Introduction
Businesses play an important role in the transmission of higher interest rates to the economy because of the adjustments that they may make to investment and employment in response directly to higher borrowing costs and indirectly via weaker aggregate demand. The corporate sector may also amplify the impacts of interest rates if a material number of firms become insolvent or financially vulnerable, and this can have knock-on impacts to the financial system if lenders are impacted.
The DMP provides a useful source of data to better understand how tighter monetary policy is impacting UK businesses, and the extent to which higher interest rates are having the effects policymakers would expect. Between November 2023 and January 2024, firms in the DMP were asked how the rise in interest rates since the end of 2021 (both on existing and new borrowing as well as on deposits) have impacted their sales, capital expenditures, and levels of employment.
Aggregate impacts of higher interest rates
At an aggregate level, firms reported that, as of 2023 Q3, higher interest rates have resulted in 8% lower capital expenditure than would otherwise have been the case. They also report that their sales were 4% lower, and that the number of workers they employ is 2% lower (Chart 1). On average, firms expected the additional impact of higher rates over the next year – in response both to past and expected increases in interest rates – to be minimal. However, there was variation within the survey period, with firms in January (after the yield curve had moved lower) reporting slightly smaller impacts on investment over the coming year to 2024 Q3 – in contrast to the growing negative impact reported by firms in November.
Chart 1: Higher interest rates have lowered investment, employment and sales
Estimates of the total impact of higher interest rates on sales, employment and investment in 2023 Q4 and 2024 Q3 (a)
Footnotes
- (a) The results are based on the question: ‘Holding other factors constant, what is your best estimate of the impact of changes in interest rates since the end of 2021 on the [number of employees/capital expenditures/sales] of your business in each of the periods: 2023 Q3, 2024 Q3?’. Firms were asked to consider interest rates both on existing and new borrowing and the impact on their deposits. The chart shows data collected between November 2023 and January 2024.
Demand channels of higher interest rates
Higher interest rates can affect investment and employment through a number of channels. Some of these involve increasing external financing costs, which can make new debt more expensive or make servicing existing debt more costly, both of which reduce the affordability of investment. Further amplification can occur if interest rates result in lower asset prices, which reduces the value of collateral a firm may use to secure borrowing or leads to an increasing risk of breaching loan covenants which may prevent a firm from taking on more debt.
Higher interest rates also lower aggregate demand in the economy more broadly and this can diminish firms’ need to invest (via reduced capacity constraints), and desire to invest, and may also reduce the ability to fund investment for those firms which rely exclusively on internally generated cash flow to pay for capital expenditures.
The DMP survey can help assess the extent to which these channels are at work and their relative importance. There is evidence that both channels have been important. The top panel of Chart 2 presents the free-text responses firms provided at to the main ways that they expect higher interest rates to affect their business over the next 12 months, grouped into the topics they refer to. Respondents widely cite ‘indirect effects through demand’ as important, and the proportion of firms referring to such effects has increased relative to when this question was previously asked earlier in the tightening cycle.
The bottom panel of Chart 2 shows the strong correlation at the firm level between the estimated impacts of higher interest rates on sales and investment. It implies that for each percentage point reduction in sales, capital expenditures are 0.5% lower. This strong relationship suggests that the general lower demand effects from high interest rates, which will come through to firms via lower sales, are leading firms to reduce their investment expenditures. A similar correlation is present for employment. These two pieces of evidence are consistent with demand channels being both salient for firms and having an important impact on their investment and employment decisions.
Chart 2: Demand channels of monetary tightening are important to firms
Proportion of free-text survey responses by theme (top panel) and binned scatterplot of the impact of higher interest rates on firm sales and capital expenditures (a)
Footnotes
- (a) The results on the top panel are created by manually assigning free-text responses to the question ‘In your own words, what are the main ways that you expect higher interest rates to affect your business over the next 12 months?’, to each theme. The results in the bottom panel are based on the question: ‘Holding other factors constant, what is your best estimate of the impact of changes in interest rates since the end of 2021 on the [number of employees/capital expenditures/sales] of your business in each of the periods: 2023 Q3, 2024 Q3?’. Firms were asked to consider interest rates both on existing and new borrowing and the impact on their deposits. Each dot represents 12% of the sample of firms, grouped according to the estimated impact of higher interest rates on sales. The chart shows data collected between November 2023 and January 2024.
Financing channels of higher interest rates
The responses from firms in the DMP also provide evidence that the external financing channels are important in the transmission of interest rates to investment. Firms were asked to report how they ordinarily fund investment, enabling us to identify firms that are completely reliant on external finance for investment (10% of the firms), those who use a mix of external and internal cash flow (40% of firms) and those who solely use internal cash flow (45% of firms). Chart 3 demonstrates that those firms that only use external finance to finance investment report significantly larger impacts from higher interest rates on investment of around 20%. This is double the impact reported by firms who use a mix of internal and external cash flow to fund investment and several times larger than that reported by firms using solely internal cash flow.
