Thursday , 18 August 2022

Hang Tight: We Will See Interest Rate Cuts In 2023! Here’s Why

Inflation rates are currently climbing to one multi-decade high after another and leading central banks are responding by raising interest rates at an ever-increasing rate. However, given the record high inflation, real interest rates are still clearly negative, giving the impression that the current global cycle of interest rate hikes is far from reaching its end but this consensus assessment will prove to be wrong . The current cycle of interest rate hikes could go down in history as the shortest and weakest in recent decades. Here’s why.

This article has been sourced from an article by  Ronni Stoeferle (goldswitzerland.com) and has been edited ([ ]) and abridged (…) for the sake of clarity and brevity to provide the reader with a faster and easier read.

1. Economic activity is slowing.

No matter what data is analyzed, the economic outlook is increasingly gloomy:

  • Commodity markets have retreated significantly from their interim highs up to mid-July.
  • Technically, the U.S. is already in recession.
  • Growth-rate projections are being revised downward around the world.
  • U.S. consumer confidence is at the lowest level in its 70-year reporting history.
Sinking consumer sentiment hints that interest rate cuts are around the corner.

2. There are no structural reasons why the state of the global economy should be better now than before the outbreak of the pandemic.

Even if the global economy were able to return to the growth levels seen before the pandemic, this would be a continuation of a fundamental downward trend. The Federal Reserve’s three rate cuts in the second half of 2019 attempted to combat this downward trend.

3. Interest rate increases are hardly digestible for the highly indebted countries.

…Another development stands against significant interest rate hikes. In the 1970s, record-high inflation was fought with strong interest rate hikes with the Federal Reserve raising its key interest rate to 20% by March 1980 but, back then, however, debt was significantly lower than it is today.

  • In the U.S., government debt in the 1970s was around 35% of GDP; today it is about 125%.
  • Corporate debt fluctuated around 50% of GDP in the 1970s; today it is almost 80%.
  • Household debt increased slightly in the 1970s but was less than 50% of GDP; today, by contrast, household debt stands at more than 75% of GDP.

At more than 275% of GDP, U.S. total debt today is more than twice as high as in the 1970s. As a result, interest service will soon become a problem for the United States, as confirmed by calculations of the Congressional Budget Office.

  • By 2024, interest service will still ease slightly from the current 1.4% of GDP to 1.1%, despite huge budget deficits in 2020 and 2021 of more than 10% each.
  • Starting in 2024, though, interest expense as a share of GDP begins to rise, reaching 8.6% in 2051 in the CBO’s baseline scenario. This would require just under one-third of tax revenues to be spent on interest service alone. This calculation is based on the assumption that the yield on 10-year U.S. Treasuries increases to 3.3% in 2030 and to 4.9% in 2050. This would be a rather moderate increase by historical standards…The assumed real growth rates of just over 1.6% per year on average may also prove too optimistic and exacerbate the problem…

4. Debt relief through inflation is counteracted by an increase in government spending.

It is one of the supposed standard wisdoms that states can deleverage themselves in phases of high inflation, however, this…debt relief works only as long as government spending grows more slowly than the inflation rate. Increases in transfer payments below the inflation rate are thus a simple and obvious instrument for deleveraging through inflation, but at the expense of the weaker members of society. To put it bluntly, transfer recipients restructure the state budget by being forced to forego consumption as a result of a real decline in transfer payments.

However, this automatism is not as strong as it may seem at first glance. Statutory inflation adjustments may diminish this effect. In the U.S., for example, the automatic increase in payments of Old-Age, Survivors and Disability Insurance (OASDI) in line with the CPI is required by law. Similarly, additional spending or tax cuts to combat the effects of inflation lessen the debt-reduction effect of inflation…

Above a certain level of inflation, the debt-relief effect of inflation on government budgets is even reversed. This is because real tax revenues erode with rising inflation…This fiscally significant phenomenon is known as the Tanzi effect…but the argument against this approach is that countless packages of measures to combat inflationary consequences have already been adopted – and many more will follow. Consequently, the (government) debt burden will not decline markedly and the scope for interest rate hikes will remain limited.

5. Markets are already pricing in interest rate cuts.

Markets have already realized that central banks have little room for maneuver. For the U.S., markets currently expect the first interest rate cuts, averaging 60 basis points, as early as the second quarter of 2023.

Conclusion

The cycle of interest rate hikes will therefore come to an end before it has really begun… 

 

 

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