Small businesses have been particularly affected by the rising prices, but the Bank’s medicine will continue to have a bitter taste for the next few years.
A perfect storm for SMEs
As highlighted by the Federation of Small Business, the downscaling of Government support on energy bills has seen many firms’ energy costs return to last year’s peak level. Together with rising costs for products and materials, supply chain issues that still persist from the pandemic, and rising staffing costs, the pressures on business are rising. And so is indebtedness.
The Bank of England released a report in 2021 that highlighted its concern about the increasing levels of debt held by SMEs. Despite the barriers that SMEs face in accessing finance, two-thirds of the increase in gross debt for the corporate sector since 2019 was accounted for by SMEs. Around 60% of SMEs that had debt did not have any before the pandemic.
Impact of the Bank Rate rises
SMEs rely almost exclusively on bank lending for external finance and these are generally floating rate loans. This means that increases in the Bank Rate translate into higher corporate debt-servicing costs more quickly than for household debt, which tends to be fixed rate. SMEs have been feeling the impact of interest rate rises far longer than households.
According to the Bank of England, the average interest rate that SMEs have faced on new loans has more than tripled in the part eighteen months, from 2.29 per cent in January 2022 to 7.19 per cent in June 2023. According to the Chief Financial Officers who completed the Decision Maker Panel Survey, higher interest rates are predicted to lower business investment by 8% and employment by 2% this year.
A recession is defined as two consecutive quarters of negative economic growth and, as such, the UK has not been in a recession over the past year, but with the highest growth in any quarter being 0.1%, this is an economy that had stalled. And the outlook is no better.
The financial markets are expecting a downturn. This is given by an inverted yield curve. In other words, longer-term interest rates have fallen below short-term interest rates, a sign that investors expect the immediate economic outlook to worsen. The widening of the gap between short-term and long-term interest rates in June was the biggest monthly increase since 1994.
According to UK Finance, 800,000 fixed rate mortgages will expire by the end of this year and a further 1.6 million fixed rate mortgages will expire next year. The Bank of England’s latest Financial Stability Report suggested that monthly mortgage payments would rise by an average of £220 per month for those households who fixed rate mortgage ends this year. As a share of household disposable income, the report suggests that mortgage payments will rise by a quarter by 2026.
Household budgets will be increasingly squeezed and that is bad news for businesses.
A necessary medicine?
The cost of living crisis has had a negative effect on businesses so it is important to bring inflation down. It has fallen to 7.9% since a peak of 11.1% in October 2022, but that has little connection with the increase in the Bank Rate that started in December 2021. It has coincided with a slowing in the price increases for fuel, raw materials and food, all determined primarily by external factors.
As for the interest rate rises, according to the Bank of England’s own research, even a full one percent increase in the Bank Rank would have no impact on inflation in the first year. The effect on inflation is felt in the second year with the maximum effect felt after nine quarters. The main channel for this is the negative impact on GDP which is felt immediately and reaches a maximum effect after five quarters.
The Bank of England is using its one tool to reduce inflation and has done it repeatedly month after month. It is having a major impact on household and business finances, but little impact on inflation. It’s time to stop doing the same thing over and over again and expecting different results.
About Dr Tony Syme
Dr Tony Syme is a Senior Lecturer in Economics and Head of the Finance and Economics Group at the University of Salford Business School, having previously held posts at the Universities of Oxford and Warwick. His last two research projects have examined the impact of Covid-19 on SMEs and explored business leader decision-making around productivity.