Macro Insights Weekly: Can the global economy handle positive real rates?
- .It has been decades since the global economy grew sustainably without negative real rates
- Countries that don’t have major inflation risks are being compelled to hike rates
- Many economies, with heavy public and corporate debt burdens are highly vulnerable to rising rates
- US real rates will likely remain elevated through next year
- This means a prolonged period of pressure on a wide range of economies in both DM and EM
Commentary: Handling positive real rates
From the US to Europe to Japan, decades of growth have been accompanied by negative real interest rates. The US Federal Reserve and the European Central Bank’s policy frameworks have been fed by an urgency to deal with the aftermath of the global financial crisis, and taking cues from the Bank of Japan’s struggles with deflation in the 2000s. The result has been nearly 15 years of rock bottom interest rates and ample liquidity, with interludes at attempted policy normalisation, only to return to the rates floor as new shocks materialised.
But all that is changing this year, with the US leading the path with a number of large rate hikes. This has propelled the USD to two-decade record highs, which helps in dampening imported inflation and increasing Americans’ purchasing capacity with respect to imported goods. But this in turn has been destabilizing for global economies and markets. While inflation is a problem everywhere, output gaps remain wide in many economies as recovery from the pandemic remains far from complete. And yet, from the European Central Bank, which is facing a looming recession in the continent, to the Reserve Bank of India, rate hikes have begun in earnest. The Bank of Japan may not be keen to begin normalising rates, but the pressure of higher US rates has manifested in the yen weakening to levels not seen since mid-1980s, and Japan’s trade balance has swung into ever widening deficits.
It could be argued that rock bottom rates kept a great deal of economic distortion and asset price froth in place for way too long, and now is as good a time as any to get going with policy normalisation. After all, financial fragility builds up during ultra-low rates, as it becomes challenging to distinguish between good and bad credit. With yields from fixed income so low, froth in housing and equities become inevitable, and financial stability risks build up.
As much as policy normalisation is needed, the pace and duration can cause their own set of dislocations. As mentioned earlier, central banks that do not need to raise rates substantially, given relatively softer inflation and still nascent recoveries, are being forced to hike rates, risking an unwelcome slowdown in growth. A rapid pace of policy tightening could also spill over readily into debt distress, stock of which is exceptionally high at the public and private levels.
US rate hikes and a soaring USD have already caused currency and debt market distress in Argentina, Pakistan, Sri Lanka, and Turkey, with many other EM economies looking at uncomfortable times ahead. US rates are on course to turn positive in real terms next year as inflation stabilises but the Fed keeps policy unchanged to re-anchor inflation expectations. This would mean a prolonged period of pressure on a wide range of economies in both DM and EM, in our view.
Accompanying the rising real rates is fiscal tightening. In the US, fiscal has been subtracting from GDP since the Q421, and the trend is likely to continue as Covid-era support measures expire and other spending are kept in check. This trend is increasingly global—by design or necessity, governments around the world are on belt-tightening mode, amplifying the impact of rising real interest rates. All these together point toward growing risk of a sharp slowdown in the global economy.
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