What are the most significant economic impacts of higher interest rates? Chief economists explain

In 2022, as inflation spiralled upwards around the world, central banks began a cycle of interest rate hikes in an effort to lower prices.

The contractionary monetary policy mitigated inflation, but elevated interest rates have also caused various ripple effects throughout the global economy. This includes, for instance, recent distress in the banking sector.

As the World Economic Forum’s latest Chief Economists Outlook notes, “central banks now face a trade-off between, on the one hand, persisting with the pace of their tightening cycles until inflation is back down to more manageable levels, and on the other hand, doing anything that might trigger further distress in the financial sector.”

The report also found that property markets and financial businesses as well as sovereign and corporate debt sustainability remain large sources of concern with regards to high interest rates.

Of the chief economists surveyed in the report, 82% said they expect the pace of interest-rate raises to slow over the remainder of 2023. Nonetheless, the report notes that “even if there is a dovish shift in the stance of the world’s central banks, the prospects of a full-scale shift to monetary loosening are remote.”

So what will be the most significant financial and real economy impacts of higher interest rates? In the following statements, three leading chief economists give their insights.

“The interest rate hiking cycle is near its end, with only marginal rate rises still expected to come from central banks. Given still-high inflation, I personally disagree with US bond market pricing suggesting that policy rates may be cut later this year.

“Over the long term, higher interest rates are positive for financial markets, the real economy, and for the global re/insurance industry. Finally, risk free rates are not return free – and we have finally exited the negative interest rate era.

“Japan is now the outlier, but here too I expect the Bank of Japan to move sooner rather than later, supporting a higher-for-longer global interest rate environment. For the real economy, higher interest rates mean higher economic returns and this should revive investment into areas such as sustainable infrastructure. We need more investment into the real economy, to make economies globally more resilient against shocks. The resilience gap needs to narrow.”

“Despite the rapid and synchronous tightening in global interest rates, central banks are struggling to tackle inflation. Further rate hikes are anticipated and potential impacts are wide-ranging.

“Beyond the likely demand and credit contraction that usually follow higher rates, other areas of concern include: 1) Non-bank financial institutions which tend to be highly leveraged and prone maturity mismatches and 2) Commercial real estate sector, where valuations have remained under strain since the pandemic amid ongoing shifts in occupancy patterns.

“The recent banking turmoil is a powerful reminder that these sectors are the other pockets with elevated financial vulnerabilities and can erupt as rates go higher.”

“The increase in nominal interest rates is likely to have an uneven impact on real economic performance. There are obvious differences in the duration of debt: US mortgage holders with long term fixed-rate mortgages have an indifference to moves in short term rates, while Swedish mortgage holders experience a direct and near immediate impact from higher policy rates.

“Potentially more significant is the issue of real borrowing costs. Consumer borrowing rates, when deflated by nominal income growth, have risen significantly over the course of this tightening cycle. That places a meaningful burden on household budgets, already impacted by the higher cost of living. Both new borrowers and existing borrowers with variable rate debt will have to reduce their consumption volume. The damage of higher interest rates is likely to fall disproportionately on lower income households, who face above average inflation and who are more likely to borrow to cover day-to-day expenses.

“Many corporations are less constrained. In some cases this is because they are able to borrow at nominal market interest rates. But corporate debt affordability is likely to be easier than for consumers, as real cost of borrowing deflated by corporate income growth benefits from the profit-led nature of the current inflation episode.”