By Nicole Busuttil
Money promotes economic growth, savings and investments, and so one can say that the global economy runs on money. In recent years, we have seen falling interest rates which made debt cheap to service, resulting in an increased level of borrowings being taken by both the public and private sectors. Now central banks are raising interest rates to fight the notable surge in inflation and borrowings are becoming more burdensome.
The Federal Reserve raised interest rates by 75bps to 1.50%-1.75% in the June meeting. Expectations are for the Federal Reserve to raise rates by a further 75bps in the July meeting to 2.25%-2.50% and to reach c. 3.25%-3.50% by year end, before being reversed thereafter to end 2023 at c. 2.75%-3.00%. The European Central Bank hiked rates for the first time in July by 50bps, ending eight years of negative rates and reaching 0%, with markets expecting interest rates to reach 1.25% by year end. The Bank of England also raised rates in its June meeting by 25bps to 1.25%, pushing borrowing costs to the highest in 13 years. Markets are pricing in a further c. 50bps hike at the August meeting, to reach c. 1.75% and then to reach c. 2.75% by year end.
The pace at which central banks are hiking rates is based on the continuous surging inflation month-on-month. At the moment, inflation may seem to be a result of the Russia-Ukraine war increasing food and energy prices across the globe or the supply chain disruptions being seen in China due to the lockdowns as COVID-19 cases have resurged. These may be interpreted as one-off factors, falling out of the comparison next year, which, if it is the case, may see central banks taking a wait and see approach. However, the current inflationary pressures are also a result of the tight labour market conditions pushing employers to raise wages to meet the rising cost of living.
The cost of money, which is a result of rapidly rising interest rates, may result in a sharp slowdown in economic growth and possibly give rise to a recession. Gradual increases in interest rates give persons the time to adapt, be it for households with regards to mortgages and for businesses evaluating the cost of refinancing old debt and financing new initiatives. If rates rise rapidly, they may discourage investments, weaken savings reserves, cause havoc in financial markets and disrupt economic planning by central banks.
Corporates and individuals are exposed to variable/floating interest rates on debt financing and therefore, their annual cash reserves or real disposable income will be highly impacted by increasing rates. This will in turn weaken credit demand and potentially lead to some defaults. Firms will charge more for their services and this will decrease demand, which will ultimately curtail GDP growth. What may help economies is the factor by how much funding and savings have remained in the hands of individuals and corporates due to accumulated savings and generally the extended period of quantitative easing during the pandemic months. Dipping into such reserves may assist individuals and corporates to reduce the need for additional funding at higher rates of interest and may therefore help to weather this period of rapidly rising cost of credit and other inflated costs. However, this reprieve would not last for long should interest rates continue to rise into the medium term. Furthermore, over the recent years of unprecedented low interest rates, most corporate borrowers have tried to extend their debt maturity profile at favourable fixed rates.
On the other hand, sovereign debt is mostly in the form of fixed rate bonds. So, even if bond yields are increasing in all economies, the actual effective interest rate being paid by governments will not increase substantially on the securities currently in issue. However, there will be a dilution in interest rates to be paid as governments issue new sovereign debt at the higher fixed term rates once the sovereign debt currently available on the market begins to mature.
To conclude, this may be the most aggressive worldwide interest rate hiking pace in decades, and so it is likely that it will cause a marked slowdown in economic growth. That be said, it should not cause a severe global recession, but there are increasing risks to the downside as central banks attempt to ward off the surging inflationary pressures.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.