Interest rates represent the cost of borrowing, or the cost of obtaining money. Though central banks can influence interest rates by adjusting their benchmark interbank overnight lending rate, the most important interest rates are set in open markets, such as the U.S. Treasury market. Other important rates, like the London Interbank Offered Rate (LIBOR), reflect an average of actual rates paid by large institutional borrowers. From such benchmarks, the actual rates paid by most businesses and consumers are determined. High interest rates affect business because they influence both their own direct costs and the ability of their customers to borrow and spend.
Changes in interest rates have a gradual effect on the economy over time. The types of businesses most immediately impacted are those that require frequent borrowing. As businesses are forced to renegotiate the terms of their loans, their fixed costs increase. The ultimate effect on the business will be determined by its pricing power, whether it can pass these costs on to consumers or is forced to absorb them. Unfortunately, many of these capital-intensive businesses have the least price elasticity and are least able to offset increased borrowing costs with higher prices.
As rates increase, consumers find their cost of borrowing goes up as well. This is evident in the cost of financing (or refinancing) large purchases with home mortgages or car loans, down to the APR on their credit cards. Higher interest rates act as a disincentive to carry a balance, which ultimately curbs consumer spending. While this decline in the velocity of money is often a direct aim of central bank rate hikes, it has the consequence of dampening revenue forecasts for retail business.
Many businesses, of course, are not dependent on end consumers for their profits. These companies are better insulated from high interest rates, but not immune. Ultimately, a slowdown in the rate of growth in the economy causes a build of inventories at the retail level, which leads to a reduction in durable goods and manufacturing orders. Thus, producers, many of whom felt the initial effects of higher borrowing costs, eventually feel the effects of prolonged high interest rates as a decline in demand as well.
Another consequence of high interest rates is that it makes saving more attractive. Consumers receive a higher return on their savings accounts and cash-like investments (CDs and money-market accounts). The combination of high costs to borrow and high return on savings are an effective deterrent to spending disposable income on nonessential items. Most savvy consumers are willing to earn high rates on savings and spend when rates are low. Businesses also must reevaluate the utility of investing money, and the margin of return they can receive from doing business, against the risk-free return of holding cash.
The slowing of production as a result of high inventories causes businesses to postpone capital expenditure, that is, reinvestment of profits back into the business for purposes of expanding. When end demand among consumers is declining, most businesses will find it an unpromising time to increase their spending. Rather, businesses are more likely to try approaches that increase productivity and cut costs in an attempt to meet profit forecasts in a lower-revenue, lower-margin environment. Retailers, by lowering prices, can attempt to make up for the loss in margins through increased volume, capitalizing on the consumer's likely shift to lower-priced goods.