No more normal now - the threat of rising interest rates

Since the 2008/9 recession, western world governments have reduced and maintained interest rates at exceptionally low levels. We can call them exceptionally low because, in most countries, they are at their lowest rate in living memory and are close to zero. Indeed, the ‘lower bound of interest rates’ (the zero rate) is one that has exercised the minds of economists: could rates be reduced even lower, to become significantly negative, thereby encouraging holders of cash to either invest it or spend it? Either would add to economic growth, which is what is desperately needed. Not content with taking rates to zero, the ECB was the first major central bank to introduce negative interest rates with a deposit rate of -0.1% in June 2014, followed by the Swiss central bank the following year, and by the Japanese central bank in January 2016. In the early years after the 2008/9 recession, economists continued to produce forecasts that interest rates would rise in about 18 months’ time. As these forecasts were regularly updated, the time of the forecast rate rise was typically 18 months from the date of the new forecast. At the same time, the mantra of central bankers – led by the US and the UK – is that they are ultimately seeking a ‘normalisation of interest rates’. By this, they do not mean a return to the interest rates of the 2000s – which were also apparently ‘abnormal’, albeit not as abnormal as they are now – but more to a rate known as the ‘natural’ or ‘neutral’ rate, which economists used to believe was around 5%, although the belief was forming that the ‘natural’ rate had become lower than that. According to the Financial Times in 2014, Morgan Stanley believed, however, that the normal rate had reduced to around 3%, although this is probably a US perspective. Charlie Bean, ex-Bank of England, also believed that, for the UK, a rate of around 3% would be a reasonable target. Many others would argue that the eurozone ‘natural’ rate is now even lower, particularly as it tends to be less inflation-prone. As western world economies produced reasonable growth from, say, 2015 onwards, the mantra become one of the ‘new normal. Interest rates of close to zero may not be permanently that low, but the expectation was that they would not revert to the 3% to 5% that was considered the ‘normal’ historically. Central banks still wanted to raise rates, even if only because of the slightly bizarre logic that unless they were raised significantly above zero, it gave thenm no leeway to reduce them when the next recession occurred - which surely must be getting closer. Nevertheless, there appeared to be no ability to raise interest rates. Inflation, which was the usual target for setting interest rates, remained elusively below central banks’ target rates and the other objective, of ensuring financial stability or reasonable economic growth, was typically only barely being achieved. The reality is that we had become used to very low interest rates for the best part of 20 years. When we did last raise them, in the period 2006/7, the act itself was a prime factor in the subsequent banking crisis and recession. Given that the pandemic has caused, or perhaps triggered, a global recession, it has become difficult to imagine that they will be raised soon. In property, we mainly think of low interest rates as being beneficial, in that they reduce the cost of debt and, therefore, the cost of capital, thereby improving returns. We dismiss the downside risks, particularly when property values are rising, as being more the concern of the lending banks. But, to central banks, this benefit to property assets is fairly incidental or, in some cases, an unwanted side-effect. What they really want is for businesses to borrow to invest in projects to grow economic activity. That typically has not happened. Businesses have had serious difficulty in finding investments that produce positive real rates of return, even with interest rates close to zero. Indeed, they have been sitting on strong cash-reserves in their balance sheets – even if some of that cash is locked in offshore locations – and have been trying to find a use for it, such as buying back their own shares (enhancing profits per share, but effectively shrinking the company) or taking over other companies (generating a wave of M&A activity). This lack of a genuine economic benefit for low interest rates is just another reason why central banks would like tio raise them again - if such rises could be achieved without damaging the limited economic growth that had been occurring prior to the pandemic. There is, however, a growing risk on the near-term horizon. With the election of President Biden in the US, there is now an expectation that an economic stimulus package will be voted through Congress. Unlike most previous stimulus, which favoured investment capital, the proposals include cash being distributed to the poorer households who, with an high propensity to consume, are expected to generate sufficient short-term demand for consumer products that inflation starts to rise. A further factor, particularly in the US, is that one reason why inflation in the western world has been constrained for so long is that China has effectively been exporting deflation in manufactured goods, particularly technological products such as mobile ‘phones and entertainment systems. There are some signs that that defaltionary effect is reducing, partly because of sanctions by the SS. But the rise in inflationary pressure will undoubtedly be accompanied, in the western world, by the return of economies to more ‘normal’ levels of economic activity as vaccine programmes very significantly reduce the number of excess deaths cause by Covid-19. The combination of these two events could prove lethal to central banks’ inflation targets, albeit that the EU will be lagging in the economic recovery and it may be some time before the ECB needs to respond. A rise in interest rates would have a very negative impact on the commercial real estate markets. Lending banks have become increasingly cautious about the security offered by property assets and have been either withdrawing from certain segments of the market or increasing their margins. The addition of central banks’ interest rate rises in an asset class that is so very dependent on debt finance to produce adequete returns would normall cause investment yieklss to rise and asset values to fall. But asset values have already been falling (or at lthe least, not rising by much) and this would cause some downward repricing in the sector.