Central banks are tasked with preserving economic stability within a country’s financial system. By using powerful financial policies, they administer and transmit planned fiscal strategies to guide or respond to economic conditions. These policies include the oversight and distribution of a nation’s currency or money supply. Central banks aren’t market-based and are mostly concerned with keeping inflation in line with interest rates. They constantly monitor the movement of prices for goods and services and adjust interest rates to slow growth when inflation exceeds its target or lower interest rates to stimulate growth when inflation drops below the target.
The world’s most powerful central banks, the Federal Reserve, the European Central Bank and the Bank of England have all increased their interest rates sharply this year. Only a few months ago, all three of them had historically record low rates. However, soon after the ending of the Covid pandemic, several factors came together to force aggressive interest rate adjustments. To this end, commercial banks are key for the implementation of monetary policy because they express liquidity conditions. This is because deposit and lending rates have a wide and definite impact on the overall economy and its financing conditions.
Thus, central banks use interest rates to make borrowing more expensive and slow down growth, or cut rates to boost borrowing and investment. Hence, the latest increase by the ECB signals to European companies and global investors that low cost money supply driven by the pandemic is now ending. Inflation is becoming a major concern and outdoes the effort to stimulate further growth. This is a challenging scenario because inflation keeps rising while there is concern for an imminent recession. Repressed demand from Covid has rebounded but interest rates and now increasing cost structures and hurting businesses.
So, here is a list of things to keep in mind right now:
- Higher borrowing costs will erode existing margins
- Increased prices of goods from suppliers will lead to lower margins
- Slower economic activity will lead to lower demand of goods or services
- A rising Euro might see companies with international trades incur reductions in sales
- Effective Cash flow management against borrowing during rising rates is the remedy
In general, higher interest rates predictably affect companies’ cash flow and their capacity to buy, borrow, invest, or expand their workforce. However, in the overall scheme of things, interest rates are still, historically speaking, quite low. Therefore, this article does not seek to be intimate with scare mongering but rather prepares business leaders for the current inflationary environment. The ECBs approach signals an inflationary adjustment rather than a plain attempt to slow the economy as it tries to keep inflation at around 2%. For now, the ECB expects inflation to average 8.1% this year before starting to slow down and settle at 5.5% in 2023 and 2.3% in 2024. Based on the ECB strategy, business leaders should implement the right corporate strategies to weather these next three years aiming to minimise the impact and sustain profitability and growth.