Governments use interest rate hikes to strike a balance between economic growth and rising inflation. A high interest rate helps in reining in economic instability and maintains pricing at a macro level.
Macroeconomic issues like inflation, interest rate hikes, foreign exchange rates, and balance of payments, etc., have always been a subject of concern and debate globally. In the case of inflation, RBI-the central bank of India – introduces economic policies to curb the same. Interest rate hikes are a policy response to inflation. Macroeconomic policy changes and shifting trends have a ripple effect on various aspects such as spending power, businesses – especially small businesses, housing markets, loans, and investments.
How does an interest rate hike reduce inflationary pressure on the economy?
To reduce inflation, steps need to be taken to reduce spending and lower borrowing. The government of India, and the Central Bank- RBI, increase the benchmark interest rate when the economy is under heavy inflationary pressure. Introducing an interest rate hike curbs excessive borrowing, and this in turn incentivizes savings/investments.
Now that we have understood how interest rate hikes reduce inflation in the economy, let us investigate their impact on the following:
A. Impact on small businesses
Medium and small enterprises in India are estimated to contribute around 30% to the overall GDP, according to PIB. However, it is important to note that much of the financing for MSMEs is from external sources. They often rely on informal sources of financing as well. So, when there is an interest rate hike, it stunts their growth, and sustaining their operations becomes harder.
B. Impact on spending power
Consumers are affected significantly by the interest rate hikes. This is because there is a high borrowing cost for large purchases. In such cases, it may become difficult to invest in houses, vehicles, and other goods. In the short term, till the economy stabilizes itself, consumer spending might be curbed. But at the same time, a hike in the rate of interest gives higher returns on savings.
C. Impact on borrowings
An interest rate hike curtails the purchasing power of not just consumers, but also slows down business investments. Consequently, governments must slow down their borrowing as well. Economic activities on a macro level basis slow down due to interest rate hikes.
D. Impact on enterprises
Businesses are hit hard by interest rate hikes. As mentioned previously, large monetary transactions are affected significantly. Furthermore, higher borrowing costs discourage businesses from expanding and make them risk averse. Interest hikes also deter operations, and businesses find it hard to take on new capital investments.
E. Impact on labor
Businesses take a hard hit when interest rates hike. They are discouraged from expanding their businesses and deterred from taking new capital investments, and operations are streamlined to adapt to the changing policies. This affects the labor/manpower adversely as many businesses lower the rates of hiring or don’t hire during this period altogether. This is where we see many companies downsizing their workforce, restructuring, and changing priorities to adapt to new policies.
F. Impact on inventory
Supply chains go through drastic changes in the process of adapting to interest rate hikes. A high borrowing cost means that manufacturers struggle with the production and delivery of goods and services. The ripple effect is evident in changing consumption patterns, which in turn cause transitions in demand and supply.
How to cope with interest rate hikes?
Interest rate hikes cause a domino effect on the economy. But there are ways to cope with this. One way to combat the side effects of a high-interest rate is to plan your budget down to the T. This helps you cut down on unnecessary spending and allows you to push those funds towards savings. Experts suggest making plans for your debt repayment process and assessing the risks associated with it.
It helps to understand that the impact of interest rate hikes depends on various factors such as industry, and current economic conditions, among others. Further, the magnitude of a hike and it’s timing also plays a role in the larger picture.
