High interest rates? Here’s why they are a problem

In recent months, central banks throughout the Western world have increased interest rates very sharply, in order to remedy what they did in previous years with regard to their normal activities of controlling the economy and finance.

Let’s see how the increase in interest rates, i.e. the increase in the cost of money, is a problem for the financial markets, how this creates a cascade effect on the economy and the effect that rising interest rate dynamics have on markets and final consumer.

Why are interest rates rising?

As discussed above, interest rates represent the cost of money set by central banks to regulate the price level. The task of a central bank is to monitor, control and regulate as much as possible the price level, ie the level of inflation.

Each central bank has its own “preferred” inflation level, the best increase in the price level that generates stability and growth at the same time, a real “target inflation rate”. The task of the central banks is therefore that of inflation targeting, ie to ensure that inflation reaches levels as close as possible to this target rate.

For the ECB (European Central Bank) and the Federal Reserve (American Central Bank), the target rate is equal to or close to 2%. Once the optimal inflation rate has been established, we proceed to the analysis of the instruments used to bring inflation closer to the target. These instruments ensure that inflation is influenced more or less directly by liquidity in circulation: the more liquidity circulates, the more inflation is led to rise, vice versa, with a decrease in liquidity, inflation will be reduced over time.

So what to do to reduce inflation by controlling liquidity? In this case, the central bank will implement a “restrictive” economic policy, ie by making sure that circulating liquidity is reduced by means of a increase in the “cost of money”.

The first useful stratagem for this purpose is to provoke an increase in interest rates, in order to increase the cost faced by banks asking for liquidity from the ECB. Liquidity that will then be injected into the system through investments in the financial markets and through loans and mortgages. Basically, an increase in interest rates corresponds to a decrease in liquidity which in turn brings less “fuel” to the economic system. This slowdown in the economic system should lead to the much hoped for stop inflation, and to the fall in prices.

Let’s move on to see how all this affects the current situation and how, theoretically, things should go.

The effects on the markets

We have said that a decrease in liquidity brings less "fuel" to the economic machine, which is slowing down. The first sector to be affected is the financial one, in direct relation with the interest rate.

Let’s take a concrete example using the situation in Europe as a reference: the ECB raises interest rates, the euros that European banks will have to take from the ECB will start to cost more. The banks will therefore only require the necessary liquidity to keep the economic machine going, the only way to “save”, by stopping investing and spending.

The first real scapegoat for this maneuver is the global financial market. Investments that have previously paid off are decreasing and efforts are being made to allocate money to sectors that could further protect the capital owned. The high-risk sector is sold, so the stock market is the one that is hit first, in favor of markets that until then had been seen as "unprofitable" and which are now considered interesting sectors in terms of capital protection.

In these cases we say: "cash is the king", so all products that represent something easily liquid and negotiable are seen as low-risk assets, primarily the currency market and the bond market (government bonds). So, with an increase in interest rates, investors liquidate what is now risky and try to hedge against any liquidity drawdowns.

What happens in this historical moment

In this historical moment there is a huge problem represented by inflation which is close to 9% in the EU, the USA and the UK, well beyond the targets of the central banks.

This leads to an unnatural reduction in liquidity, just as the financial world has been unnatural in recent years. The reason is that inflation was close to 0% until the pre-pandemic period. From 2010 onwards, after the sub-prime crisis in the US, the world has seen a sharp reduction in liquidity, which led central banks first to sharply decrease interest rates and then, another instrument available of central banks, buying government bonds through acquisition programs.

Let’s explain this last step: the central banks, since they had interest rates at 0%, to increase inflation have fed the economic circuit by financing the States through the purchase of government bonds. This has led to a sharp rise in the prices of these securities which are now seen as risky by 2022 as they no longer yield anything and protect against any risk. In this context, therefore, in addition to the stock market, which is risky by definition, a market which by its nature protected from risks, namely the bond market, is seen as risky as well!

The current situation therefore sees strong selling on both markets (equity and bond), leaving investors Forex as the only market on which to operate. In this context, however, even the Forex is biased in favor of the US dollar, the only currency that appears to be purchased globally, a scenario that foresees strong risks for the other currencies present.

The credit market

We get to the final consumer. If banks pay more for the money they will have to lend, on who will they offload these costs? On the final consumer who will ask for loans, financing and mortgages. All installments will cost more in the future, and an increase in the cost of borrowing will lead to raise the prices even more of these loans and installment payments, effectively blocking the economy. A situation that should then lead to a reduction in inflation with what we could define a "hard landing", that is a heavy and dangerous landing where the final consumer will pay.