Why US, UK and Europe should not
increase interest rates
Economists Predict, further rate increases by Central banks
of US, UK And Europe. The inflation level in US is down and in Europe/UK ,
inflation is still at a higher level. The reasons attributed in Europe and UK ,are
higher Gas prices and increased food prices. These Economies are growing very
slowly and keeping interest rates at high levels have several Consequences to
the various stake holders in these Economies and to the Global Economy.
To contain inflation, Central Banks are adopting Traditional
theories and embarked on a interest rate hiking cycle. Whereas most of the
time, the inflation seen today is due to Supply side factors and paucity of
supply. When commodity prices are softening, it is surprising to note that in
UK and Europe , Inflation is still at higher levels. The following factors
should be taken into account while setting the interest rates.
1.
Reduced
GDP growth. Interest rates in the Economy decide the competitiveness of factors
of production. When interest rates are high, the cost of factors of production
are also high , which results in lower demand and lower production for goods.
This results in reduced GDP growth. When there is a good growth, it lifts many
people out of poverty. When the growth comes down, it affects people who are
from Low Income house holds. The GDP projections for these countries are not
encouraging.
2.
High
Probability of Recession. The recent studies have predicted that the
probability of recession is very high in
countries where the interest rates are going up. Technically in two quarters,
if there is a negative growth, recession sets in . Recession has its own side
effects .
3.
Increase
in cost of developing Infrastructure / Long Gestation Projects. There is a large budget for revamping the infrastructure
in US. This will increase the cost of projects. The projects with long
gestation periods will see a steep increase in interest cost during
construction, thereby increasing the overall project cost.
4.
Increase
in EMI for Consumer loans. Today People borrow money for Housing , Consumer
Durables and even Consumer items on EMI. In case of Mortgages, they take long
tenure loans. Many a times , they take a floating rate loan. We had a big
global crisis resulting from Mortgage defaults on account of increase in interest rates.
5.
Increase
in Cost of borrowing by Governments. After Covid, the Governments have borrowed
lot of money and the government debt has increased by leaps and bounds. In an
Economy, one of the major borrowers is Government. Increase in interest rates,
increase the cost of borrowing by Governments.
6.
Erosion
in value of Government Bonds held by Banks and others. After the 2008 Economic
Crisis, Banks around the world was investing more in Government bonds to reduce
the risk. As far as interest rate was showing a decline, banks can witness
capital gains on the bonds. When, interest rates rise, the value of bonds held
by Banks witness a big erosion. The recent Bank failures in US and Europe are
only indicators. The Financial Stability reports by Central Banks present a good
picture. But bonds held to maturity , do not show the stress signals. Many
banks in these countries have unrealised losses and if HTM bonds are taken into
consideration, the level of stability measured would come down.
7.
Consumer
price Increase. The increase in price of factors of production pressures the
Producers to increase the price of Products. This results in increased Consumer
Price Inflation. The most affected segment of the society is those who are able
to barely meet the basic needs.
8.
Increased
inflow of funds to these countries / Appreciation of Currency. Dollar is the
most preferred currency for international trade and Global capital flows.
Whenever a country increases interest rates, investment in the country become
very attractive. The country starts witnessing inflow of funds.
9.
Loss
of Export Competitiveness. The increased inflow of funds results in currency
appreciation results in loss of Export Competitiveness. In fact ,few countries
in the world keep their currency weak, so that the exports are competitive.
10.Capital outflows from Developing markets. During the last
Financial crisis, when US was not giving guidance on the indicators for raising
interest rates, there was an uncertainty and funds started exiting from the
Emerging markets. Now , most of Central Banks have set guidance for target for
Parameters in deciding the interest rates. In this interest rate hiking cycle,
the fund outflow was not very severe but still, there was an outflow of funds
from few countries. Some of the emerging countries saw an erosion in their
exchange rate which resulted in Economic Crisis.
11.Increased Global Financial Instability. The global financial
crisis, started with one company, one country ,then affected the whole world.
The Central banks and Financial Institutions
learnt a lot from the crisis, which helped them to manage the Crisis
during the COVID period.
12.Reduced Global trade. Movement of Goods and services across
the world depends on Prospects for Economic Growth in Developed countries. When
there is a lower Economic growth, it results in lower domestic demand and lower
demand for imported goods. Coupling with increased protectionism affects the
Global trade and Global Capital Flows.
What the Central Banks / Governments should do.
They should stop the increase in interest rates. The increase
in interest rates so far has taken the interest rates to vey high levels
considering the potential Economic growth in these Economies. Instead of
focussing on Inflation, the focus should be on increasing the Economic Growth. Like
the targets set for Inflation, now the Countries should set targets for
Economic Growth and work backwards to develop the Sectoral Development Plans.
For the next two years increase the target for inflation.
After the last financial crisis, Many Central banks have set the target for
Inflation and said, the main focus is on inflation. The inflation today is due
to extraordinary factors and the targets set last time are difficult to
achieve. Like in the last financial crisis, there was a relaxation in valuation
of investments by banks, this time, Inflation targets could be increased
between 100 to 200 bps based on each Country’s Position today.
Review the basket of Goods and Services included in the
calculation of Inflation and make necessary changes in the composition of index
. We are living in a service Economy and contribution of manufacturing is much
smaller than contribution of services. Further the consumption pattern of goods
and services by the Population has undergone a significant change. The basket
of goods and services could be carefully
reviewed and The indices could be recast to reflect the reality.
Manage the Demand and Supply side factors to keep the prices
of essential goods in control. This time , the higher inflation is due to
supply factors, disruption in supply chains due to Covid and Geo political
tensions. Measures have to be identified to reduce the Demand Supply Gap and
management of optimal inventory in various sectors.
Focus on Geo Economics and reduce the focus on Geo politics.
In the last three years, tensions due to Geo Politics was leading to disruption
in supply chains and shortages of goods and services for production. Geo
political tensions generally results in loss to both the parties. Underplaying
Geo Politics and emphasising on Geo Economics is Good for the entire Global
Economy.
By R.Kannan
Corporate and Economic Advisor
rajakannan@rediffmail.com
