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Will Interest Rate Rises Cause a Crash?

Some of the world’s biggest financial crises were sparked by the Fed raising interest rates. It’s planning rate rises, so we asked Capital Economics’ Andrew Kenningham whether we could see an economic downturn.

14 June 2022

The US Federal Reserve is the world’s most powerful central bank. Known as the ‘Fed’, it sets monetary policy for the United States, but its actions can set unintended effects rippling throughout the world.

Some the biggest financial crises in history have taken place shortly after the Fed raised interest rates, including these huge worldwide upheavals:

  • The 1929 Wall Street Crash
  • The dotcom crash of 2001
  • The Global Financial Crisis (GFC).

Fed officials have made it plain they will tighten monetary policy this year, so it’s no wonder that some investors are worried. But how concerned should we be?

Knock-on effects

The most obvious worry is that higher interest rates in the US can directly cause problems for other countries.

This is particularly true of countries which find their currencies weakening against the dollar, or which have pegged their currencies to the dollar or borrowed in dollars.

These problems are more common in emerging economies – and there are fewer countries now pegging their currencies to the dollar than in the past.

Synchronised tightening cycle

Another concern is that the Fed will not be the only central bank raising interest rates this year.

In most countries, the rebound from the pandemic has been stronger than many people expected. That’s clearly welcome, but it’s pushed inflation up almost everywhere, and led to supply problems in countries which have been hit by the pandemic.

In response, many central banks in the emerging world have already raised interest rates and a growing number in advanced economies have followed suit – including the Reserve Bank of New Zealand.

So, I predict global monetary conditions will get tighter, potentially slowing the economy.

Global debt at all-time high

Another worry is that debt is now much higher than it was before the pandemic.

The International Monetary Fund estimates that 2020 saw the largest ever one-year surge in global debt.

It reached a mind-boggling $226 trillion or over 250 per cent of world gross domestic product (GDP). GDP is a measure of a country’s market value and covers all the goods and services produced over a year.

With the pandemic dragging on last year (2021), the debt burden increased further.

During the pandemic this wasn’t too big a problem, precisely because debtors have been helped by the very low level of interest rates and because central banks have stepped up and bought a lot of government bonds.

But as interest rates rise, this debt will become more expensive to service.

Difficult transition

The upshot is that the world is starting a difficult transition from a period of ultra-low interest rates to one in which rates are a bit higher.

This change could cause problems in some countries and it could cause asset prices to fall.

The US stock market has often declined during periods of rising interest rates and there are risks to property prices in countries which see the biggest interest rate increases, or where prices are unusually high, like New Zealand.

Reasons for cautious optimism

But I would say it’s not inevitable that slightly higher interest rates in the US, or elsewhere, will lead to a major economic downturn.
And in some respects the world is better placed now to cope with rising interest rates than it was before previous crises. Three points are worth emphasising.

Interest rates are rising from a very low level

First, the Fed’s key interest rate is currently close to zero and in other economies – including Japan and the euro-zone – interest rates are actually negative.

So rates could go up a bit without reaching levels which are unaffordable.

For example, Fed officials think they’re likely to raise rates to only 2 per cent in the coming years, which is below the previous peaks of 2.5 per cent in 2019 or over 5 per cent in 2007.

Central banks need to raise rates

Second, some major central banks will not be raising rates significantly.

The European Central Bank and Bank of Japan, for example, are likely to leave their interest rates at or below zero this year, and the People’s Bank of China, which is worrying about its weakening property sector, will probably reduce its interest rates.

The situation would be more worrying if these central banks were also planning to put their foot on the brake.

Household and corporate debt not so high

And third, although total debt has risen since the start of the pandemic, most of the increase has been in public sector debt.

This is reassuring because the public sector has the deepest pockets and is best able to service high debt burdens, not least because it has the power to electronically “print money”.
Also, central banks (which are part of the state) own a lot of this debt so, in a sense, the state owes the money to itself.

All in all, the coming period of higher interest rates may cause problems in some countries, but there are good reasons to think that the major economies are quite well placed to cope with higher borrowing costs – as long as they do not go too high.

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