Interest Rates and Industry: A Historical Perspective

Interest rates and the cost of borrowing money play a crucial role in the economy. Central banks' decisions to raise or lower rates have far-reaching consequences, impacting various industries in different ways. This article explores the historical impact of interest rate changes on the manufacturing, oil and gas, and utilities sectors, drawing on academic research and recent examples to provide insights.

Manufacturing: A Delicate Balance

For manufacturers, interest rates can be a double-edged sword. On one hand, low rates make borrowing cheaper, allowing companies to invest in expansion, modernization, and hiring. This can boost output and competitiveness. On the other hand, low rates can also lead to inflation, increasing the costs of raw materials and labor. Furthermore, a strong currency resulting from high interest rates can make exports more expensive and less competitive in the global market.

A study examining the impact of monetary policy on manufacturing companies found that benchmark interest rates significantly negatively affected these firms' financial performance. As rates increased, the cost of capital rose, negatively impacting profitability.

The impact of rising interest rates on manufacturers has been evident in recent years. High interest rates have weakened demand for manufacturing firms and raised prices on their cost for materials. Higher interest rates may restrict growth for smaller manufacturers, as these businesses often operate with tight cash flow (Optimation). The manufacturing industry has struggled with weak demand conditions and high interest rates, while the service sector has displayed notable resilience. After a positive start to the year showed signs of an industry rebound, manufacturing growth has plateaued as the Federal Reserve declines to lower interest rates.

Oil & Gas: A Complex Relationship

The oil & gas industry's relationship with interest rates is complex and influenced by various factors. While interest rates may not directly impact the cost of extracting oil and gas, they can affect the industry in other ways.

A study examining risk factors in oil and gas industry returns found that interest rates, oil prices, and market portfolios were significant factors influencing industry returns. Changes in interest rates can impact the attractiveness of oil and gas investments compared to other assets, affecting stock prices.

Another study focusing on the US oil and gas sector found that the interest rate risk factor had no significant impact on oil and gas companies. However, this may be due to the specific characteristics of the firms studied.

In recent months, oil prices have fluctuated in response to interest rate expectations. Higher interest rates increase the cost of borrowing, which can slow economic activity and dampen oil demand. Despite oil and gas companies cutting debt sharply since 2020, high interest rates can reduce energy demand as economic activity shrinks, forcing producers to lower oil and gas prices to balance commodity markets (S&P Global).

Utilities: Regulated Stability

Due to its regulated nature, the utility sector can be less volatile in response to interest rate changes than other industries. However, changes in rates can still have significant effects.

A classic 1978 study assessed the interest rate risk associated with the assets of public utility companies. The researchers found that changes in interest rates could affect utilities' allowed rate of return, impacting their financial performance.

In a more recent study evaluating the effect of technology transformation on the electricity utility industry, the authors noted that changes in the regulatory environment, potentially influenced by interest rates, could significantly impact utility businesses.

In recent years, rising interest rates have impacted utilities more than other sectors, as bonds become more attractive to conservative investors seeking yield. Higher interest rates pose a risk for the renewable energy sector, complicating the global push to switch to sustainable energy. According to an analysis by Wood Mackenzie, a 2-percentage-point increase in interest rates pushes up the levelized cost of electricity for renewables by as much as 20%.

Conclusion

Interest rate changes, driven by central banks' monetary policies, profoundly affect various industries. For manufacturers, rates influence borrowing costs, investment, and competitiveness. The oil & gas sector's complex relationship with interest rates involves factors like investment attractiveness and stock prices. The nature of the regulated industry provides stability for utilities, but rate changes can still impact allowed returns and the business environment.

For today's Federal Interest Rate Cut, we expect to see some excitement and renewed enthusiasm in the industrial sector. We would expect an uptick in many indexed items in the Federal Reserve Bank of Virgina's September Report.