Part 1: The connection between interest rates and sales you must understand.
Sagiv Gurvitch, Saleograph’s chief strategist, explains.
To better understand how interest rates will affect the success of your advertising campaigns, we need to go back a few years to understand what the economic future is expected to be in the coming year.
Hold on tight, it’s going to be steep!
On Monday, July 10, 2023, the Bank of Israel announced interest rates and halted a streak of ten increases.
The Bank of Israel left the basic interest rate at 4.75%. (The prime rate remained at 6.25%).
What does this mean? And how does it affect our advertising and business results?
I am Sagiv Gurvitz, chief strategist at Saleograph.
Welcome to the first episode of the first season of “The Big Picture of Small Business” by Saleograph.
In a new weekly series, all built to serve small business owners.
We will upload content, methods, tools, and modules, and host special guests to help small business owners navigate the challenges of everyday business reality and provide additional insights on how to become more efficient, grow, and do business better.
So, what exactly does a 4.75% interest rate mean? Spoiler alert! As bad as it sounds, the goal is unemployment, yes, and I want to explain. So, here’s how it is, since 2018 we have been in a very low interest rate environment, to make it clear, the Bank of Israel’s interest rate was very close to zero for the past 7 years. What does that mean? A near-zero interest rate is a move by central banks around the world, and of course also here in Israel, to encourage economic growth or to curb it. Of course, we will expand on many other aspects in other episodes. So, for the past 7 years, the interest rate has been almost zero, how exactly does this encourage growth? I’ll explain…
A low interest rate means that we do not receive interest on deposits and savings, and therefore we have no incentive to keep our money in the bank. In the past seven years, when the interest rate was almost zero, if we had, for example, 100,000 NIS in a deposit at one bank or another, we would expect to receive almost zero interest at the end of the deposit period, and therefore the public saved less and did not expect that savings could generate income for them.
In addition, in an environment of low-interest rates close to zero, the loans we receive from banks or non-bank loans from credit card companies and various financing companies are relatively cheap, and the public increases its credit consumption. In this case, on a NIS 100,000 loan we received from one of these entities, we will pay a few percentage points of interest (the era of cheap money) “You may have already heard deceased”
These two forces, and several other forces that we will expand on in other episodes, all create growth in the economy through consumption. Less saving, more borrowing (receiving cheap money), more buying, and that is exactly the wheel of economic growth in the context of interest rates.
Then, in December 2019, the COVID-19 pandemic broke out in the world. When Israel entered the global map of infections on February 27, 2020, the pandemic met the startup nation. When we talk about the connection between interest rates in Israel and the global pandemic, we have a small difference from the rest of the world. We are here in Israel, a special country. The economy coping with the pandemic was a bit different from other countries or large cities around the world.
For example, unlike countries where most of the economic activity depends on tourism or manufacturing and industry (and remember the word manufacturing will play a leading role soon), we in Israel are a tech nation. Of course, we have tourism and manufacturing sectors, but they are still a relatively marginal part of the pie, and therefore a significant part of the Israeli public was not harmed. To understand where there was a severe impact, we will use an example. Think for a moment about the Greek island of Crete (I know you’re already feeling better, but that wasn’t the case during the pandemic) in Crete for example, tourism has a major impact on the local economy. Zero flights, lockdowns, and restrictions on freedom of movement, all of these severely impacted all businesses surrounding the industry.
The impact of the pandemic was not limited to hotels, restaurants, attractions, and retail complexes. It also spread to what are known as “SOHO businesses,” which are small businesses, freelancers, and businesses that operate from home. These businesses are also known as SOHO (Small office / Home office) or “satellite business” of the industry. These are businesses that serve the industry, such as laundries, printing houses, clinics, event organizers, and more.
