30 Oct 2023
After a sustained era of cheap money, an abrupt and unprecedented shift in the global interest rate hiking cycle was ushered in, as the world’s major central banks sought to stave off surging inflation. The Bank of England moved first, increasing its base rate to 0.25% from a historic low of 0.1% in December 2021. The Federal Reserve (Fed) was next, announcing a rate hike in March 2022, with the European Central Bank (ECB) following suit in July of that year. We take a look at the implications – in the real economy – of the largest global interest rate raising exercise in recent history.
Since then, the Fed has hiked 11 times, taking rates from 0.5% to 5.5%, in what has been the fastest and largest rate hike cycle ever in the US. However, despite the scale of the movements, it has taken much longer than many had expected to see the impact of these rate hikes in the real economy.
It is widely understood that monetary policy works with a lag, with interest rate changes typically taking around 18 months before their full effect is felt. However, given the pace of interest rate hikes over the last year and a half, the continued resilience of the US economy has undoubtedly taken many by surprise. We think there are several factors which can explain the lack of economic response during this particular cycle.
The private sector and households have deleveraged significantly since the Global Financial Crisis (GFC) of 2008. As a result, there is simply much less corporate debt which stands to be negatively impacted by the higher rates. In addition, many companies have taken the opportunity to fix their debt at cheap rates for a long period, further helping to mitigate the impact of higher interest rates.
While nominal interest rates have increased sharply over the past 18 months, the move in real (or inflation-adjusted) rates has been much less extreme. As the rate of inflation has come down over the past year and interest rates have risen, in the US at least, real rates are now in positive territory, having been in negative territory for most of the period since the GFC.
This means that while borrowers will have been hurt by higher costs, this will have been partially offset by inflation helping to erode the real value of their debt. As a result, the real impact on the economy has been less severe than might have been expected by looking at headline rates.
The vast increase in savings that were accumulated during the pandemic and subsequent lockdown has still not fully unwound (although it has been drawn down). This has no doubt helped to cushion consumer balance sheets against higher rates and prices.
Furthermore, compared to the situation going into the GFC, households are carrying much lower levels of debt. This has meant that consumers have been much better insulated against the impact of rising rates in this cycle compared to 2008, when households had high levels of leverage.
That said, there is evidence that excess savings are now close to being exhausted, which means this tailwind could start to become a headwind as households start to tighten their belts.
There are other factors in play now, too, that may mean that US consumers will be under more pressure going forwards. For instance, in October the resumption of student loan repayments will start after a three-year moratorium, potentially reducing households’ discretionary spending.
We are also seeing an increase in the paying down of credit card debts, which suggests some consumers are battening down the hatches.
In the US, the average 30-year fixed rate mortgage has risen to 7%1. However, in recent years many homeowners have taken advantage of low borrowing costs and locked in cheap rates on 30-year mortgages. As a result, the majority of US households are arguably well-protected against the current high rates.
In terms of the UK market, a significant number of homes have no mortgage (28%)2, while 63% of mortgages have strong loan-to-value ratios (LTVs) under 75%3. Furthermore, only 5% of UK households find themselves on variable rate mortgages, which track changes in the Bank of England’s base rate, and a further 5% have had or will need to refinance in the second half of 20234.
Therefore, while pain will be felt amongst UK households as a result of higher borrowing costs, it will likely be concentrated in a relatively small part of the market.
The strength of the labour market continues to surprise and is particularly tight in certain sectors. While some parts of the labour market have been hit by interest rate rises, other areas that would have been expected to come under pressure have held up well. For instance, despite a lack of demand for new homes, we haven’t seen significant job losses in this area, which is likely to be due to the acute shortage of housing supply.
It should also be remembered that some individuals and businesses are actually benefiting from higher interest rates. In particular, cash-rich consumers or companies are now able to earn an attractive level of interest on their cash savings. This should in turn increase their spending power, helping to at least partially offset the negative impact of higher rates on other parts of the economy.
The ECB’s 10th consecutive rate rise to 4% in September 2023 marked the highest policy rate in the institution’s history. It is also the steepest rate hiking cycle – when the tightening cycle began back in July 2022, the rate was at a record low of -0.5.5
While inflation in the eurozone has come down from last year’s highs, it remains a way above the ECB’s 2% target. However, it is generally expected that this was the last hike in the current cycle. This partly reflects the fact the region’s economy is experiencing a slowdown currently: the ECB downgraded its growth forecast for the eurozone this year amid weak business and consumer confidence. Manufacturing activity and services data are both slowing and there is a risk that rising wages and energy prices could lead the eurozone into contraction.
Likewise, it is generally estimated that it takes up to 18 months before the economic effect of tighter monetary policy is actually felt. With signs of slowing in the European economy, and with inflation in the region falling, the ECB may look now to pause to assess the impact of its rate hikes so far before pursuing a further tightening in policy.
The story has been slightly different in the emerging markets space. Emerging markets (EM), particularly those in Latin America (LatAm), began their hiking cycle even before the UK, and in some cases, a full nine months before the US.
Unlike developed markets, EM countries didn’t have time to debate whether inflation was transitory or if the dynamics of inflation were going to be supply or demand driven – immediate action was required.
The inflation story, and subsequently monetary policy, varied greatly across EM regions with LatAm seeing much larger price increases and rate hikes. Over a 2-year period to the end of August, Colombia raised rates by 11.5%, Brazil by 9% and Chile by 8%.
This is in sharp contrast to select Asian countries such as the Philippines, Thailand, and Malaysia which raised rates over the same period by 4.25%, 1.75% and 1.25%, respectively.6 Reflecting this dynamic, LatAm currencies have been some of the best performing year-to-date, with Asian currencies being some of the worst performing.
In most cases, the swift response had its intended target, with inflation coming under control. Central banks in LatAm are now beginning to start cutting. Dominican Republic and Uruguay have already cut rates this year by 100 basis points (bps) and 75bps respectively, with Brazil and Chile also cutting rates in August. Peru, Mexico and Colombia are expected to follow suit later this year. Cuts in LatAm are timely due to the predictions of rising corporate default rates in the region which has the potential to put some of the most indebted issuers under pressure.
The resilience of the US economy suggests we could see interest rates stay at an elevated level for an extended period of time. Wages continue to rise, helping to prop up headline inflation despite the fall in commodity and goods prices. Lower earners, in particular, have seen a significant uptick in their salaries, which has supported consumers and the wider economy.
Higher real rates help to bring inflation under control. We are now starting to see signs of this as inflation moderates, although it should be remembered that things typically start to break in the system as real rates approach 3%, potentially leading to a more severe contraction in economic activity.
One of our key concerns is that central banks could be looking at the wrong indicator in order to determine when to pause rates. Instead of looking at the rapid fall in money supply – traditionally a reliable leading indicator of economic growth over the subsequent 18 months – they appear to be focused on current levels of growth.
As growth continues to surprise to the upside, there is a risk that central banks continue to hike, potentially overtightening just at the point that growth falls over, thus leading to a more severe economic contraction further down the line.
1 US mortgage rates remain at historic highs as inflation bites – view from across the pond - Mortgage Solutions
2 Money.co.uk (March 2023)
3 FCA and Bank of England (March 2023)
4 M&G, Barclays (June 2023)
5 ECB raises rates to record high, signals end to hikes, Reuters, September 14, 2023.
6 Bloomberg (31 August 2023)
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