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If interest rates are raised high enough to kill off inflation, how bad will the consequences be?

Central banks are having to choose between ruinous inflation or ruinous interest rates.

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7 months ago

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Cineworld has signalled its intention to declare bankruptcy. Like many companies in the UK and elsewhere, the London-based cinema chain took on massive amounts of debt to expand. It is expected to use the Chapter 11 process in the US to restructure its debt and other obligations.

Variations of this story are set to be repeated again and again. With benchmark interest rates rising from the near-zero levels adopted by central banks over a decade ago, a reckoning is coming for all the “zombie” companies that are only able to pay the interest on their debts but never the principal. The same goes for individuals and governments in similar positions.

So far, central banks have only taken small steps to get inflation under control. The Bank of England has raised its benchmark rate from 0.1% to 1.75%, whereas until the financial crisis of 2008 it ranged from 5% to 15%. A return to normal would therefore suggest rates increasing to at least 5%.

Benchmark lending rates: UK, US, eurozone

Orange = US; Blue = UK; Turquoise = eurozone. Trading View

That might sound frightening, but it’s nothing compared to what happened when Paul Volcker was chair of the US Federal Reserve between 1979 and 1987. While his predecessors had understood the need to raise rates to fight inflation, they kept caving in to political pressure and cutting rates before the medicine had taken effect.

With inflation rampant by the late 1970s, Volcker simply declared an end to this back and forth and raised rates to over 15% – and then 20% in 1981. This ultimately broke the back of inflation around the world until its current resurgence.

US benchmark rate v inflation

Graph comparing US federal funds rate and inflation
US benchmark rate = blue; Inflation = red. Trading View

What economists get wrong today

In 2016 the leading macroeconomist Paul Romer wrote a devastating critique called The Trouble with Macroeconomics, pointing to “three decades of intellectual regress”. He said macroeconomists had become comfortable with the idea that increases in economic variables like inflation were caused by “imaginary shocks, instead of actions that people take”.

For example, most economists and central bankers blame today’s double-digit inflation on the “shocks” of the pandemic and Russia’s invasion of Ukraine. But that is like saying that when a driver hits a rock going at 120mph on a country road, the rock caused the accident.

Thanks to zero interest rates and money creation in the form of quantitative easing (QE), the money supply has exploded. Reserves held at the Bank of England, which form the largest part of the core money supply, have risen from around £30 billion in mid-2008 to £946 billion today – doubling in the past two years alone.

This is worrisome by any standards, and my forthcoming book will look at why it was allowed to continue so long. According to the quantity theory of money, popularised by Milton Friedman and Anna Schwarz, this expansion should increase prices in the actual economy by a factor of ten.

Until it became inconvenient, economists and central banks generally believed that you should set benchmark interest rates using a formula known as the Taylor rule. By this calculation, we currently need a rate of 15%.

Central banks hopefully won’t have to go that far to convince the markets they are serious about fighting inflation. After all, everyone has gotten used to historically aberrant low and falling rates over four decades.

So far, however, the markets are pricing 30-year UK government bonds (gilts) at just 2.7%, meaning they still expect very low rates in the long term. And in the US, markets are already pricing in rate reductions. Since higher rates will only work once the markets believe they are here to stay, the worry is that maybe even 15% won’t be enough.

What higher rates entail

To get a sense of what much higher rates would mean, consider the UK housing market. If the Bank of England obeyed the Taylor rule, your tracker mortgage would rise from the low of roughly 1% to above 15%.

Two million homeowners have variable rate mortgages, so would be affected immediately. Besides that, most fixed-rate mortgages in the UK are two or five-year fixes (unlike in the US, where most people get 30-year fixed mortgages). When these deals end, a further 7 million people would be exposed too.

The average mortgage balance today in the UK is about £150,000 (the good news is that fewer than 1% are currently in arrears). For someone with 25 years to repay on that size of mortgage, each percentage point increase on the rate will push up the annual repayment by an average of nearly £1,300 (or £1,500 on interest-only mortgages). So an increase in rates from 2% to 7% would cost home owners well in excess of the forthcoming utilities price hike.

How higher rates will affect repayments

Chart showing how increasing interest rates will affect mortgage repayments
The chart is referring to capital repayment mortgages. Author provided

Yet without downplaying the potential effect of forced repossessions and sales in our property-owning economy, the more important impact on the housing market from higher rates would be on new purchases. If rates merely double, house prices would have to roughly halve to maintain the same level of (un)affordability. For example, if someone buys a property for £200,000 with a 2% mortgage rate and no deposit, they pay about £4,000 annual interest. If interest rates double to 4%, they pay £8,000 interest. For repayments to remain the same, the house price would have to fall to £100,000.

