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High Borrowing Costs: The Future of Business in a High Interest Rate Environment

Unless the real interest rate drops, companies that borrow to raise capital can expect to keep paying high rates for quite a while. Here’s what this is likely to mean for how they do business.

Key Takeaways

  • Despite the Fed’s best efforts, inflation is expected to stay slightly above its target of 2% for several years.
  • The actual interest rate that companies must pay to borrow starts with this 2% number and adds inflation on top. So at 3% inflation — where the economy seems to be stuck right now — the total rate comes out to at least 5%.
  • This means there will be a greater focus on labor, with a steadier if perhaps less dynamic labor market. After the wild ride of the past few years, that’s something workers might actually welcome.

The Real Interest Rate and Its Impact

There’s a significant change occurring in business that isn’t often highlighted in daily headlines: the underlying cost of capital in the economy. One of its biggest effects will be on the market for labor and how companies utilize it.

The “real interest rate” — the baseline cost of borrowing after adjusting for inflation — is what’s changing. In most growing economies, this rate is positive, reflecting a concrete return on investing in new capital. For years, however, the real interest rate in the U.S. was close to zero or even negative, as the Fed injected trillions of dollars into credit markets.

Those days are over. Even with interest rates on hold, the Fed continues to withdraw money from credit markets by selling long-term securities. Simultaneously, governments worldwide are maintaining historically high levels of debt, significantly increasing demand for credit. These factors make funding harder to come by for businesses.

Rising Costs of Borrowing

The Fed’s latest estimates suggest that the real interest rate for safe securities with a 10-year term has risen close to 2%, up from around 0.5% before the COVID-19 pandemic. The actual interest rate that companies must pay to borrow begins with this 2% figure and adds inflation on top. With current inflation around 3%, the total borrowing rate is at least 5%, and this is for the safest borrowers. Growing companies will likely face even higher rates.

Despite the Fed’s efforts, inflation is expected to remain slightly above its 2% target for several years. Therefore, unless the real interest rate decreases, companies borrowing to raise capital can expect high rates to persist for some time. Here’s how this is likely to affect business operations.

More Labor, Less Capital

The increase in the real interest rate makes capital — including buildings, machinery, and technology — more expensive relative to labor. In response, companies may shift their production inputs, favoring labor over capital. Growing companies might hire more and borrow less, while those not expanding might slow down staff attrition. This greater demand for labor in a tight market could restore some of the bargaining power that workers lost in recent years.

Automation on Hold

With the cost of capital rising, trends in production processes will change. Moves towards greater automation in manufacturing and services may slow down, as will the adoption of new technologies like artificial intelligence. Automation, previously seen as a solution for labor shortages, may now be more costly and less appealing.

Slower Growth in Pay

If companies invest less in new capital, their workers will have fewer productive tools to work with. This can limit productivity growth, meaning that although higher labor demand might push wages up, the economic fundamentals driving long-term pay increases could weaken. Consequently, the economy might experience lower unemployment but without rapid wage growth.

Greater Stability in the Workforce

High real interest rates are usually linked with higher saving rates. When people and businesses save more, they can better withstand economic shocks. There is also evidence suggesting that prices become less volatile when real interest rates are higher. Thus, the coming years might see more stability, driven by economic fundamentals rather than external shocks.

Final Thoughts

This stability will be welcomed by the labor market, which is finding a measure of steadiness after the pandemic’s dramatic swings. A volatile economic cycle often leads to high hiring and firing rates, increased recruiting costs, production disruptions, and smaller investments in training and employee relationships. A more stable economic cycle would mitigate these negatives, turning them into positives.

All these trends will unfold simultaneously and might reinforce or counteract each other before the economy settles into a new equilibrium. The overall tendency points to a greater focus on labor, with a steadier if less dynamic labor market. After the wild ride of the past few years, this stability might be welcomed by workers.

For businesses, those needing to borrow to raise capital may need to reconsider their plans. Relying more on labor and less on technology may seem like a step backward, but it doesn’t have to be. New and cost-effective tools, like generative artificial intelligence, can provide the best of both worlds. At the very least, businesses can capitalize on labor market stability by investing more deeply in long-term staff relationships.

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