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Interest rates and inflation: how they impact small businesses

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Last editedMay 20222 min read

Inflation and interest rates impact businesses in a variety of ways, from how much products and services cost to how much a company can borrow. While distinctly different, both inflation and interest rates are connected, so understanding how they work is a good idea.

In basic terms, when inflation rises, then so do interest rates. This means it costs more to spend and borrow, although you can also earn more interest on any money you save. When inflation goes down, again, so do interest rates. In this instance, the cost of goods and services is lower, though rates on savings also diminish.

Let's get into more detail to understand better how inflation and interest rates impact your business.

What is inflation?

Inflation represents a currency's decline in purchasing power over some time. It means a certain amount of money buys less than it did in previous times. For example, the average house price in the UK in 1950 was around £1,800. It is now £274,000, thanks to 72 years’ worth of inflation.

Here are the costs of some famous cars from 1965 compared to the equivalent cost today due to inflation: 

  • Volkswagen Beetle was £650, now £8,100

  • Rover 2000 was £1,298, now £18,000

  • Jaguar E-Type was £1,867, now £25,000

  • Aston Martin DB5 was £4,412, now £60,000

The opposite of inflation is deflation, which means the purchasing power of a currency has increased over time resulting in things costing less overall.

What are interest rates?

Interest is a percentage charged on the total amount that a person or entity borrows or saves. So an interest rate informs us how high the cost of borrowing is or how high the rewards are for saving.

When borrowing money, the interest rate is the amount you are charged for borrowing that money, which will be shown as a percentage of the total amount of the loan. The higher the percentage of the interest rate, the more the borrower must pay back to pay off the loan.

When saving money, the interest or savings rate tells you how much extra money will be paid into the account as a percentage of the savings.

Similarly to the borrowing rate, a higher savings rate means more money will be paid into the account for a particular deposit.

What is a bank rate? 

The term ‘bank rate’ refers to the base rate set by the Bank of England, which influences most of the other interest rates in the economy. This is especially true with borrowing and savings rates offered through banks and building societies.

The Bank of England publishes a Monetary Policy Report which explains why they set the bank rate at the level they have. Usually, the bank rate is set at a level that the Bank of England believes will help stimulate the economy in one way or another.

For example, in response to the Covid-19 crisis, the Bank of England cut the bank rate to just 0.1%. This meant that other banks could borrow money from the Bank of England at this reduced rate, which meant they could offer their customers much lower borrowing rates. This resulted in significantly lower interest rates on certain loans, although it also meant lower interest rates on some savings accounts, too.

How can businesses handle rising interest rates and inflation?

Unfortunately, both interest rates and inflation are out of the control of small businesses. The best ways to handle it are to raise the cost of your product or service by a small increment and look for efficiencies you can make in your existing business system.

Examples of problems areas you can optimise for efficiency are administrative time and costs, delays to cash flow, and reduction of customer churn.

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