Chart 3: Firms that borrow to invest report the largest impact of interest rate on their capital expenditure
Estimates of the total impact of higher interest rates on sales, employment and investment in 2023 Q3, by how firms typically finance investment (a)
Footnotes
- (a) The results are based on the question: ‘Holding other factors constant, what is your best estimate of the impact of changes in interest rates since the end of 2021 on the [number of employees/capital expenditures/sales] of your business in each of the periods: 2023 Q3, 2024 Q3?’. Firms were asked to consider interest rates both on existing and new borrowing and the impact on their deposits. How firms fund their investment is based on the question: ‘How does your businesses typically finance its investment?’ with options for different forms or external and internal finance. Firms were allowed to select multiple options.
Focusing on firms with debt, it is clear that the size of the change in the interest rates that these firms face on their borrowing is important in explaining the extent to which they report their investment has decreased. On average, firms report that the interest rates they are paying on their borrowing have increased from around 3.5% at the end of 2021 to almost 7% at the start of 2024. But there is heterogeneity across firms. The change in interest rates that individual firms face will depend on whether they have any fixed-rate debt, and when those fixed-rate loans were taken out, but also on factors such as how those loans are secured and how lenders view their credit risk. Chart 4 uses a binned scatterplot to show the relationship between the reported change in the interest rates that firms face on their borrowing since 2021 and the impact that they report that higher interest rates has had on investment to date. The downward slope shows that a larger increase in the cost of borrowing is associated with larger cuts in investment. This may be due to the fact that higher borrowing costs have reduced the availability of cash flow for investment, but also the higher cost of new debt making projects less profitable. A similar relationship also holds when looking at the level of interest rates on firm borrowing rather than the change in these rates.
Chart 4: Borrowing costs are important in explaining the impact of higher interest rates on investment
Binned scatterplot of reported changes in borrowing costs since 2021 and reported impact of higher interest rates on investment (a)
Footnotes
- (a) These results are based on responses to the questions: ‘Holding other factors constant, what is your best estimate of the impact of changes in interest rates since the end of 2021 on the [number of capital expenditures/sales] of your business in each of the periods: 2023 Q3, 2024 Q3?’ and ‘What is the approximate average annualised interest rate on the interest-bearing borrowing that your business has, both now and at the end of 2021?’. Each dot represents 7% of the sample of firms, grouped according to the change in borrowing rate since the end of 2021.
The role that the funding arrangements of firms play in the transmission of higher interest rates to the real economy highlights the importance of the financial system and understanding how interest rates are impacting financially vulnerable firms. To some extent, a larger impact of higher rates for financially weaker firms is a normal part of the transmission mechanism. However, these impacts may become worrying if there is a sufficiently large number of vulnerable firms, or if the adjustments being made by indebted firms are sufficiently outsized that they amplify macroeconomic downturns and losses for lenders. Chart 5 shows at the relationship between the impacts of higher interest rates on investment and employment and versus firms’ prior level of indebtedness. It demonstrates that more leveraged firms report large falls in investment and employment, but these relationships are not obviously non-linear.
Chart 5: Indebted firms report larger impacts of interest rates on investment and employment
Binned scatterplot of firm debt to asset ratios and reported impact of higher interest rates on investment (left panel) and employment (right panel) (a)
Footnotes
- (a) These results are based on a regression using firms’ responses to the questions: ‘Holding other factors constant, what is your best estimate of the impact of changes in interest rates since the end of 2021 on the [number of capital expenditures/employment] of your business in each of the periods: 2023 Q3, 2024 Q3?’. Each point represents 6% of the sample, grouped according to debt to assets ratios. Debt to asset ratios are calculated using company account data from Bureau van Dijk FAME and are mostly for financial year 2021.
Methodology
The DMP consists of the Chief Financial Officers of small, medium, and large UK businesses operating in a broad range of industries.
We survey panel members to monitor developments in the UK economy and to track businesses’ views on them. This work complements the intelligence gathered by our Agents.
This note is a summary of surveys conducted with DMP members up to January 2024. The January survey was in the field between 5 and 19 January. The January survey received 2,352 responses.
Further monthly data from the February survey for a limited number of DMP series was published on 7 March 2024. Aggregate level data for all survey questions are published on a quarterly basis. Data from the November to January surveys were released on 1 February. More information can also be found on the DMP website.
The panel was set up in August 2016 by the Bank of England in collaboration with Kings College London and the University of Nottingham. It was designed to be representative of the population of UK businesses. All results are weighted using employment data. See Bloom et al (2017) for more details.
The DMP receives funding from the Economic and Social Research Council.