Strangely, America’s companies will soon face higher interest rates
Even though the Federal Reserve is about to loosen monetary policy
Between early 2022 and mid-2023, the Federal Reserve tightened monetary policy at the fastest pace since the early 1980s, lifting America’s policy interest rate from 0-0.25% to 5.25-5%. When the central bank’s policymakers next meet on September 17th and 18th, they will almost certainly start cutting rates. Investors even wonder whether they will begin with a 0.5-percentage-point reduction, in response to cooler-than-expected economic data.
The immediate impact, though, may be muted. Central bankers have long thought that monetary policy does not have an instantaneous effect on the economy; Milton Friedman once described the lag between an adjustment and its impact as “long and variable”. Yet in the most recent cycle the lag, for corporate borrowers at least, seems to have been even longer than usual. The strange outcome is that just as policymakers are about to cut, perhaps sharply, interest-rate conditions for parts of the economy will tighten.
During previous periods of monetary tightening, the relationship between policy rates and corporate interest payments was more familiar: as rates rose so did the expense of borrowing. For example, in the last Fed hiking cycle, between 2016 and 2019, companies’ net interest expenses rose by 9%, according to IMF analysis (see chart), which is how tightening is supposed to work. By raising borrowing costs, the Fed reduces corporate investment and slows the pace of hiring. This may be painful for those affected, but the consequence is lower demand and reduced inflationary pressure.
Things have worked rather differently this time. Although interest rates have shot up, companies’ net interest payments fell by almost 35%. If the relationship in previous cycles had held, they would have instead risen by 50%.
Why has this happened? The first explanation is that American firms entered the tightening cycle unusually cash-rich. Holdings rose in the decade before the covid-19 pandemic, and then spiked as the disease spread and investment plans were put on hold. Cash held on companies’ balance sheets rose from an average of $1.1trn in the decade to 2019 to a peak of $2.7trn in 2021. Higher interest rates therefore meant higher returns on their cash piles.
Another explanation concerns lenders. Even as policy rates rose, many were slow to pass higher costs on to borrowers. The spread charged on loans to the very safest borrowers, for example, fell by more than 1.5 percentage points between early 2022 and mid-2023. The Kansas City Fed has noted that this is unusual: spreads typically rise during a tightening cycle. Greater corporate cash reserves seem to have given institutions the confidence to lend more liberally. Costs rose for firms, but not by as much as might have been expected.
The most important explanation reflects the behaviour of finance directors. American companies borrowed heavily on longer-term deals in 2020 and 2021, after the Fed had cut rates and before the tightening cycle got underway. Low rates were locked in and firms were relatively insulated from the subsequent tightening. Indeed, the unusually strong performance of the S&P 500 index of large American companies, which has risen by 24% since the Fed first raised interest rates, may in part be explained by this protection.
Now, however, locked-in arrangements are starting to expire. Fixed-rate deals typically last for three to five years. More than $2.5trn—an amount equivalent to 9% of American GDP—of fixed-term corporate loans are due to be refinanced before the end of 2027, with $700bn due in 2025 and more than $1trn in 2026. The sectors most exposed to refinancing risk are those that benefited the most from cheap fixed deals immediately after the pandemic struck, notably manufacturers. The pain may be considerable. Bonds of the typical American, non-financial, BBB-rated firm due to expire in 2025 have a median interest rate of just 3.8%. On current trends, they will probably attract a rate of closer to 6% when reissued. Interest costs will rise just as interest received falls.
Jerome Powell, the Fed’s chair, has signalled that he now favours cheaper borrowing. Yet whatever the Fed does next, corporate America is likely to see interest expenses rise. The delayed reaction to tightening complicates the Fed’s job. Although its policymakers are now ready to press the accelerator, many firms are still experiencing a delayed reaction from when they slammed on the brakes.
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