monetary policy around the world.

When the RBA published its latest set of forecasts in early May, we expected that inflation would peak at around 6 per cent at the end of this year. The information available since then has led us to push this forecast peak higher. Since early May, petrol prices have risen further due to global developments and the outlooks for retail electricity and gas prices have been revised higher due to pressures on capacity in that sector. As a result, we are now expecting inflation to peak at around 7 per cent in the December quarter. Following this, by early next year, we expect that inflation will begin to decline.

I would like to highlight three factors that lie behind this assessment that inflation will moderate next year.
The first is that some of the pandemic-related supply-side problems in the global economy are gradually being resolved. Firms have been adjusting to their new operating environment and solving the problems in global production and logistic networks – as a result, delivery times have shortened a little from last year, the prices of semiconductors have declined from their recent peak and the global production of cars is showing signs of a recovery. While it is still possible there will be further setbacks, the global production system is adjusting and this should help lessen some of the inflationary pressures.

The second factor is a more technical one, but one that we should not lose sight of. It is important to remember that inflation is the rate of change of prices. It is not a measure of the level of prices. This means that for inflation to stay high, prices have to keep increasing at an elevated rate; if prices simply remain steady at a high level, the rate of inflation falls to zero. As an example of this, if global oil prices were to stay at the current elevated level, the annual rate of increase in oil prices would fall from 66 per cent to zero per cent. This might not be of much comfort to people struggling with the current high level of prices, but it would mean that the rate of measured inflation would decline.

The third factor that provides confidence that inflation will decline is the tightening of monetary policy that is underway around the world, including here in Australia. The higher interest rates globally will help to create a more sustainable balance between the demand for goods and services and the ability of our economies to meet that demand. Achieving that balance is not straightforward and there are risks involved, but higher interest rates will lessen the current inflationary pressures.

The Board judged that, given the inflation data and outlook that I have just discussed, it was no longer appropriate for interest rates in Australia to remain at the COVID-emergency levels. The increase in the cash rate in May followed the higher-than-expected CPI outcome in the March quarter and evidence from business surveys and our own liaison that growth in labour costs had picked up and would continue to do so in the months ahead. In June, we decided to make a bigger, 50 basis points, adjustment on the basis of the additional information suggesting a further upward revision to an already high inflation forecast. The Board also gave consideration to the fact that the level of interest rates was still very low.

The Board is committed to doing what is necessary to ensure that inflation returns to the 2 to 3 per cent target range over time. High inflation damages the economy, reduces the purchasing power of people's incomes and devalues people's savings. It is also regressive, hurting most those who are least well equipped to protect themselves.
So it is important that we chart our way back to an inflation rate in the 2 to 3 per cent target range. We do not need to, nor can we, get there immediately. Australia has long had a flexible medium-term inflation target, which, by design, can accommodate deviations of inflation from target. For a number of years inflation was below target and now it is above. What is important here is that we chart a credible path back to an inflation rate of 2 to 3 per cent.

That path will be easier to navigate if the inflation psychology in Australia does not shift too much. A lesson from the 1970s is that if an inflation shock shifts people's expectations about the ongoing rate of inflation, it becomes harder to reverse. Applying this lesson to today, it is important that the higher rate of inflation this year does not feed through into ongoing inflation expectations. If it did, the period of higher inflation would persist and it would be more costly to reverse. To date, medium-term inflation expectations have been well anchored at around 2 to 3 per cent, suggesting that people believe we will get back to target. We want to do what we can to make sure this remains the case. Higher interest rates have a role to play here, by helping ensure that spending grows broadly in line with the economy's capacity to produce goods and services. Higher interest rates can also directly affect expectations by demonstrating the commitment of the RBA to return inflation to target.

As we chart our way back to 2 to 3 per cent inflation, Australians should be prepared for more interest rate increases. The level of interest rates is still very low for an economy with low unemployment and that is experiencing high inflation. I want to emphasise though that we are not on a pre-set path. How fast we increase interest rates, and how far we need to go, will be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market.
As we make that assessment each month, the Board will be paying close attention to developments in the global economy, the evolution of labour costs and how household spending is responding to higher interest rates.

The recent news on household spending has been broadly positive, with spending bouncing back following the Omicron setback. Household balance sheets are generally in good shape, with households overall having accumulated more than $200 billion in additional savings during the pandemic. Furthermore, the current rate of saving out of income remains materially higher than it was before the pandemic, so there is a degree of flexibility in many household budgets. It is also relevant that strong employment growth is continuing and that there are many job opportunities at the moment. However, on the other side of the ledger, many households have not previously experienced a period of rising interest rates. Households are also experiencing a decline in real incomes because of the higher inflation and some of the large gains in housing prices over recent years are being unwound. Given these various considerations, we will be watching household spending carefully as we chart our way back to 2 to 3 per cent inflation.”