The $300 Trillion Question

Lucy White, Catarina Saraiva and Swati Pandey
Sun, September 17, 2023

(Bloomberg) -- Ligaya Kelly worries her pet boarding facility on the outskirts of Los Angeles won’t survive the winter if loan costs keep rising. Economist Diana Mousina says she’ll have to sell her Sydney investment property if interest rates remain higher. John Stanyer has cut back plans for his holiday park in the north of England after his mortgage repayments almost tripled.

Like millions of borrowers across the world, the aspirations of Kelly, Mousina and Stanyer have collided with the steepest monetary tightening campaign in a generation. They’ve done what they can to weather the storm – Kelly has cut workers, Mousina dines at home these days and Stanyer’s expansion plans are on hold -- but how long they can hold out will depend on factors beyond their control, such as deglobalization, aging and the cost of the energy transition.It’s arguably the biggest question in economics right now: Are these higher interest rates here to stay? In textbook jargon, it all comes down to R-Star (written as R* in economic models) -- the long-term neutral interest rate that keeps inflation steady at central bank’s preferred pace of around 2%.

In the decade or so after the 2008 financial crisis, the neutral rate dropped across developed economies as inflation remained generally subdued even as central banks kept interest rates at historically low levels. Deepening globalization meant cheap TVs and clothes, while memories of the crisis kept consumers subdued and held businesses back from investments, putting a lid on demand.

The post-Covid price spike shattered that calm, spurring a debate among economists, central bankers and bond traders about the future of inflation and interest rates – with very real implications for a world saddled with about $300 trillion in debt. If central banks conclude that R* is now higher, then they'll need to keep their benchmark rates more elevated too.

Anna Wong, chief U.S. economist for Bloomberg Economics, recently ran the numbers on what varying estimates of the neutral interest rate would mean for policy settings of the Federal Reserve, which meets later this week. She found a higher neutral rate would result in fewer interest-rate cuts in the next couple of years.

Kelly was paying about $7,000 a month in interest when she first took her Small Business Administration loan back in 2018 to expand a dog and cat kennel in Santa Clarita, California. The business had good prospects and pedigree — it was founded in the 1970s by the son of a famed trainer whose dog Terry starred alongside Judy Garland in the Wizard of Oz.

Now, after the Fed’s 5.25 percentage points of interest-rate hikes over the past year and a half, those repayments are almost $12,000 a month and the outlook is bleak.

"Rising interest rates are killing me," says Kelly, who runs the kennel with her husband and adult children. "I have to find ways to cut this because if we don’t, we’re not going to survive another winter."

Kelly has laid off two employees, reduced hours for others and dialed back on services like bookkeeping. A busy summer travel season has given a bit of a cushion, but looking ahead she’s worried interest rates will keep rising and is drafting next year's budget assuming higher payments, though she hopes they won't exceed $15,000 per month.

Some 2,300 miles east, at the austere Fed offices in Washington DC, officials aren’t ruling out more rates pain for Kelly and her kennel. In an August speech at the central bank's annual economic symposium in Jackson Hole, Wyoming, Chair Jerome Powell signaled that interest rates will likely stay high for some time, or even move higher, should inflation remain sticky.

Seared by the failure in analysis and communication that led to erroneous calls that inflation would prove transitory as prices spiked in 2021, Fed officials these days aren’t giving much away when it comes to their longer-term rates view. Powell has led officials in saying it’s too early to tell exactly where inflation and rates will settle once the economy normalizes.

As deputy chief economist at financial giant AMP Ltd., 35-year-old Mousina is doing OK for herself. In August 2016, with official interest rates recently cut to 1.5%, she jumped into the investment property game, buying a two-bedroom apartment near Maroubra beach in Sydney’s south.After 4 percentage points of interest-rate increases since May 2022, Mousina now says most of her income is going toward mortgage repayments on her home and the apartment, leaving little room for "fun expenses" such as holidaying and eating out.

"It's going to make it harder for me to keep it," if benchmark interest rates stay around 3-4% for an extended period, said Mousina of the Maroubra apartment. "If we're at a point where I can't continue to service the loan on it I will sell it off."

In contrast with America, where most home borrowers are on 30-year fixed rates, more than 70% of home loans in Australia are tied to variable rates that move largely in line with central bank levels. With household debt averaging about 190% of disposable incomes, each of the Reserve Bank of Australia’s interest-rate hikes has ratcheted up the pain on mortgagees.

Former Governor Philip Lowe, whose seven-year tenure wasn’t extended amid criticism of his communication failures as inflation surged, weighed in on the debate in his final speech as RBA chief on Sept. 7, saying it’ll be difficult to return to the days of low and steady inflation.

“The increased prevalence of supply shocks, deglobalisation, climate change, the energy transition and shifts in demographics mean either steeper supply curves or more variable supply curves,” he said. “While this doesn’t mean that the inflation target can’t be achieved on average, it does mean that inflation is likely to be more variable around that target.”

The debate is especially relevant in the UK, which has seen some of the highest rates of inflation among major economies in the wake of Covid.Holiday park owner Stanyer saw the first virus lockdown in 2020 as an opportunity to scale up his business. As the price of vacation lodges fell, he snapped up a couple more, adding to his collection nestled across a cluster of fields in the picturesque county of Cumbria.

Three years on, Stanyer thinks it could be some time before he’s able to invest in expansion again. He’s mortgaged his house and taken out a loan to generate the cash with which to build Wallace Lane Farm, and the cost of that debt has surged.

“A few years ago repayments were about £280 a month,” says Stanyer, 59, of his variable-rate mortgage. “Now they’ve almost trebled.”

A March speech at the London School of Economics by Bank of England Governor Andrew Bailey may have given Stanyer some hope. Bailey said it wasn’t unreasonable to expect the UK’s neutral interest rate would “remain low” due to weak productivity and an aging population.

Older demographics lead to wealth being stored in the economy as people tend to save throughout their working life. At the same time, lower productivity has caused companies to invest less. This means “ageing households have sought to lend more at a time when less productive firms have sought to borrow less,” Bailey concluded, and the only way to “establish an equilibrium” is for “the price of those funds, the real interest rate, to fall.”

Yet other economists are using some of those same factors, including an aging population, to argue the exact opposite. In its recent midyear outlook, economists at asset management giant Blackrock reasoned that the demographic shift could be inflationary because there’ll be fewer people of working-age, causing a supply squeeze.

Economist Charles Goodhart has yet another theory, advanced in his 2020 book `The Great Demographic Reversal,’ co-authored with Manoj Pradhan. As the population gets older, he argues, saving rates will slow as fewer people hoard money into a pension. In order to incentivize saving to fund investment, interest rates will need to be higher, he says.

Back in Cumbria, Stanyer says he’s lived through periods of higher interest rates before, having worked in small and family-run businesses since the 1980s. But he’s worried that, this time round, the business environment will make it more difficult to cope with higher repayments.

Higher rates “makes expanding the business very much more difficult, very much more expensive, and very much more risky than it once was,” he says. “I, like many others, have cut back on my plans for expansion because I'm not willing to bet the company on the chance that the economy will do well in the next few years.”

Bloomberg Businessweek