Companies have been working on their 2023 business plans and budgets since the beginning of fall 2022. During this time, numerous developments have occurred in the economy and financial markets. One of the biggest concerns is rising interest rates around the world and how long they may remain elevated.

For the U.S Federal Reserve, the interest rate is expected to rise to 5.25-5.5% in 2023 and maintain that level until inflation is under control. Other central banks are taking similar actions around the globe. A U.S recession is expected in 2023, but its length and depth are uncertain.

Terminal interest rates will probably be held beyond 2023 and into 2024 – and perhaps even into 2025. Given the degree of uncertainty and global market risk, companies face numerous scenarios for which they must be prepared.

How Interest Rates Affect a Business

A key question for planning professionals is “How will interest rates affect my customers, my business, and my business operations?” Interest rate levels and changes can have both direct and indirect effects on a business and its customers.

1. They can affect the interest expense for financing working capital, such as inventory.

2. They can affect the financing cost of capital goods and capital projects.

3. They can affect the interest expense of rolling over debt when maturity has been reached.

4. They can affect the company’s cost of capital through interest expense directly and through investor expectation for equity returns as interest rates rise or fall.

5. They can affect the ROI hurdle rates used in making capital investment decisions and in product development projects.

6. They can affect the currency exchange rates faced by the company when buying and selling goods as well as those faced by the company’s customers.

7. They can affect the overall capital structure of the company through the relative proportion of debt financing and equity financing.

8. They can affect the interest costs for customers purchasing the company’s products, especially inventory and “big ticket” items like cars, trucks, and other capital assets.

So, interest rates and their effects are important considerations in many business scenarios for demand planning and Financial Planning & Analysis (FP&A) purposes.

Re-Evaluate Your 2023 Financial & Operating Plans

Any “approved” 2023 business plans, demand plans, budgets, and financial plans should be re-evaluated, and stress-tested to reflect how interest rate changes will affect the business and its customers. They may already be out of date.

Any adjustments to operational and financial plans should be made before implementing the financial reporting processes for 2023 to ensure that business metrics are utilizing a realistic set of goals, benchmarks, and budgets throughout the company. These should be periodically reviewed during the 2023 financial year. 2023 will be a time of changing business and market dynamics.

Interest Rates & Requests for Investment

When making requests for investment in product development, capital investments or new software, for example, it is important to consider the effect of changing ROI hurdle rates as interest rates change. The foundation of these ROI hurdle rates is the company’s cost of capital – debt and equity. The increase in interest rates into 2023 will have an associated effect increasing the investment ROI hurdle rates for the company so the justification for investments will require greater financial benefits. (ROI hurdle rates are also adjusted to reflect the degree of financial risk in investment types and so are modulated up and down to reflect this consideration.)

When requesting resources during 2023, it is important to work with the FP&A function to ensure that the request can be structured to meet the level of performance necessary to make the investment financially successful for the company.

2023 is upon us. It is essential that we be analytical and adaptive if we are to choose the best path towards operational and financial success. Understanding the impacts of interest rates is an important part of this effort.

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As of this writing, Central Banks’ efforts to reduce inflation are underway. Central Banks around the globe are increasing their interest rates in response to the rate increases by the U.S. Federal Reserve. Whether you’re in the USA or elsewhere, the impact of rising interest rates on firms and the broader economy can be severe, and requires robust planning responses. 

Rising interest rates are designed to tackle inflation by reducing demand. The cost of borrowing increases which impacts cash flows for firms and consumers alike, eroding economic growth and financial performance of businesses. Further, as equity markets decline around the globe (US equity markets have declined around 20% from their peak), consumer wealth is declining.

All this means we’re in for a rough ride ahead. Here’s what we as planning professionals can do to understand what is happening to our demand and mitigate the impacts of rising interest rates on our businesses.

What Rising Interest Rates Mean for Demand Planners

One thing is for sure – customer and consumer behaviors are changing in the face of attempts to dampen inflation. Time series models are typically used when forecasting demand in the short term but their accuracy is eroding rapidly in the current environment of volatility and of demand pattern change.

If our usual forecasting techniques are not working, we need a different approach

The accuracy of these methods is dependent upon the recurring patterns of demand through time and assumes that the factors affecting demand are stable. We have seen how COVID has disrupted these patterns and we are seeing it again with Central Banks’ efforts to reduce inflation with increased interest rates. If our usual forecasting techniques are not working, we need a different approach.

Start Discussing the Drivers of Demand

Using historical time series data for estimating demand will be a risky proposition under the current circumstances. It is time for us to analyse and evaluate how the evolving economic and financial conditions are affecting our consumers, customers, and business. Collaboration is essential in gaining different perspectives on the situation and how behaviors are changing. [Ed: More on understanding changing consumer behavior here]

Develop hypotheses regarding the current drivers of behavior

The place to start is to develop an ongoing conversation and exploration with experts inside and outside of the company. This allows us to develop hypotheses regarding the current drivers of behavior that underline demand.

