Rising Interest Rates and a Recession Looming

On 4th August, the MPC (Monetary Policy Committee), who are in charge of designing monetary policy, so as to meet the inflation target of 2%, announced their decision to increase the base rate to 1.75%. This will be the largest increase in interest rates since 1995.

The Bank of England’s base rate refers to the effective interest rate they pay on deposits held with it by commercial banks. It wouldn’t make sense for commercial banks to borrow money to individuals, and small businesses, at a cost that is less than the amount of money they’d receive from depositing the same amount of money with the Central Bank – commercial banks would probably want to maximise their revenue after all. And for this reason, interest rates charged by commercial banks must at least be equal to the Central Bank’s base rate.

This drastic change in monetary policy comes about as a result of the current cost-of-living crisis and inflation, which hit 9.4% in June. Increasing interest rates should lead to downward pressure on demand, as a result of borrowing becoming more expensive and the return on savings increasing. This downward pressure on demand is then expected to cause corresponding downwards pressure on the price level. Simultaneously, however, there will be adverse effects on national output and economic growth. Two successive quarters of negative economic growth is defined as a recession; the Central Bank has claimed that the UK economy is forecasted to start contracting in the final quarter of 2002, and continue to do so throughout the whole of 2023, therefore qualifying this as a recession.

The bank has said that they’re expecting inflation to reach approximately 13% in October 2022. And subsequently, investors are expecting interest rates to rise further to roughly 3% in early 2023.

The implications for small businesses

Firstly, and most obviously, individuals are facing significantly higher costs of borrowing combined with high inflation and rising costs-of-living. Therefore, consumer demand is likely to falter, potentially causing cash flow issues through reduced revenue.

For small businesses, of course, another major issue arises as borrowing for investment purposes becomes more difficult and expensive.

A greater impact is likely to be felt amongst buy-to-let landlords with floating rate mortgages. The proportion of buy-to-let mortgages that are on floating rates is approximately 30%. Buy-to-let landlords are therefore likely to face large struggles, and perhaps, if this upwards pressure on cost is partially passed onto the tenants, they will also be adversely affected. The magnitude of such effects will depend on the extent to which the higher rates constrain new buyers and therefore exert downward pressure on house prices, as this could partially offset these interest rate effects.

Given that a proportion of government debt rises in line with inflation, which recently has been at very high levels, the government is more likely to borrow more, in order to fund its original borrowing. Also, when the Central Bank purchases a government bond, the bank must pay the base rate on the deposit created to buy the bond, increasing the cost of the debt. Therefore, the Treasury’s interest bill increases and consequently pushes up borrowing further. This, without spending cuts elsewhere, is likely to require further monetary policy tightening, e.g. further interest rate increases exacerbating the recession and the above problems.

How can small businesses prepare for a recession?

1)      Keep an eye on your cash flow!

- Chase any outstanding receivables. Consider adding late payment fees to incentivise punctual payments.

- Pay any outstanding debt – lenders may chase this up deeper into the recession. Also, perhaps increase repayment amounts before the recession hits so they’re less of a burden later!

-Negotiate with suppliers, where possible, in order to cut costs.

2) Ensure your emergency fund is large enough to sufficiently cushion the blow!

3) Invest in your employees

 - increasing efficiency and productivity of workers means less staff required and therefore reduced wage costs

4) Search for cheaper suppliers

- Making sure you don’t compromise quality!

5) If you were planning to borrow for investment in the very near future:

Given interest rates are expected to increase further in the next year, perhaps consider taking the loan out (with fixed interest) sooner rather than later

On a slightly optimistic note: the current high rate of inflation means the real value of debt decreases, particularly debt with fixed interest payments. And on top of this, some assets, e.g. property, machines, and gold, increase in price and retain their value.

Cheylesmore Limited T/A Cheylesmore Accountants accepts no liability for actions taken in reliance upon the information given, and it is recommended that appropriate professional advice be taken.