Adapting to a higher-for-longer world

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Now that interest rates are at, or near, their peak, attention has turned to how long they will stay elevated. Central bankers, wary of being complacent on inflation, have united behind a mantra of “higher for longer”. Huw Pill, the Bank of England’s chief economist, even chose to compare the UK’s likely rate path to Cape Town’s Table Mountain, with its high, flat top. That reality — reinforced by Friday’s strong US jobs data — is unnerving investors. In recent weeks, stock markets have tumbled, and long-term bond yields have soared.

Economies have, so far, demonstrated resilience in the face of higher rates. But as post-pandemic cash buffers wind down and loans locked in at low rates expire, businesses and households will be squeezed more in the coming months. Rising bond yields threaten deeper turmoil, while slowdowns are already expected across the US and Europe next year. Indeed, with inflation on its way down, having fallen from 40-year highs, rates will eventually need to be cut. Yet hoping that the cost of credit will plunge back to the lows experienced after the financial crisis is foolish.

Structural economic changes could keep price pressures — and interest rates — higher in the long term. Rising protectionism means globalisation may not be the deflationary force it once was. Spending on the climate transition, ageing populations and defence means fiscal policy will continue to prop up demand. A greying workforce will add to existing labour shortages. For the coming years at least, policy rates are set to remain raised: Fitch Ratings forecasts the US Federal Reserve, European Central Bank and BoE to end 2025 with rates between 3 and 3.5 per cent. The shift away from a diet of cheap money will have significant economic implications.

Governments face tough choices. They enter the higher-rate era with both public debt and demands on spending having ballooned. A higher proportion of revenues will be lost to interest payments. Cutting back on public services or raising taxes, however, remains politically toxic. Something will have to give. Further signs of fiscal profligacy are likely to be punished by bond markets trying to digest both new issuance and the unwinding balance sheets of central banks.

Financial conditions will remain volatile. Hidden pockets of leverage, particularly in hedge funds and private capital markets — which may not have anticipated higher medium-term rates — are an ongoing systemic concern. Higher interest rates could nonetheless return some discipline to markets, in contrast to the past decade’s search for yield which led to the emergence of complex and dodgy financial assets, from cryptocurrency to risky corporate loans.

It will feel like a different world for businesses and households. Many of the zombie firms that were kept alive by low-rate loans are unlikely to survive. Bankruptcy filings in the US this year are on course to reach among their highest in more than a decade, and have surged in the eurozone too. While this may support productivity, some innovative start-ups may miss out as investors raise their due diligence standards. Below-cost pricing strategies used by Netflix, Uber and Deliveroo — darlings of the free cash era — will be less feasible.

Corporates will face consumers with tighter pockets. Higher loan payments, and greater rewards for saving, will squeeze spending. The relentless upward march of house prices over the past decade is also likely to slow due to costlier mortgages. The UK and eurozone have already posted annual house price drops. Supply limitations will avert a crash, but that still means little reprieve for first-time buyers.

With productivity languid, and the green transition behind schedule, future generations will no doubt lament the squandering of low interest rates on streaming services, fast food delivery apps and inflated house prices. The new normal will feel unfamiliar. But it was the prior decade of rock-bottom rates and endless liquidity that was the aberration.

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