Test Alternate Drivers of Demand With Regression Analysis

Regression analysis can be an excellent means of evaluating and testing alternative drivers of demand that result from these discussions. It can also measure the degree of influence that each driver has on demand, both individually and collectively. The variables identified can be deployed to simulate alternative scenarios given assumed conditions that the demand forecaster wants to evaluate.

Regression analysis is an excellent means of testing alternative drivers of demand

The assumed conditions result from gathering information, experiences, and expectations from customers, consumers and related industry experts. This qualitative information is key in a collaborative process where one is dealing with shifting conditions and customers are adapting to new circumstances. Having this qualitative information gathered as part of the demand forecasting and planning process is essential when prevailing conditions make assumptions of time series models invalid.

Tap Sales & Marketing for Insight

Two of the best internal sources of customer and consumer behavior information are Marketing and Sales. Quite often they are fielding research that provides key insights into behavioral shifts and changes. These field studies in conjunction with their professional experience in market facing roles can be a valuable source of information which can improve the quality of demand forecasts and plans.

Used in conjunction with the regression analytics, this can marry quantitative and qualitative demand information. Diversity of perspectives and opinions is an important dimension that time series projections cannot capture during times of momentous change and behavioral shifts.

Things You Can Do Now

Act now: Review your demand forecasting and demand planning processes. Expand the qualitative information dimensions of these processes and develop regression analysis and modeling activities to capture how consumers and customers are reacting to current circumstances.

Collaborate: Expand the breadth of collaboration to add market information research to your demand forecasting efforts. Continuously update this information to track behavioral adaptations of your customers and consumers. Seek out information and opinions from stakeholders.

Be Dynamic: Be prepared to roll with changes. The situation requires a dynamic rather than a static mindset to capture the evolving conditions affecting customer and consumer demand.

Scenario Plan: Develop alternative scenarios and contingency plans. Think in terms of hedging where possible. Collaborate on multiple fronts – demand planning’s efforts in this regard can aid in informing marketing and sales strategies that respond effectively to changing demand. [Ed: More on scenario planning in high interest rate environments here]

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2022 is beginning with substantial uncertainty and risk for businesses of all types. Much of this comes from the financial markets, and part of it relates to operating for 2 years in the pandemic. The list is long, but the main risks for demand planning and supply chain management are rising interest rates, shifting currency exchange rates, and price and cost inflation.

The interest rate risk is heightened by the planned normalization policies of central banks, including the Federal Reserve Bank of the U.S. Interest rates have been kept exceptionally low by central banks around the world, going back to the Financial Crisis more than 12 years ago. Rising inflation is forcing central banks to unwind their positions after years of accumulation and to increase their lending rates to banks.

Interest Rate Hikes Mean Changes In Demand

These will affect the cost of borrowing for businesses and consumers alike, in turn affecting the cost of inventory as well as the demand for products by businesses and consumers. For consumers who are acquiring products using debt (borrowing and leasing), the ramifications of higher interest rates can have magnified effects. Interest rates also impact currency exchange rates, adding more risk for global supply chains.

Scenario Planning To Mitigate Financial Risk

Now is the time for Demand Planners and Supply Chain Planners working within FP&A to begin developing risk scenarios for their companies, and to develop strategies to mitigate the financial effects for each. Given the number of risk elements for 2022, and the diversity of their effects by company and industry, scenario testing and planning is especially important. Contingency plans are essential in responding to changing conditions that will alter your product demand and business operations.

How Will Your Customers Respond To Interest Rate Hikes?

Consider how customers and consumers are likely to respond to interest rate changes and inflation in their budgets. For companies in your supply chain, how might they attempt to protect their margins with pricing that affects your costs of operation and your inventories? Consider how you can protect margins with price changes, and how that may affect demand for your products. Given the global nature of our businesses and the effects of currency exchange rates, how might company costs be affected by the coming changes in interest rates?

So, the scenario development and testing, and the development of contingency plans should be systematically undertaken. These should look at the effects on product demand, the effects on operational costs, the effects on inventory costs and financing, and how any ‘margin protection’ actions will impact demand.

How Will Your Responses To Risk Impact Your Trading Partners?

These issues you are facing are shared across all companies in the industry, and across all companies in your supply chain. The responses of each can be additive or multiplicative so Demand Planners need to create scenarios that fully incorporate the risk factors and understand the impacts of any resulting actions on our trade partners, as well as the effects of any actions taken by our suppliers and customers and consumers. Such scenario planning requires cross-functional participation to capture the many possible outcomes and risk factors. FP&A is essential to dollarizing each scenario and each course of action.

FP&A Must Dollarize Each Scenario & Response

Set-up a working group on a cross-functional basis with FP&A taking the lead in putting a dollar value on each scenario and response. This is not an operations forecasting process, but a scenario and contingency planning process. It is important for all members of the working group to realize this. Identifying the interacting elements and their effects on one another is essential. The process and the considerations are dynamic in nature, and will require iterations to test and evaluate the resulting scenarios.

Review these as a group on a regular basis to ensure prompt implementation of contingency plans and action. It is important to be prepared and it is essential to respond to the changing conditions on the ground in a proper and prompt manner.

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