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Inflation surge delivers negative real interest rates for leading economies

The surge in inflation is leaving the world’s leading economies with their lowest real interest rates in decades, as central banks delay any abrupt tightening of the extra-loose monetary policy used to help weather the coronavirus crisis, arguing that the recent rise in prices is transitory.

Real interest rates, which subtract inflation from central bank policy rates, reflect the real cost of borrowing and real return on savings. The combination of accelerating inflation in the US, eurozone and UK, and their central banks’ decision to remain patient when it comes to rate increases, effectively raises monetary stimulus despite these countries being close to recovering lost output from the crisis.

Real interest rates “will remain at historically low levels for the next several years”, said Elena Duggar, managing director at the rating agency Moody’s.

In the US, where nominal interest rates are near zero, real rates stand at around -5.3 per cent. They are at -3 per cent in the UK and -4.6 per cent in Germany, according to Financial Times analysis.

Those remain highly stimulative interest rates, given that multiple studies suggest the neutral real interest rate — which neither deters nor encourages borrowers and investors — has fallen in developed economies to around zero today, from roughly 4 per cent in the 1980s.

The last time real rates were as negative as today was in the 1970s, when rising energy prices pushed up inflation, studies show. Real interest rates also slumped in the wake of the 2008 financial crisis.

Negative rates “keep financing conditions accommodative and should support credit growth, as it makes the cost of debt sustainable”, said Ana Boata, global head of economic research at Euler Hermes Group.

Line chart of policy rate minus inflation, showing real interest rates have fallen in developed economies since the 1980s

This may help governments finance the massive debts they took on during the pandemic. However, as negative rates are stimulative in monetary policy terms, Boata warned that they could cause already richly valued financial markets to “become exceedingly unsustainable, causing concerns about financial stability risks”.

The big exception is China, where real rates are already positive despite slowing growth. Last week, the Czech Republic and Poland joined countries such as Russia, Mexico and Brazil in raising interest rates aggressively. But higher inflation meant that real rates remained negative. However, as inflation is forecast to fall next year, real rates will turn positive — rising up to as much as 3.3 per cent in Brazil and 3 per cent in Russia — reflecting the perceived risk premium traditionally attached to investing in emerging markets.

In developed economies, central banks are only slowly removing the massive stimulus put in place during the pandemic, even though economists have revised up their inflation forecasts recently on the back of supply chain problems and surging energy prices.

Line chart of annual % change on consumer price index by date of forecast, showing economists have revised up their global inflation forecasts

Last week, US Federal Reserve chair Jay Powell said it was too early to raise interest rates. The Fed, which has begun reducing its bond-buying programme, said that US inflation — currently running at a 13-year high of 5.4 per cent — was due to factors “that are expected to be transitory”.

Christine Lagarde, European Central Bank president, also pushed back on expectations that rates would rise next year despite inflation rising to a 13-year high of 4.1 per cent in October. She said the ECB, which had also slowed its pandemic bond-buying programme, expected inflation to fall next year.

Similarly, the Bank of England last week backed away from an immediate increase in nominal rates from their historic low of 0.1 per cent, even though it predicted inflation would reach 5 per cent early next year before falling back.

Yet even if inflation does retreat, real rates are expected to remain negative. Using consensus inflation forecasts for 2022, real rates are expected to stand at around -3.3 per cent in the US, -2.7 per cent in Germany and -3.2 per cent in the UK.

Even for the central banks of Canada and Australia, which have signalled that they may raise rates soon, inflation of more than 3 per cent combined with a near zero level of interest means they also have negative real rates.

“Real rates are going to be well below most estimates of neutral [rates] for the foreseeable future,” said Neil Shearing, chief economist at Capital Economics.

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