We saw this phenomenon in Israel as well but to a lesser extent. (Of course, any business that was in a sensitive segment at that time, undoubtedly had a challenging time, and not everyone survived.) But in Israel, the situation is different. Here, Israel is a tech nation, and exports services and technology industries. The demand for workers in the industry jumped by hundreds of percent, as the pandemic pushed the entire world into the internet, and Israel was just in the right industry to thrive in this event. What happened is that money continued to flow into the pockets of most workers in the economy, and on the other hand, there was a steep decline in spending on vacations, culture, and events. This created a large stockpile of money for many Israelis, which was available to be wasted.
In an article we published in Saleograph in May 2020, we prepared a strategy for the businesses we work with during the pandemic period. The article and insights provided an enormous lever for flourishing in the period for those who took action to implement what was written in it. (Link to the article)
The big problem that has managed to shake the world.
At the same time, a huge problem is rising, one that the world has never known before. It is what will determine the moment of the beginning of inflation (price increase), and it is what will determine that central banks around the world, including in Israel, will have no choice but to raise interest rates most sharply in nearly 20 years. This monster has a name, and it is also the “A” and “B” of economics – when there is high demand (people want to buy) but there is no supply (no available product inventory), prices soar!
What is the reason for this situation, you ask?
Lockdowns reduced the ability of factories around the world to supply goods. We all remember, that there is no stock of webcams that people want to make the Passover Seder on Zoom, computers are missing, weight training equipment (because everyone trained at home), and these are just a few cases. Due to the lockdowns, workers in manufacturing countries such as China, India, Turkey, and others were unable to meet demand and the global production system collapsed. Even before talking about the logistics system that caused shipping problems by sea, air, and land for the same reason. So what happens when there is a shortage of goods while there are many buyers? Prices go up sharply.
And so begins the process of the dangerous phenomenon called inflation, “the value of money is being eroded.” Prices rise, but the average wage in the economy remains the same or at least does not grow with the increase in the basket of inflation, which is measured by the Consumer Price Index (CPI), which is the responsibility of the Central Bureau of Statistics. This index measures the change in the average expenses required for citizens to live comfortably in consumption, taking into account many factors. The index examines the change in prices of goods and services (change in the cost of car prices, rent, supermarket products, services we consume such as education, culture, consulting, etc.).
So, when products and services rise sharply and we don’t earn more at the same rate of growth as the rise in prices, then the value of our money is being eroded, we are going backward, and this in general, without going into depth, is not good, really not good.
We are making a profit, but we don’t feel the money. And I have a feeling you know what I’m talking about.
The one who is responsible for sorting out this mess is the Bank of Israel, and its main weapon, which has not been taken out of the closet for a long time, at least in the last 7 years, is the interest rate. So how does a rise in interest rates stop inflation? In general, that’s the goal, I’ll explain.
We are now in July 2023 at an interest rate of 4.75%. Over the past year and a half, the Bank of Israel has raised interest rates gradually and continuously – 10 times!
So, now that interest rates are relatively high, it is much more worthwhile for us to make deposits in savings accounts because we will be able to earn interest on them (of course, there are many other investment avenues, but for this discussion, we will not delve into them at this time, but rather in other chapters). Our money finally has a good place now that it is in savings or a deposit account, and it is returning us a nice interest rate. The result is that it is not worth wasting money, we earn money on our money that is sitting in the bank “risk-free (relative) return,” so the public increases savings (and less consumption or less waste).
At the same time, our loans have become more expensive and less attractive. When the Bank of Israel’s interest rate is 4.75%, banks or non-bank institutions will generally be able to charge 8% or more, depending on the type of borrower. For every 100,000 shekels we borrow, we will pay an average gross annual interest of 8,000 shekels, just on the interest. We will pay a non-negligible amount of 667 shekels per month for 12 months, again just on the interest! (And this is just a quick and inaccurate example, but it is the new situation). So, to reduce our reliance on credit, less credit consumption leads to a reduction in our consumption (of goods and services), vacations, cars, appliances, leisure, restaurants, and everything… And now, of course, not to get into payments and credit, and even the credit line on the bank’s overdraft is now very expensive! This event sharply reduces our consumption. This leads to an additional and dramatic effect
If we have consumed high credit lines for our household or business, such as long-term loans, and mortgages, they have simply become significantly more expensive and created additional expenses that require us to recalculate every expense (which further reduces our current consumption and another burden on our monthly cash flow).
