The $300 trillion question – The Washington Post

Lijaya Kelly worries that her pet shelter facility in suburban Los Angeles won’t survive the winter if loan costs continue to rise. Economist Diana Musina says she will have to sell her investment property in Sydney if interest rates remain high. John Stanier has scaled back plans for his holiday park in northern England after his mortgage repayments almost tripled.

Like millions of borrowers around the world, the aspirations of Kelly, Mussina and Stanier have collided with the sharpest monetary policy tightening campaign in a generation. They’ve done what they can to weather the storm — Kelly has cut workers, Mussina is eating dinner at home these days, and Stanier’s expansion plans are on hold — but how long they can weather it will depend on factors beyond their control, such as declining globalization, aging, and the cost of the energy transition.

This is arguably the biggest question in economics right now: Are these high interest rates here to stay? In school terminology, it all comes down to R-Star (written as R* in economic models) – the long-term neutral interest rate that keeps inflation stable at the central bank’s preferred pace of around 2%.

In the decade or so following the 2008 financial crisis, the neutral rate fell in all advanced economies as inflation remained generally weak even as central banks kept interest rates at historically low levels. Deepening globalization meant cheap televisions and clothes, while memories of the crisis kept consumers in check and prevented companies from investing, reducing demand.

The post-Covid price rise has shattered this calm, sparking debate among economists, central bankers and bond traders about the future of inflation and interest rates – with very real implications for a world burdened by some $300 trillion in debt. If central banks conclude that R* is higher now, they will need to keep benchmark interest rates high as well.

Anna Wong, chief U.S. economist at Bloomberg Economics, recently released numbers on what varying estimates of the neutral interest rate will mean for policy settings at the Federal Reserve, which meets later this week. It found that a higher neutral rate would lead to smaller interest rate cuts in the next two years.

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

Now, with the Fed raising interest rates by 5.25 percentage points over the past year and a half, those premiums are at nearly $12,000 a month, and the outlook is bleak.

“High interest rates are killing me,” says Kelly, who runs the kennel with her husband and adult children. “I have to find ways to reduce this because if we don’t, we won’t be able to survive another winter.”

Kelly laid off two employees, reduced hours for others and ordered services such as bookkeeping. The busy summer travel season has provided some relief, but she worries that interest rates will continue to rise and is formulating next year’s budget assuming higher payments, though she hopes they won’t exceed $15,000 a month.

About 2,300 miles east, in the Federal Reserve’s spartan offices in Washington, D.C., officials are not ruling out more pain in interest rates for Kelly and her dog breeders. In an August speech at the central bank’s annual economic symposium in Jackson Hole, Wyoming, Chairman Jerome Powell noted that interest rates were likely to remain high for some time, or even rise, if inflation remained steady.

Because of failures in analysis and communication that led to false calls that inflation would be transitory as rates rise in 2021, Fed officials these days are offering little when it comes to their view on longer-term interest rates. Powell led officials to say it was too early to say exactly where inflation and interest rates will land once the economy returns to normal.

As deputy chief economist at financial giant AMP, Mussina, 35, is in a good position 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, Mussina now says most of her income goes toward mortgage payments on her house and condo, leaving little room for “fun expenses” like vacations and dining out.

“It will make it more difficult for me to hold on to it,” if benchmark interest rates remain at around 3-4% for a long time, Musina said from Maroubra Apartment. “If we get to a point where I can no longer service the loan, I will sell it.”

In contrast to America, where most home borrowers rely on 30-year fixed interest rates, more than 70% of home loans in Australia are linked to variable interest rates that move largely in line with central bank levels. With household debt on average at about 190% of disposable income, every RBA interest rate increase has exacerbated the pain for mortgages.

Former governor Philip Lowe, whose seven-year term was not extended amid criticism of his failed communications as inflation rose, weighed in on the debate in his final speech as RBA chief on September 7, saying it would be difficult to return to the RBA. Days of low and steady inflation.

“The greater prevalence of supply shocks, de-globalization, climate change, energy transition, and shifts in demographics mean either steeper supply curves or more variable supply curves,” he said. “While this does not mean that the inflation target cannot be achieved on average, it does mean that inflation is likely to be more volatile around that target.”

This debate is particularly relevant in the UK, which has seen some of the highest inflation rates among major economies in the wake of Covid. Stanier, owner of Holiday Park, saw the first virus shutdown in 2020 as an opportunity to expand his business. As holiday lodge prices fell, he snapped up a few more homes, adding to his collection set across a range of fields in picturesque Cumbria.

Three years later, Stanier believes it may be some time before he can invest in expansion again. He mortgaged his house and took out a loan to generate the funds needed to build the Wallace Lane farm, and the cost of that debt rose.

“A few years ago, repayments were about £280 a month,” says Stanier, 59, of his variable-rate mortgage. “Now their numbers have almost tripled.”

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

Older demographics lead to the storage of wealth in the economy as people tend to save throughout their working lives. At the same time, lower productivity has led companies to invest less. This meant that “older households sought to lend more while less productive firms sought to borrow less,” Bailey concluded, and the only way to “establish equilibrium” was “the price of that money, the real interest rate.” “to fall or fall.”

However, other economists use some of these same factors, including population aging, to argue just the opposite. In a recent mid-year forecast, economists at asset management giant BlackRock opined that the demographic shift could be inflationary because there will be fewer working-age people, causing a supply squeeze.

Economist Charles Goodhart has another theory, which he presented in his 2020 book The Great Demographic Reversal, co-authored with Manoj Pradhan. He says that as the population ages, savings rates will slow as fewer people save money into pensions. He says that in order to stimulate saving to finance investment, interest rates must be higher.

Back in Cumbria, Stanier says he has lived through periods of high interest rates before, having worked in small, family-run businesses since the 1980s. But this time he is concerned that the business environment will make it difficult to cope with higher repayments.

He says high interest rates “make expanding a business much more difficult, much more expensive, and much more risky than it was before.” “I, like many others, have scaled back my expansion plans because I am not willing to bet the company on the possibility that the economy will do well in the next few years.”

More stories like this are available at bloomberg.com

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