One word has dominated the economic...
...and financial landscape in 2022
Inflation
In the battle to control inflation...
...central banks have a key weapon...
...in their monetary arsenal
Interest rates
Raising interest rates
Base interest rates have risen at regular intervals throughout 2022...
...which has been a new and potentially painful experience...
...for many of us
Because for almost 15 years...
...all we've known is extremely low...
...and in some cases even negative interest rates
It suddenly means our mortgages...
...credit cards, business loans...
...all types of borrowing...
...is likely to become more expensive...
...causing significant economic pain...
...at a time when the cost of living...
...is already soaring
It's a double whammy
So how did we get here?
And even more importantly,
how high could interest rates go?
Here at Capital.com...
...we make all kinds of explainers...
...about the stock market...
...and the world of finance...
...giving you the analysis and insight...
...you need to make informed decisions
And after watching this film...
...you might want to check out...
...our interactive map of interest rates...
...across the world
Just click the link
Anyway, back to interest rates
To understand why they're rising...
...first, we need to talk about inflation
We spoke to Ed Yardeni
He runs his own research firm...
...and is kind of a go-to guy...
...when it comes to interest rates
A lot of people are wondering why inflation has been...
...rising to such an extent over the past year
How did we get into this mess?
And I think the answer is the pandemic
There had been a drive...
...since the 2008 financial crisis...
...to stimulate economic growth...
...through loose monetary policy and economic stimulus...
also known as quantitative easing
Then came the pandemic and a need to ramp up...
...financial support
Combine this with post-pandemic supply chain disruptions...
...a global energy crisis...
...and the tightest labour market in decades...
...and you get the perfect inflationary storm
The combination of all that monetary and fiscal stimulus...
...did something that the central banks weren't able to do...
...for many years...
...which was to get inflation over 2%
And beware of what you wish for...
...because not only do they get over 2% they got it to...
...basically close to 8-10%
Which is why central banks started raising interest rates
The question is...
...when are they going to stop?
Now, I need to be clear
We can't tell you exactly where rates will go
I can't predict the future
If I could, I wouldn't be sitting here speaking to you
I'd be a very rich man...
...drinking strawberry woo-wooos on a beach in St Lucia
But what I can do...
...is look at history
Analyse some data...
...and speak to an expert in the field
So let's start with the last time...
...global inflation was at a similar level to today
And look at how high interest rates were hiked...
...to get it under control
In the 1970s and early eighties...
...a decade long period of huge economic and political instability...
...characterised by something called...
...stagflation
The recipe for stagflation...
...is one cup of stagnating economy...
...two cups of high inflation...
...and one cup of high unemployment...
...mix it all together...
...and you've got yourself a stale...
...overcooked and extremely hard to recover economic pie
The way it was dealt with back then is...
...the Federal Reserve...
...let interest rates rise...
...to levels that caused a recession...
...and the collapse in demand relative to supply created...
...disinflationary, if not outright deflationary forces
In the US, then Chair of the Fed, Paul Volcker...
...ramped up the base interest rate...
...to an unprecedented 20% in 1980
Central banks in several other major economies...
...took a similar approach to the Fed...
...though their rates weren't quite as bold
Volcker's maverick approach...
...intentionally pushed the US economy into a recession...
...and brought inflation under control
If you'd like to learn more about that period of Fed history...
...and all about Volckernomics...
...we've got an explainer on that too
So could we see Fed Chair Jerome Powell...
...and his other central bank counterparts...
...following the same aggressive Volckereque use of interest rates?
So we're basically on the same path...
...the question is whether the Fed can tighten too...
...such an extent that it will cause a recession...
...or whether we'll be lucky and find that...
...demand slows just enough relative to supply...
...to bring inflation down.
Unfortunately, without a crystal ball...
...it's impossible to say for certain
But there are some things we do know...
...that might give us indications...
...of why rates are unlikely to go that high this time
Firstly, it's a very different...
...political and economic landscape from the seventies to now
The Volcker shock, 20% Fed rates...
...were only implemented after a decade long struggle...
...to reduce high inflation
We cannot wish our way out of inflation
Today's battle against inflation is still very much in its infancy
Central bankers and politicians also don't like recessions...
...so they'll be wary of hiking rates too much and causing one
I'm an optimist at heart...
...so I think it's conceivable...
...that unlike the seventies...
...will see the economy slow...
...without a hard landing...
...and nevertheless will see inflation coming down
Not everyone agrees, though
Bloomberg just announced a 100% chance...
...of a US recession by 2023
So the politicians may not get what they want
Secondly, the housing market...
...one of the most important markets hit when interest rates rise...
...is a very different beast to the 1970s...
...and the early eighties
In a nutshell...
...housing prices today just aren't sustainable...
...at the interest rate levels seen then
Let me explain and bear with me here because...
...I'm about to throw a lot of numbers at you
An average US house in 1981 was around $70,000...
...at the peak mortgage rate of 18.45% with a 20% deposit
That's a monthly payment of $864
And here's the key bit...
...that $864 amounted to roughly 55%...
...of the average household income after tax
Now let's input that with today's...
...average house price of $440,000...
...at the current average US...
...30 year mortgage rate of 7.2% with a 20% deposit
This would mean monthly payments of $2,389
That's around 50% of median household income...
...after tax today
So although rates are much lower now...
...it's almost at the same level of affordability as it was in 1981
The reason for this is, wage increases haven't matched...
...the rise of house prices...
