Where Next for Interest Rates?

Written by: Robert Farago | Hargreaves Lansdown

• Global interest rates have risen sharply over the last quarter – and are up dramatically since the US Federal Reserve first raised rates in March 2022. 

• To predict what happens next, we need to understand what drove the fall in rates from their 1981 highs.

• There were seven factors involved. All have now either reversed or run their course. What were these factors?

"1) Stronger central banks. In 1979, Paul Volker became head of the Fed. US rates were raised significantly, sending the economy into recession and reversing the upward trend in inflation. This signalled the peak in interest rates. The Bank of England and other central banks were made independent of government in in the 1990s and adopted inflation targets – typically at 2%.

2) Lower inflation expectations. This enhanced commitment to stable inflation paid off in terms of lowered inflation expectations. Even through the recent spike in inflation, surveys of professional economic forecasters projected that inflation would remain close to target levels over the long term.

3) Globalisation. The Chinese economy opened up under the leadership of Deng Xioping in the 1980s. Its integration into the global economy significantly boosted the world’s labour supply. The fall of the Berlin Wall brought the whole of Eastern Europe into the world’s trading system. The World Trade Organisation reduced barriers to trade and cut tariffs. These events combined to lower inflation in global wages and goods prices.

3) Ageing populations. As populations aged, people spent less and saved more. This led to lower economic activity and contributed to a savings glut – too much money seeking too few investment opportunities. This put downward pressure on lending rates.

4) Economic shocks. When crises hit – the bursting of the dotcom bubble and the Global Financial Crisis – they were deflationary. Central banks were quick to cut rates. But slower to raise them as economies recovered. Economic cycles increased in length - and were less volatile. There were no major wars too.

5) Protection from equity sell-offs. Because economic shocks were deflationary, when they struck bonds rose as equities fell. This was not the case in the 1970s when inflation soared. This is an attractive property for balancing the risks in portfolios, increasing the value of bonds - and therefore decreasing their yield.

6) Central bank bond purchases. In the decade after the Global Financial Crisis, central banks were fighting deflation, not inflation. They expanded their policy toolkit beyond cutting interest rates. They bought government bonds to push long-term rates down and boost money supply – or quantitative easing.

7) This combination of factors drove inflation and interest rates lower. The volatility of inflation fell and the premium for holding more volatile long-dated bonds over cash disappeared. Yields on government bonds fell to the lowest levels in history – turning negative in some countries. 

Today’s situation

The COVID shutdown brought massive monetary and fiscal stimulus. As economies reopened, this stimulus combined with pent up demand to get out and spend. The result: inflation soared. Price rises were exacerbated when Russian oil and gas supplies were cut off following the invasion of Ukraine. Short and long-dated interest rates moved up significantly. 

Today, inflation remains high but is declining. Central banks across the developed world are signalling that inflation is not beaten yet. They indicate that interest rates are close to the peak, but they will not cut until inflation is convincingly lower. 

Where next?

When we think about the seven factors that drove rates down in the last cycle, how do these impact the rate outlook today?

1) Strong central banks. Independent central banks and inflation targets intact. Fears of that highly indebted governments borrowing will force central banks to lower interest rates are premature – see, for example, the market reaction to the Liz Truss mini-budget, when plans for unfunded tax cuts led to a sharp rise in borrowing costs. But the benefit from strengthening these institutions was a one-off boost to confidence that cannot be repeated.

2) Inflation expectations remain stable, as investors continue to believe that – eventually – central banks will bring inflation down towards target levels.

3) Globalisation has stalled and will no longer be a source of disinflation. The invasion of Ukraine and the ending of trade with Russia has limited impact. But it highlighted the risks associated with China’s policy towards Taiwan. Manufacturers are diversifying supply chains to reduce reliance on any one country – typically shifting manufacturing to other emerging nations. 

4) Populations continue to age. This means we expect economic growth to remain slow. But there are inflationary influences of ageing societies too. A shrinking working age population could put upward pressure on wages.

5) Economic shocks. We think supply shocks are more likely going forward. Even if demand shocks are equally common, the overall effect will be inflationary. Wages act asymmetrically, rising with inflation but not falling when recessions come along.

6) Protection from equity sell offs by holding government bonds has not worked, with equities and bonds falling in tandem as inflation soared. With future shocks as likely in either direction, hedging equities by holding bonds will be less effective. This reduces the value of bonds – increasing their yield.

7) Central bank bond sales. Actions by central banks to tackle high inflation include a reversal of the bond buying of the last decade, helping to push bond yields higher.

8) An eighth factor has come into play. Higher levels of government debt mean higher interest rates according to the standard economic model – and this model is working again. There is little prospect of these high debt levels being reduced. Aging populations require increased healthcare spending. So too do armed forces in a more hostile geopolitical environment. Tax increases and spending cuts are difficult to deliver without political consensus. And, in the US in particular, politics has never looked more divided.

Over the last quarter, bond yields have risen even as inflation has fallen and central banks have indicated that rates are close to their peaks. The recent rise in rates tells us investors are demanding a higher risk premium for owning longer-dated bonds. 

Summary of factors driving change in interest rates

	1981 - 2021	2021 - today
Central bank mandates	↘	→
Inflation expectations	↘	→
Globalisation	↘	→
Demographics	↘	↗
Supply or demand shocks	↘	↗
Portfolio hedging	↘	↗
Central bank bond buying or selling	↘	↗
Govt. debt-to-GDP	→	↗

So, where next for interest rates?

On one thing we can be confident. Inflation and interest rates will be more volatile. This means the top-to-bottom range for both will be higher in the next cycle. 

In the immediate future, the outlook for inflation is improving. Rate have risen for two years. They act with a lag and are helping to bring supply and demand back into balance. This should allow central banks to cut rates next year. Indeed, we see more risk of recessions than further bouts of inflation in 2024. 

But authorities will have a harder job in balancing policies to sustain growth and suppress inflation in the future. A little inflation is helpful in eroding government debt. Therefore, bond holders will demand a higher premium over cash rates for governments who have borrowed heavily.

Rate cuts are coming in 2024. This should mean lower bond yields too. But the decade ahead will see higher average interest rates. And more volatile markets.

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