Even though central banks and governments aim for the markets to constantly be in a state of inflation, sometimes the cost of goods can increase rapidly. According to monetary theory, inflation of around 2% is the sweet spot for the economy. If retail and wholesale price indexes begin to increase, central banks begin to consider increasing the interest rates. That slows down the economy and causes deflation in businesses but protects them from potential galloping inflation or even hyperinflation. In this article, we’ll share more about the role of high interest rates in today’s economy. We’ll also shed more light on the negative and positive effects of high interest rates on businesses. This blog post is part of our series on economic conditions. You can also read our article on the effects of low interest rates on businesses.
What Are High Interest Rates
The terms refer to the increase to above-average levels of interest rates on both borrowing and lending. The main effect of high interest rates on businesses and individuals is that borrowing money becomes more expensive.
There are a few implications of higher borrowing costs:
- Spending is discouraged. As businesses and individuals borrow money with a higher interest, it’s expected that they will limit spending for projects like technology integrations or other capital expenditures.
- Higher unemployment. With rising interest rates, unemployment is also expected to rise. That’s because business owners postpone new projects or need to cut labor costs due to their debt situation.
- Increase in debt. One of the effects of high interest rates on businesses is that loans become more expensive. This puts households and companies that have acquired a lot of debt at risk as their payments increase.
- Spending is discouraged and saving is incentivized. Higher interest rates on deposits and savings mean that people and companies can get a good profit if they deposit their money in the bank.
Key takeaway: High interest rates have more negative than positive effects on businesses. However, they might be a necessary monetary policy in case of increasing inflation.
Positive Effects of High Interest Rates on Businesses
Although there are more advantages and beneficial effects of low interest rates on businesses, increasing them can be beneficial in some cases too. Let’s dive a little deeper into the main categories of positive effects of high interest rates on businesses and the economy.
Saving Is Encouraged
Even though companies strive to achieve a higher ROI and maximize revenue, investments should be made when the market conditions are right. That’s why during a period of high interest rates, companies can use the time to restructure their debt and use business analytics tools to optimize business processes. When the rates start to decline again, companies can invest in capital expenditures aimed at lowering the cost of goods sold and maximizing profits.
Saving can be done in different ways. The most popular methods include deposits and investments in bonds.
Both high inflation and deflation in the economy can pose a significant threat to companies. That’s why central banks mitigate their negative effects by increasing or decreasing interest rates.
High interest rates increase the value of the currency. That can help companies that import raw materials or other goods internationally. This will lower their operating expenses and increase their profit margins.
Negative Effects of High Interest Rates on Businesses
Drastic changes to interest rates can cause supply chain disruptions or other serious economic conditions. That’s why central banks change interest rates gradually and over a period of months or years. Decreasing or increasing borrowing rates rapidly risks causing the effects of economic stagnation.
Even if the rates are increased moderately, there are still negative effects of high interest rates on businesses. Let’s examine the main ones.
- High borrowing costs. Companies that have planned capital projects might need to postpone them as high interest rates increase the cost of borrowing money.
- Reduced spending. Customers are discouraged from purchasing goods and services. There are two main reasons behind this. The first one is that borrowing is more expensive. The second one is that during a period of high interest rates, there are many factors affecting business growth negatively. Ergo, companies might need to reduce their prices. Consumers hold off on spending as they wait for prices to fall. That’s especially true for more expensive assets such as real estate.
- Economic slowdown. As spending and borrowing are reduced, the economy slows down. This can lead to bankruptcies and hard times. If the period of high interest rates continues for too long, the economy will go into a recession.
- Decline in stock markets. You might be wondering how does recession affect businesses and why it can snowball and accelerate. It’s because markets are very interconnected. For example, many investors put their money in stocks or ETFs. However, high interest rates of bank deposits can make them more attractive compared to investments in stocks. This can incentivize investors to sell their shares or derivatives and put their money in banks as a safer option.
- Challenges for exporters. As strengthening the currency is a consequence of high interest rates, this can be challenging for companies that export goods. Their products become more expensive on the international markets.
- Difficulties servicing debt. Governments, companies, and individuals might find it challenging to service their existing debt. The increase in interest rates means that interest expenses of current debts also increase.
Frequently Asked Questions about the Effects of High Interest Rates on Businesses
Interest rates are a complex part of monetary policy. That’s why even experienced economists might have questions on the topic. Below we’ve given more details on some common questions regarding the topic of high interest rates.
Is Choosing the Highest Interest Rate on a Savings Account the Best?
High interest rates on deposits are not always a good thing. When creating a savings account or a deposit, one should also check the fees and hidden costs. Choosing a financial institution that has the highest rates on deposits might not be optimal.
Additionally, when creating a savings account, check the credibility of the institution. Promises for much higher returns compared to the market average can be a sign of a Ponzi scheme.
Why Central Banks Increase Interest Rates?
During a period of inflation, both companies and individuals are losing purchasing power. That’s why the central bank should intervene with different monetary policies. A common way to fight the impact of inflation on businesses is by raising short-term interest rates. The effect of high interest will be the cooling of the economy. Central banks keep an eye on year-on-year and month-on-month inflation. Unemployment is also taken into consideration. By combining these aspects, central bankers make decisions about whether the interest rate should be increased, kept the same, or decreased.
What Countries Have the Highest Interest Rates?
High interest rates are a way to manage inflation. Ergo, countries with high price levels might increase their interest rates. That way, they aim to fight the effects of inflation. Increasing borrowing rates either stop the rise of prices or cause a mild deflation. Countries with traditionally high interest rates include Zimbabwe and Ghana. However, in recent years Argentina and Turkey have also experienced serious inflation issues. That’s why their central banks have increased interest rates.