For almost two decades, the global economy has been administered a potent steroid – lowinterest rates. There is no doubt that this has prevented some economies from falling into a depression, as first the financial crisis, the stagnation in the EU economies and then the COVID pandemic forced central banks to use monetary policy to help businesses survive.
The trillions of dollars and euros pumped into the global economies in the last two years will sooner or later give rise to high inflation. However, many economists think that this will be a very temporary experience.
A Financial Times opinion poll of leading academic economists has indicated that elevated inflation will compel the Federal Reserve to raise US interest rates at least twice by the end of 2023.
Like his counterpart at the ECB, Federal Reserve chair Jerome Powell has persistently argued that raising interest rates may spook financial markets. This reluctance on the part of central bankers to warn about the risks of increasing interest rates, when there are clear indications that this might sooner or later become a reality, could damage their credibility.
Markets and investors are more pragmatic and are beginning to hedge against the risk of higher interest rates. The sentiment now is that risk is not being sufficiently compensated for, and yields on long-term bonds are rising. Soon central banks and political leaders will have to start being honest about their plans to tackle the long-term economic consequences of the pandemic.
Sovereign and private debt is increasing at a very fast rate. Economic growth remains sluggish, especially in Europe. When the escape clause in the Stability and Growth Pact is withdrawn, probably in 2023, EU governments have to announce their long-term plans to reduce deficits and debts.
Corporates will also have to start repaying the loans they received in the last several months to weather the headwinds of the pandemic. Those that were solvent before the pandemic will probably manage their repayment programmes effectively. However, there will still be many companies that are now so used to low-interest rates that they will struggle to cope with a higher cost of money.
Interest rates are very effective tools to price risk
Retail investors who stuck to conservative risk appetites will undoubtedly welcome better returns on their savings as long as their money is not locked in long-term bonds. However, many have reacted to low yields by getting involved in non-investment grade securities, many of which under-priced risk substantially. There is a risk of moral hazard increasing if governments and central banks commit themselves to buy non-investment grade corporate bonds to prevent incidents that threaten financial stability.
Perhaps the most significant risk of low-interest rates and loose monetary policy is that the fear of high inflation has encouraged price appreciation of real estate and many financial assets.
Some countries are experiencing significant increases in property prices partly because investors believe that this is the best way to hedge against rising inflation. Stock markets are booming despite the real uncertainty about how fast economies will recover. One can expect a market correction that might puncture this bubble of assets, appreciating partly on the back of the low cost of borrowing.
Other factors are behind the accelerating growth of inflation. China, the global manufacturing powerhouse, is no longer such a low-cost producer. The shortage of essential commodities like rare metals and semiconductors is driving prices up. Increasing transportation demand is affecting the price of oil. As these factors combine, higher inflation will start to worry central bankers, who will be forced to raise interest rates.
Economies that are more dependent on service industries like tourism also face challenging times. Allan Timmermann, an economics professor at the University of California, argues that “there is considerable uncertainty about how fast service sectors will bounce back, whether labour market shortages will hamper growth, and how savings and consumption will respond once the fiscal stimulus is dialled down”.
Fiscal rectitude has been put on the back burner for several years as central bankers and politicians used their most powerful fiscal and monetary weapons to fight the risk of a global depression. But this situation cannot last forever.
Interest rates are very effective tools to price risk. Keeping insolvent businesses in existence thanks to the low cost of borrowing, subsidies financed by taxpayers and savers, and light-touch regulation could save a few jobs but will ultimately hardwire inefficiency in the economies of a country.
Structural economic reforms cannot be postponed forever.
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