Impact of inflation on corporate treasury

The measures taken by the Fed and how they impact the economy are back in focus given the dramatic increase in inflation over the past year, coupled with very low levels of unemployment. But what do the Fed’s actions mean for corporations as they look to adjust their processes? How can corporations, particularly within the treasury organization, proactively position their organizations for success in this new rising rate environment?

When fighting inflation, one key tool at the Fed’s disposal is changing the Fed Funds rate (the rate banks pay for overnight borrowing in the federal funds market). When the Fed raises or lowers the Fed Funds rate, interest rates across the spectrum change, impacting both consumers and businesses. 

For many businesses, the low interest rate environment in place since the Great Recession of 2008 created a lack of focus on interest rates, given both the near zero rates and the Fed’s announced intention to keep rates low for an extended period of time. 

While the Fed raised rates in 2015, there were cuts in 2019 and again in March 2020, when they took rates back to near zero following the outbreak of the COVID-19 pandemic. Rates stayed near zero from March 2020 through March 2022.

In 2021, inflation began to pick up, but the Fed viewed the impacts as transitory and increasing as a result of pent-up demand following the pandemic. That view changed when inflation began to increase quite dramatically by early 2022. 

In March 2022, the Fed began a series of interest rate increases, some larger than any seen in over 20 years, to combat inflation. Additional hikes are expected in upcoming meetings, with the Fed attempting an economic “soft landing” rather than a recession.

A wide range of factors are influenced by interest rates, including working capital, forecasting, interest income, borrowing costs, risk management, access to credit, and vendor/supplier terms. Given the rapidly changing interest rate and liquidity environment, corporate treasury teams should make sure their focus on these new factors adequately positions the company to meet the new challenges the environment presents.

1. Forecasting 

Many treasury teams employ an interest rate forecast “overlay” on their cash forecasting or other treasury forecasts. The interest rate forecast includes the company’s opinion of where Fed rates will go over the course of the short term. Incorporating interest rate forecasts into the treasury forecasting process allows for scenario analysis to help ensure adequate levels of liquidity and borrowing capacity are available. Forecasting tools provide capabilities for optimizing forecasts, and treasury teams should make sure their forecasting methods are nimble enough to adequately address the changing environment.

2. Borrowing costs

As Fed Funds rates rise, borrowing costs generally increase across the board. With higher rates, organizations can typically borrow less as lenders calculate the company’s ability to repay the debt, and this can be exacerbated by lower demand for products and services given the impact of inflation. As a result, access to credit becomes more scarce, particularly for borrowers who are heavily leveraged. Adequately planning ahead for credit needs and securing needed borrowing facilities, or looking for alternative sources of funding, should be reviewed in the near term. Additional analysis as to the benefit of short-term versus long-term credit facilities should be undertaken to ensure the company retains the most efficient cost of capital.

3. Working capital and liquidity

As the ability to borrow may become more challenging for businesses, and cost of capital increases, ensuring adequate liquidity will become critical. Treasury teams should focus on improving days sales outstanding (DSO) and days payable outstanding (DPO) to provide more efficient access to working capital. This can be accomplished through digitization efforts, including moving payables and receivables to more efficient methods, or considering solutions where pools of cash can more easily be deployed.

4. Vendor/Supplier terms

Similarly, terms related to vendor or supplier payments can change as interest rates increase. Companies should review their methodology for making payments (cost of payment with or without a discount versus cost of capital to pay it). Analysis should also be completed on setting terms for their own suppliers. While many rates are based on contractual terms, companies should review their policies to ensure they are aligning new contracts with prevailing (or future expected) rates.

5. Interest income

On the positive side, interest income can increase for those who have excess cash to invest. With investment returns at historical lows for many years, many firms did not invest idle cash. As rates rise, treasury should review investment alternatives, while ensuring compliance with the company’s investment policy guidelines. Treasury teams should analyze counterparty risk, liquidity, and credit risk as they make allocations to investment options. They should also review their investment policies on a regular cadence to align the company’s risk tolerance with available investment vehicles.

6. Risk management

Rising interest rates may also impact a company’s risk management tools, particularly the use of foreign exchange and derivatives to hedge risk. Best practices indicate a need to reassess the use of these tools in a rising rate environment. Determine whether these risks remain appropriately hedged or if adjustments should be made to incorporate new rate forecasts.

7. LIBOR transition

Most treasury teams are aware of the regulatory changes dictating a move away from LIBOR. As LIBOR is retired, contracts primarily based on LIBOR historically may indicate “prime +” rates as the back-up rate if LIBOR is no longer available. With prime rates increasing, treasury teams should ensure their contracts address rates in advance of the deadline for LIBOR transition. Read more on the LIBOR transition.

Companies that effectively manage the new environment can adjust and thrive. Those that continue to operate without addressing the impacts of inflation and the rising rate environment will likely face challenges.

Just as treasury teams had to pivot at the beginning of the pandemic to operate in a remote economy, treasury is now tasked with understanding and proactively managing the risks and opportunities that come with the new rising interest rate environment and resulting economic conditions. 

Capital One is committed to helping our clients thrive in the current environment with custom thinking that delivers custom solutions. We look forward to working with your treasury team to understand your goals and provide insights to help you meet them.