Read more: Corporate debt is in serious trouble – here's what it means if the market collapses

Of course, the government would want to step in with house-price support measures in the face of higher rates. But that implies more borrowing when it is already paying nearly £20 billion in monthly debt interest.

Then there is the Bank of England. The Bank pays the benchmark rate on all the reserves it holds from UK banks and other financial institutions. Its balance sheet also massively expanded via QE, which involved buying lots of gilts at fixed interest rates from UK financial institutions by increasing their reserves at the Bank. For years, the interest from the gilts more than covered the interest payments on the reserves, but that situation is now reversing as benchmark rates rise, thereby adding to the government deficit.

The government will need to balance its books to cover these costs. It shouldn’t do this by restricting public sector wages or infrastructure investment. Tax rates on corporations and wealthy people will need to rise.

The coming hangover

After 40 years of partying, interest rates now have to go up sharply – the 7% rate associated with Professor Patrick Minford, Liz Truss’s economist advisor, would be a good starting point. Unfortunately the hangover will be massive.

But bite the bullet now and it’s possible that, like the Volcker years, the scene will be set for a prolonged period of technology-driven expansion and prosperity on the back of a low-inflation environment. There will also be other advantages, such as making homes more affordable for younger people and higher-interest savings accounts. These will be the consolations in a difficult period ahead.

Jefferson Frank does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Government

Biden Signs Bill To Declassify COVID Origins Intel

Biden Signs Bill To Declassify COVID Origins Intel

Having earlier issued his first veto since taking office, rejecting a bill that would have…

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22 mins ago

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March 20, 2023

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Biden Signs Bill To Declassify COVID Origins Intel

Having earlier issued his first veto since taking office, rejecting a bill that would have reversed a Labor Department rule on ESG investing, President Biden signed a bipartisan bill late on Monday that directs the federal government to declassify as much intelligence as possible about the origins of COVID-19.

His signature follows both the House and Senate unanimously approving of the measure, a rare moment of overwhelming bipartisan consensus.

The vote tallies meant that the measure would likely have survived a presidential veto had Biden opted to withhold his signature.

Biden, in a statement, said he was pleased to sign the legislation.

“My Administration will continue to review all classified information relating to COVID–19’s origins, including potential links to the Wuhan Institute of Virology,” he said.

"In implementing this legislation, my administration will declassify and share as much of that information as possible, consistent with my constitutional authority to protect against the disclosure of information that would harm national security."

Of particular interest to freedom-loving Americans who were tyrannized, censored, banned, and deplatformed for even daring to mention it, is the small matter of whether the virus leaked from the Level 4 Virus Lab at the Wuhan Institute of Virology (or instead, as The Atlantic proclaimed recently, a sick pangolin fucked a raccoon dog and coughed in someone's bat soup in a wet market.

The Department of Energy and other federal agents such as the FBI have increasingly backed a lab leak as the likely origin of the virus, while some lawmakers have even suggested Beijing may have deliberately allowed it to spread.

Tyler Durden Mon, 03/20/2023 - 20:41

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Spread & Containment

Asia’s trade at a turning point

Policymakers in Asia are rightly focused on the potential reconfiguration of global supply chains, given the implications these shifts may have for the…

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1 hour ago

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March 20, 2023

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By Sebastian Eckardt, Jun Ge, Hassan Zaman

Policymakers in Asia are rightly focused on the potential reconfiguration of global supply chains, given the implications these shifts may have for the development of their export-oriented and highly open economies. While the focus on potential shifts on the supply side of the global and regional trading system is well-justified, equally dramatic shifts on the demand side deserve as much attention. This blog provides evidence of the growing role of final demand originating from within emerging Asia and draws policy implications for the further evolution of trade integration in the region.

