We’ve yet to feel the worst of the pain from the high price of money

For Times readers under fifty years of age their adulthood has been set against a steady backdrop of falling interest rates. The relative attraction of saving – when compared to borrowing – has been gradually eroded even after allowing for the low inflation of the last three decades. In October 1987, the average interest rate in the global bond market – a key reference point for the borrowing and savings rates – reached an all-time high of 9.95%. In March 2020 this bottomed out at an all-time low of just 0.83%.

Borrowers have become familiar with being able to refinance their debts at ever more attractive terms. Savers have become conditioned to hunting for a return at any price – and this has pushed them into ever more exotic assets. There is now a rude awakening underway. It is an awakening that is penalising these entrenched behaviours. Economic history is littered with examples of where long-held patterns of behaviour reverse – unearthing unsustainable practices and unwise decisions. The fallout often takes time to emerge, often creating something of an artificial sense. Three years into the reversal in interest rates, businesses and households that have been trying to hold their nerve, hoping that prior trends economic trends reassert themselves. Recent events have added to signs that such hopes may have to give way to a new reality.

First up was a warning from one of the ratings agencies, Fitch Ratings, that the outlook for the public finances of the US economy has deteriorated. Fitch cut the rating it ascribed to arguably the world’s most important asset – US Treasuries – to AA+, from AAA. Now a downgrade of US government debt from a ratings agency – an industry whose record of leading opinion is patchy at best – is not in itself a cause for acute concern. However, the commentary that accompanied this cut does speak to the concern that benign inflation can no longer be taken for granted. The combination of unfunded spending commitments in attempts to onshore technology and energy capacity, an ageing US population, and greater economic hostility to its geopolitical foes all raise the spectre of sustainably higher US inflation. This means that the Federal Reserve Bank can no longer be relied on to buy trillions of dollars’ worth of US government debt and keep the lid on the rate of interest that the US government pays. Last week this pushed the interest rate on 30-year US government debt to a twelve-year high.

Second, the Bank of Japan – which since 2016 has intervened to cap the cost of its government debt in a range around zero – recently announced a less rigorous interpretation of this headline policy. As a result, the interest rates on Japanese government debt have risen to a level last seen nine years ago. For a country whose public debt is an eye-watering 2.6 times the size of its domestic economy, and whose cheap money has been exported around the world, this is an important sign of turbulence to the global economy.

Third, there are signs from Saudi Arabia, China and Russia that their collective tolerance for recent falls in oil, gas, manufactured goods and food prices is waning as they begin to translate into lower export earnings. Should this pushback continue then recent price inflation will prove rather more stubborn, and the interest rate cuts that financial markets are still hoping will crystalise early next year will fail to arrive.

These financial market, central bank and geopolitical rumbles – all pointing to a very different secular backdrop for interest rates – may all seem rather distant to the UK economy. But quoted mortgage rates, rent, fuel and food inflation in the UK all take important cues from these events. One of the most frustrating aspects of UK economic commentary is the parochial lens through which many economic issues are often considered. “Global Britain” is a political soundbite, but an economic reality.

Adjusting to these higher interest rates will generate a very different economy to the one that has predominated over the last thirty-five years. Some changes will be welcome, and long overdue. Others will painfully destroy livelihoods.

Economists interested in wealth distribution – and how an uneven allocation has been an impediment to growth – will look at this period of higher interest rates as a welcome opportunity to redress the balance. A concentration of wealth is not just politically unpopular, it also curtails the ability of the average voter to shape their economic outcomes. An economy that relies on the spending of a small number of companies or consumers is impeding its chance of fast growth.  

Furthermore, the era of hyper-low interest rates led to money finding its way into a whole host of assets that had questionable contributions to growth and wellbeing. As the hurdle rate for investment increases there will be greater focus on how money is allocated around the economy. It is one of the reasons I am optimistic about the future for productivity growth.

Consumers will initially find these adjustments to higher productivity a painful experience. There are large parts of modern market economy that have grown up funded by very low borrowing costs – often channelled by debt-fuelled private equity funds. This source of finance meant that prices in industries like hospitality, fashion, transport and digital media were kept artificially low for the consumer. As the cost of capital rises then many operators will fail. This will cut choice and allow surviving firms to raise prices. Last week’s news about the appointment of administrators at the UK retailer, Wilko, may symbolise the pain to come as the average interest rate on UK company borrowings has risen 2.4% to 6.3% – with many companies now routinely paying more than 10% to refinance their borrowings. Adaptations to behaviour as prices change – in this case the price of money – is the great advantage that the capitalist system has over its alternatives. So far, the fallout of interest rate increases has been muted. Recent events suggest that is about to change.

We’ve yet to feel the worst of the pain from the high price of money

Published: The Times 08/08/2023