By João Sousa

The Bank of England surprised market participants last month by holding Bank Rate at 5.25%. This was the first time since November 2021 that the Bank did not increase interest rates, and followed a lower-than-expected inflation reading of 6.7% for August.

The Bank’s decision to hold rates will have been broadly welcomed by the business community. When we ran our latest Scottish Business Monitor – our regular survey of around 500 firms on business sentiment and the outlook for the year ahead – nearly half of respondents were against further rate rises, and only a fifth supported further increases.

Firms feel the effect of interest rate rises even more quickly than individuals, as a lot of their funding is tied to the reference interest rate with much less of a lag. And data from the September release of the Bank of England’s Decision Maker Panel survey bears out just how much they have been affected.

At the end of 2021, the average interest rate faced by firms was around 3.5%; it had risen to 5.2% by the end of 2022, and firms expected it to rise to 5.9% by the end of 2023. But the reality has proved even harsher: it was 6.6% last month, and not expected to fall below 6.3% in the next 12 months.

This means a near-doubling of the cost of borrowing for firms in the space of just a couple of years, with important consequences for the affordability of both revolving credit and investment projects. Indeed, the cost of borrowing was one of the top reasons given by the two in five firms we surveyed that reported delaying or cancelling investment projects in the past year.

This is an important concern, as business investment in Scotland is already lower than the UK average, and lower than comparable advanced economies. With interest rates now expected to be higher for longer than previously anticipated, the consequences of even lower cumulative capital investment will be felt in the growth prospects of the country for years to come.

The latest data on input cost pressures, however, gives some cause for optimism that the peak of the inflationary shock is now behind us. Manufacturing input costs in September were 2.6% lower than in the same month of 2022, which contributed to manufactured goods’ prices being 0.1% lower than in September last year as well.

There has also been a clear easing of inflationary pressures on the services sector, although to a lesser extent. The services producer price index registered a 3.4% year-on-year increase in the quarter to September, down from a 6.2% peak a year ago.

Some of the pressures on services reflect the still tight labour market, as a larger proportion of the cost base for services firms is made up of wages. In fact, in our latest Scottish Business Monitor wages were the only cost pressure in which firms did not expecting an easing over the second half of the year.

This is corroborated in data released by the Office for National Statistics since then, which shows median pay in Scotland growing at an annual rate of 8.2% in September 2023 – significantly higher than the 5.7% recorded for the UK as a whole. In both cases, these are slower rates of growth than in previous months, but still very high by recent standards.

Vacancies continue to decline and are now below a million for the whole of the UK – the first time that has been the case since July 2021. Together with a rise in unemployment in the last few months, the signs are that although labour market pressure remain high, they are lessening relative to previous quarters. This was one of the reasons given by the Bank of England for its decision to hold interest rates steady.

Whether this is the peak of the rate rises and the start of an easing of credit conditions for businesses, however, will depend on whether these easing signs persist. Inflation in the year to September was at the 6.7% as in the year to August, so the Bank will not necessarily see this as an indication that the job is done yet.

Whether or not this proves the August rate rise proves to have been the last of this cycle, the medium-term outlook is pretty clear. There is little chance of the Bank cutting rates in any meaningful sense in the next 12 months, and they may even be held at this level for longer. Therefore, businesses need to plan for a world where borrowing costs are a lot higher than in the past decade.

Higher interest rates fundamentally alter the trade-off between debt and equity financing, and also erode net profit margins due to firms needing a higher level of earnings to cover their interest payments. Bank of England analysis from August showed a projection in the level of firms in debt-servicing distress rising over the coming months, although still lower than those seen in large historical shocks such as the early 2000s Dotcom bubble and the 2007-08 financial crisis.

The increase in debt-servicing costs is another pressure on businesses, and one that compounds the goods and services input cost shock they have experienced in the past couple of years. While much attention has been devoted to headline price increases for consumers, companies’ profitability has remained pretty much unchanged since the beginning of 2022.

While companies have been absorbing some of the additional costs, there are questions about how long this can be sustained for. Over two thirds of firms in our Scottish Business Monitor said they could not absorb rising costs for more than a year. With debt interest costs likely to remain high beyond that horizon, there is a risk that they might lead to price increases down the line as firms try to retain profitability, which might make bringing down inflation even harder.

We will be publishing the latest quarterly Scottish Business Monitor next month. So do keep an eye out for this as we will be digging deeper into how businesses are coping with this challenging and ever-changing economic landscape.

João Sousa is deputy director of the Fraser of Allander Institute at the University of Strathclyde