Trade has been a major driver of development in East Asia with Korea and Japan reaching high-income status through export-driven development strategies. Emerging economies in East Asia, today account for 17 percent of global trade in goods and services. With an average trade-to-GDP ratio of 105 percent, these emerging economies in East Asia trade a higher share of the goods and services they produce across borders than emerging economies in Latin America (73.2 percent), South Asia (61.4 percent), and Africa (73.0 percent). Only EU member states (138.0 percent), which are known to be the most deeply integrated regional trade bloc in the world, trade more. Alongside emerging East Asia’s rise in global trade, intra-regional trade—trade among economies in emerging East Asia—has expanded dramatically over the past two decades. In fact, the rise of intra-regional trade accounted for a bit more than half of total export growth in emerging East Asia in the last decade, while exports to the EU, Japan, and the United States accounted for about 30 percent, a pattern that was briefly disrupted by the COVID-19 crisis. In 2021, intra-regional trade made up about 40 percent of the region’s total trade, the highest share since 1990.

Drivers of intra-regional trade in East Asia are shifting 

Initially, much of East Asia’s intra-regional trade integration was driven by rapidly growing intra-industry trade, which in turn reflected the spread of cross-border global value chains with greater vertical specialization and geographical dispersion of production processes across the region. This led to a sharp rise in trade in intermediate goods among economies among emerging economies in Asia, while the EU, Japan, and the United States remained the main export markets for final goods. Think semiconductors and other computer parts being traded from high-wage economies, like Japan, Korea, and Taiwan, China for final assembly to lower-wage economies, initially Malaysia and China and more recently Vietnam, with final products like TV sets, computers, and cell phones being shipped to consumers in the U.S., Europe, and Japan.

The sources of global demand have been shifting. Intra-regional trade no longer primarily reflects shifts in production patterns but is increasingly underpinned by changes in the sources of demand for exports of final goods. With rapid income and population growth, domestic demand growth in emerging East Asia has been strong in recent years, expanding by an average of 6.4 percent, annually over the past ten years, exceeding both the average GDP and trade growth during that period. China is now not only the largest trading partner of most countries in the region but also the largest source of final demand for the region, recently surpassing the U.S. and the EU. Export value-added absorbed by final demand in China climbed up from 1.6 percent of the region’s GDP in 2000 to 5.4 of GDP in 2021. At the same time, final demand from the other emerging economies in East Asia has also been on the rise, expanding from around 3 percent of GDP in 2000 to above 3.5 percent of GDP in 2021. While only about 12 cents of every $1 of export value generated by emerging economies in Asia in 2000 ultimately met consumer or investment demand within the region, today more than 30 cents meet final demand originating within emerging East Asia.

Figure 1. Destined for Asia

Source: OECD Inter-Country Input-Output (ICIO) Tables, staff estimates. Note: East Asia: EM (excl. China) refers to Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Thailand, and Vietnam.

These shifting trade patterns reflect dramatic shifts in the geography and makeup of the global consumer market. Emerging East Asia’s middle class has been rising fast from 834.2 million people in 2016 to roughly 1.1 billion in 2022. Today more than half of the population—54.5 percent to be precise—has joined the ranks of the global consumer class, with daily consumer spending of $12 per day or more. According to this definition, East Asia accounted for 29.0 percent of the global consumer-class population by 2022, and by 2030 one in three members of the world’s middle class is expected to be East Asian. Meanwhile, the share of the U.S. and the EU in the global consumer class is expected to decline from 19.2 percent to 15.8 percent. If we look at consumer-class spending, emerging East Asia is expected to become home to the largest consumer market sometime in this decade, according to projections, made by Homi Kharas of the Brookings Institution and others, shown in the figure below.

Figure 2. Reshaping the geography of the global consumer market

Figure 2

Source: World Bank staff estimates using World Data Pro!, based on various household surveys. Note: Middle-class is defined as spending more than $12 (PPP adjusted) per day. Emerging East Asia countries included in the calculation refer to Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Thailand, Vietnam, and China.

Intraregional economic integration could act as a buffer against global uncertainties  

Emerging economies in Asia are known to be the factories of the world. They play an equally important role as rapidly expanding consumer markets which are already starting to shape the next wave of intra-regional and global trade flows. Policymakers in the region should heed this trend. Domestically, policies to support jobs and household income could help bolster the role of private consumption in the steady state in some countries, mainly China, and during shocks in all countries. Externally, policies to lower barriers to regional trade could foster deeper regional integration. While average tariffs have declined and are low for most goods, various non-tariff barriers remain significant and cross-border trade in services, including in digital services remains particularly cumbersome. Multilateral trade agreements, such as ASEAN, the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), and the Regional Comprehensive Economic Partnership (RCEP) offer opportunities to address these remaining constraints. Stronger intraregional trade and economic integration can help diversify not just supply chains but also sources of demand, acting as a buffer against uncertainties in global trade and growth.