...which have soared particularly in the past few years
And that has meant the ratio...
...of median household income to house prices...
...is now much higher than 1981
The ratio is almost 8:1 in the US...
...and 9:1 in the UK...
...compared to roughly half that in 1981
Not so fun bonus...
...that the average age of homebuyers...
...in the US is now 47 compared to 31 in 1981
So are current mortgage rates...
...already at the level to tip the inflation scales?
I would say there were kind of there...
...with 7, 8, 9% mortgage rates...
...for the mortgage market were there
So all these elements would suggest...
...that it's unlikely interest rates...
...might reach 1980s levels
But what do the main central banks...
...markets and forecasters predict?
Let's start with the Federal Reserve
It acts as a sort of world central bank...
...setting the pace for all the others
The Federal Open Market Committee's 12 members...
...meet eight times a year to discuss forward guidance...
...of the Fed's monetary policy...
...which gives us a pretty good indication of their thinking
Every member gives a prediction
The latest median rate predictions are 4.4% by the end of 2022...
...to the peak of 4.6% in 2023...
...before falling again
Even the most hawkish Fed members...
...don't see rates going above 5%
However, don't take the Fed's word as gospel
A year ago, the Fed thought interest rates...
...would be at 0.3% by the end of 2022
Now we're heading towards 4.5%
As we're filming this, the market has priced in a peak rate...
...of 4.9% by March 2023.
Well, in terms of the Fed funds rate...
...you know, I think it's conceivable...
...we'll get up to 5%...
...four and a half to 5%
I think the mortgage rate...
...I don't think it's peaking...
...but I think it's going to stay...
...in this sort of 7-8% range
In August, the Bank of England initially forecast...
...a peak rate of 3% in Q3 2023
However, it's been a rough few months for the UK economy
It's got the highest inflation of any G7 country...
...one of the highest median household income to house price ratios...
...and a devaluing currency...
...following a controversial government mini budget
After a series of policy U-turns...
...including an almost complete reversal of the tax cuts...
...Bank of England intervention...
...and the subsequent collapse of the Truss government...
I am resigning as leader of the Conservative Party
The market has now priced in a peak rate of 5.3%...
...in August 2023
Though some argue...
...if the new government produces a sound fiscal policy...
...this could take pressure off the Bank of England...
...to hike as high as this
The ECB is still dealing with economic problems...
...stemming from the 2008 financial crash
In particular, key Southern member states...
...are struggling with high levels of debt...
...and stagnating economies
Given the fact the EU is made up of 27 separate economies...
...some rich, others low income...
...it's much harder for the ECB...
...to hike as fast as the Fed...
...without causing financial instability
Now the ECB has used the word fragmentation...
...basically to describe the problem they have, which is...
...you know, we're not dealing with one economy...
...we're dealing with different economies...
...different amount of debt...
...different fiscal policy, different politics
The ECB rate currently sits at 1.5%
Although the bank is reluctant to give forward guidance...
...the markets have priced in a peak rate...
...of 3% in July 2023
I think the ECB and the Bank of England...
...maybe at most have about 200 basis points more...
...that they can raise their lending, their short term rates
Lastly, Japan
An economic outlier...
...with an interesting monetary policy
In recent years they've actually been trying...
...to create inflation in their stagnating deflationary economy...
...by implementing and maintaining negative interest rates...
...alongside massive quantitative easing
Japan's demography is very geriatric...
...and as a result of that...
...you know, consumption...
...is not particularly strong
They've had this, try to stimulate the economy...
...with fiscal and monetary policies
Japan's inflation rate, despite all this...
...is at a high of 3%...
...significantly lower than the rest of the world
But that amount of QE...
...combined with a stagnating economy...
...means it's the most debt laden country on Earth...
...with their debt to GDP ratio at around 266%
This sheer quantity of debt...
...combined with stagnating growth...
...means significant interest rate rises could break its economy
The Bank of Japan has announced a commitment...
...to keeping rates ultra low...
...and is expected to maintain negative...
...or extremely low rates throughout 2023
Okay, so we've established market expectations...
...for these four major central banks' interest rate rises...
...but could they go higher than projected?
Central banks have been clear...
...that reducing inflation to target levels...
...is their main concern...
...therefore, stubborn inflation...
...or any sudden rise in inflation...
...could see interest rates...
...go higher than current projections...
...even if it means a more painful recession
And in Europe's case, the war in Ukraine...
...and the economic standoff with Russia...
...means the continent could face even harsher...
...energy price increases this winter...
...and higher energy prices are a main driver of inflation
European countries generally have the terrible situation...
...of you're just closer to that war...
...and the energy consequences that's happening...
...in terms of an energy crisis
That could cause contagion beyond Europe
So things could certainly go wrong...
...which would lead to more inflation...
...and force the Fed to go full Volcker
Full Volcker 20% interest rates
Can you imagine?
The thing is, though...
...no one really knows exactly how high rates could hike
Economies are unpredictable at best...
...as Jerome Powell has said himself
And no one knows with any certainty...
...where the economy will be a year or more from now
But if inflation remains stubborn...
...labour markets remain tight...
...and geopolitical tensions in Europe continue to escalate...
...pushing energy prices higher...
...central banks could simply keep on hiking...
...regardless of the economic pain...
...it causes for the likes of you and I
Thanks so much for watching
Let me know in the comments...
...where you think interest rates might go
And of course, if you like the video...
...drop us a like hit that subscribe button...
...and make sure you hit that notification bell...
...and I'll see you next time