Insights from tracking interest rate changes
Now it is clear to us that as interest rates rise, consumption falls. Every small increase will lead to a sharp decline in consumption of all products and services, in a broad, general way. And this is already meeting us today, and certainly soon.
But wait, if people buy less, businesses may close?
That’s right, the sad truth is that this is exactly the goal of raising interest rates. Not to close businesses, but to cause an increase in unemployment for a certain period.
What is the connection?
(Before I explain the connection, we are already starting to see that, concerning small businesses, we must get organized quickly for the near future. It will be clear that compared to strong and large businesses like public companies, a change in cash flow or sales intensity and a halt to the inventory cycle can lead to a dangerous response up to bankruptcy. Our advantage over large companies is that we are much more flexible and fast and can organize for changes. So, just like in our publication in May 2020
Take action now to avoid a crisis.
So, we said that businesses can close, I’ll explain it like this:
More businesses will find it difficult to grow and will feel a sharp decline in demand. On the one hand, this is due to the reasons we have already discussed, with people saving more money. On the other hand, the rising cost of credit makes loans and payments very unattractive. Every purchase becomes more considered and less impulsive (even with all our habits and enjoyment of consumption, we still have to close the month. After a few months, when the public does not pay attention, the credit line ceiling eventually reaches and with it the phone call from the bank).
The first reaction of businesses to a decline in sales, after the penny drops, and this also takes time, sometimes a few months, is that they must increase sales. So the next reaction is a decision to increase advertising and promotions to attract more customers. But customers are indifferent (because they don’t want to waste money). And here too, it takes time for the penny to drop (but in the meantime, the months pass). And then, as businesses, we fall into the trap again. Our response to the situation is almost automatic. We decided to press the pedal even harder, with a larger expenditure on advertising and more aggressive deep discounts. By the way, this is not just us, but all our competitors and the entire industry. We hope that this experiment will bring us some kind of preservation of cash flow, in a way that will be able to cover our obligations (to rent, to employees, to loans).
Boom! The interest rate wheel has reached its goal!
Boom! The wheel has completed a turn! The Bank of Israel’s first result has been achieved! In this way, we stop rising prices! The economy enters a period of discounts and promotions! The life cycle of this wheel usually takes a year to a year and a half. Inflation starts to rise, In 2 quarters, the central bank receives data and identifies inflation and starts to act, another 2 quarters, households start to feel it, 2 quarters, and then businesses act across the board for another 2 quarters. Bingo… but unfortunately, this is not the end. This wheel is going to complete another turn with us, and we need to understand this now! And not at the end of the turn, which is expected to be arsenic.
So, here’s how it works…
The next result is that there are no revenues and they are declining. We will approach the other side called “efficiency”. If we cannot control revenues, and also not with the help of heavy advertising guns, then at least we can certainly control expenses. And here, on the efficiency side, the first response begins layoffs of employees. If there are not enough customers, what remains to be done is to simply lay off employees, and this is exactly what is going to meet us in the coming quarters. Now, just a moment…
Layoffs of employees, this is another addition to the decline in consumption, because those laid-off employees will not buy products and services because they do not have a steady income. And then… this will lead to another decline and one more turn, hopefully, the last one, in the wheel of consumption decline in the economy.
At this point, price increases usually stop. The competition between the players and the various promotions leads to a decrease in prices for most services, products, and commodities (and sometimes real opportunities are created in new economic models, and there is no shortage of examples of businesses that were created in such an environment). When prices stop rising, inflation returns to its target!!! Ahhhh what a mess… and it is here now.
Well, so after the short economics lesson on one leg, we understood the connection between interest rates and the decline in sales.
In the next chapter, we will deal with how we are preparing for this reality, in the small business.
