How much higher will interest rates go?
The main issue in the financial markets lately has been the rise in interest rates. The two main culprits are higher oil prices and prices of petroleum products, as well as better-than-expected growth figures. The combination of these two factors is driving up inflation expectations, while inflation remains above the Fed’s and the ECB’s targets. The key question is at what interest rate level inflation will fall to or below 2%. In this regard, several factors must be taken into account.
First, the role of so-called secondary effects. This refers to the fact that the current rise in inflation is not so much caused by excessively strong demand growth, but primarily by reduced supply (in this case, of oil, gas, fertilizer, and so on). In principle, these are one-time, additional price increases, so they do not continue to drive inflation higher. It therefore makes little sense for the central bank to respond to this with a rate hike, as the effect on inflation will naturally subside after a year. However, the situation is entirely different if the rise in oil, gas, and food prices leads to price increases for all kinds of other products that use these raw materials in their manufacturing processes. A chain of price increases would then develop, which would ultimately lead to higher wage increases as well. This is all the more likely to happen as economic growth accelerates. It is therefore understandable that interest rate markets are becoming increasingly anxious as energy and food prices continue to rise and economic growth remains strong.
The U.S. and Europe Are Drifting Apart
Here, too, there is a significant difference between the U.S. and the eurozone countries. In the U.S., the economy is growing rapidly, and the first secondary effects are already becoming apparent. Moreover, the U.S. labor market is very tight, which is fueling fears of higher wage increases. In Europe, economic growth is also holding up reasonably well, but remains well below that of the U.S. Ms. Lagarde recently stated that, as far as Europe is concerned, she is not (yet) particularly concerned about spillover effects.
Furthermore, to bring inflation down, economic growth must be brought below “potential growth.” This is determined by the increase in productivity, plus the growth of the labor force.
This immediately highlights a significant uncertainty. Due to an aging population and restrictions on immigration in the U.S., the growth of the labor force is falling toward 0%. In Europe, it is even turning negative. “Potential growth”—the rate at which the economy can grow without triggering inflation or causing various imbalances—is therefore largely determined by the increase in productivity. All developments surrounding AI are creating a great deal of uncertainty in this regard.
In any case, the best estimate at this time is that potential growth in the U.S. is currently around 2.25% and in Europe around 1.25%. There is therefore a good chance that the Fed and the ECB will want to reduce economic growth to below these levels.
This brings us to the second uncertainty: how does the central bank know that interest rates have reached a level at which growth will slow sufficiently? It will likely use two indicators: the economic data being released and the trend in stock prices. High stock prices indicate strong growth expectations, but they also create a positive wealth effect, which stimulates growth.
In any case, the bottom line is that it cannot be determined in advance at what interest rate the economy’s growth will fall below “potential growth.” Nor is it possible to predict when and by how much interest rates must fall to ensure that growth does not decline too sharply again.
Based on this premise, we assume that the Fed currently aims to reduce growth to below “potential growth.” This means the Fed will likely continue raising interest rates until stock prices fall sharply and/or economic indicators clearly deteriorate. Since neither of these conditions has materialized yet, we expect interest rates—and the same applies to long-term yields—to remain under upward pressure for the time being.
Turning to Europe, the ECB is also grappling with excessively high inflation and growth around “potential growth,” if not slightly above it. However, this still amounts to very low growth. At the same time, the ECB is certainly keen to avoid a recession. For one thing, inflation isn’t high enough to warrant that, but given the high levels of debt in many European countries, this could easily lead to a new credit crisis. This likely means that the Fed will raise interest rates more than the European Central Bank and can also take on more risk in doing so. This means that the recent decline in the EUR/USD exchange rate is not over yet...