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International

Air pollution can increase the risk of COVID infection and severe disease – a roundup of what we know

Air pollution can increase COVID risk by weakening our immune defences and exacerbating underlying health conditions.

Published

7 hours ago

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March 20, 2023

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Tatiana Grozetskaya/Shutterstock

The early part of the COVID pandemic led to a significant reduction in air pollution in many parts of the world. With lockdowns, travel restrictions and decreased economic activity, there was a noticeable drop in the emission of air pollutants, such as nitrogen dioxide (NO₂) and particulate matter (PM) that is fine enough to be inhaled.

Changes in air pollution varied depending on the location and the type of pollutant, but reductions were particularly noticeable in cities and industrial areas, where emissions from transport and industrial activities are typically high. In many areas though, air pollution levels quickly increased again as restrictions eased and activity resumed.

Along with having harmful effects on the environment, it’s well established that air pollution can have negative effects on human health, including increasing the risk of respiratory and heart problems and cancers. Emerging research suggests air pollution may also affect the brain and be linked to certain developmental issues in babies. The severity of these health effects can depend on the type and concentration of pollutants, as well as individual factors that affect a person’s susceptibility.

While there has been much focus on the way the pandemic affected air quality, it has also become apparent that air quality affects COVID risk – both in terms of the likelihood of contracting COVID and how sick people get with the infection.

How does air quality increase COVID risk?

Research has shown that long-term exposure to air pollution, particularly fine particulate matter under 2.5 micrometres (PM2.5) and NO₂, may increase the risk of COVID infection, hospitalisation, and death.

A study in England, for example, showed long-term exposure to PM2.5 and NO₂ is associated with 12% and 5% increases in COVID cases, respectively, for every additional microgram of PM2.5 or NO₂ per cubic metre of air.

One of the primary ways that air pollution may increase the risk of COVID is by weakening the respiratory system’s defences against viral infections. We know long-term exposure to fine particulate matter that is inhaled can reduce the lungs’ immune responses and cause damage to them, which can make people more vulnerable to respiratory infections like COVID.

Read more: Long COVID linked to air pollution exposure in young adults – new study

Air pollution can also impact the immune system’s ability to fight off viral infections. Exposure to particulate matter, such as PM2.5, has been linked to increased levels of cytokines and inflammation in the body.

Cytokines are signalling molecules that help the immune system fight infections. But high levels can cause a “cytokine storm”, where the immune system overreacts and attacks healthy cells in addition to the virus. Cytokine storms have been associated with severe COVID and a higher likelihood of dying from the disease.

And notably, COVID binds to ACE2 receptors to enter a cell. In studies of animals, PM2.5 exposure has been linked to a significant increase in ACE2 receptors. PM2.5 may therefore increase the probability of COVID entering cells in humans.

A crowd of people walking a New York street wearing masks.
There are a variety of factors which could explain why air pollution increases COVID risk. blvdone/Shutterstock

Further, air pollution may increase the severity of COVID symptoms by exacerbating underlying health conditions. Exposure to air pollution has been linked to increased rates of conditions such as diabetes and heart disease, which have been identified as risk factors for severe COVID.

Air pollution may also increase COVID transmission rates by acting as a carrier for the virus. Researchers continue to debate the potential of respiratory droplets from infected people attaching to particulate matter in the air and travelling long distances, potentially increasing the virus’s spread.

How can I reduce exposure to air pollutants?

With all this in mind, reducing air pollution levels may be an important strategy for mitigating the impact of COVID and protecting public health.

This requires a combination of individual actions and collective efforts to address the sources of pollution. There are several ways you can decrease your and others’ exposure to air pollution, including:

Limit outdoor activity during high-pollution days. Check air quality forecasts and limit outdoor activities on “high” days. Try to go outside at times of the day when pollution levels are lower, such as early morning or late evening.

Think about your mode of transport. Using public transport, walking or riding a bike instead of driving can help to reduce pollution levels. If you do drive, try to carpool or use an electric or hybrid vehicle.

Read more: Wuhan's lockdown cut air pollution by up to 63% – new research

Use indoor air filters. Having air filters in your home can help reduce indoor pollution levels. Hepa filters can remove many pollutants, including fine particulate matter. Further, the use of Hepa air systems can successfully filter COVID virus particles from the air.

Samuel J. White advises on air quality and receives funding from Fédération Equestre Internationale.

Philippe B. Wilson does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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