How does the rise in the cost of money affect us?
The United States has just raised interest rates and the European Central Bank is expected to do so shortly. Both measures will have a direct impact on our economy. The most immediate is the increase in the cost of credit for families, the self-employed and SMEs.
Inflation is running rampant in the major economies, as shown by the rate of 8.5% that the United States reached in March, the highest in four decades. After several years of ultra-loose monetary policies to stimulate the economy, several countries have decided this week to curb the rise in prices by raising the interest rates on the money they lend to banks.
On Tuesday, the Reserve Bank of Australia raised its interest rate by 25 basis points to 0.35%, the first increase in more than a decade. On Wednesday, India, Asia’s third largest economy, raised borrowing costs by 40 basis points to 4.40%. Just a few hours later, the US Federal Reserve (Fed) raised interest rates by half a point, the largest increase since 2000, bringing the policy rate to a range of 0.75% to 1%. On Thursday, it was the turn of the Bank of England, which raised it by 25 basis points to 1 %.
It is only a matter of time before the European Central Bank (ECB) follows suit. It has not raised the price of money since November 2013. On the contrary. In the last eight years only decreases have been approved, the last one in September 2019. In total, the price of money in the Eurozone has fallen during this period by 1.5%, bringing it to a range of -0.25% to 0.25%.
Most central banks are raising or intend to raise interest rates after more than a decade in which the banknote machines have been working full-time to avoid economic stagnation. Although the risk of recession is still there, the enormous levels of inflation no longer allow central banks to look the other way. The need to curb rising prices has become an inescapable priority. As Fed Chairman Jerome H. Powell said after announcing the new US rates, “inflation is much too high.” It is as simple as that.
How will the US decision affect us?
Although it is decided many miles away, the move to raise interest rates in the United States will have a major impact on our economy, as many countries and commodity markets depend on the dollar. If the dollar appreciates, it will increase the cost of many commodities and make borrowing in dollars in emerging economies more expensive.
On the other hand, it will have a positive effect on European exports to the United States in real terms, as they will become more competitive because of the dollar/euro exchange rate. Even companies that do not export may benefit if they compete with companies that manufacture in the United States, as the latter’s products will be more expensive.
A question of time
What consequences will the ECB’s future increase in the price of money have for our economy?
The most immediate one will be the increase in the cost of loans for companies and individuals. For example, a mortgage on a house with a variable interest rate will lead to higher monthly repayments due to the increase in interest rates, meaning that we will end up paying more for the same property. To compensate for this increase, prices in the real estate market will tend to moderate. Moreover, it should be borne in mind that those who already have loans will have less income to spend because of the increase in the interest they pay.
Higher credit costs tend to cool the overall economy by dampening consumer spending and business investment. As demand for goods and services falls, prices tend to moderate.
In this context, companies may reduce production and lay off workers, thus increasing unemployment and further reducing demand. It is the fish that bites its own tail. The risk of an excessive economic slowdown, and even a recession, is real. Many experts are warning of a possible stagflation if interest rate hikes put the brakes on the economy and fail to contain inflation.
Almost everyone loses
Rising rates are bad news for the business world in general, as the cost of capital needed to expand increases and the profitability of their investments is reduced. In addition, some investors are likely to reduce the money they have in the stock market and buy debt as yields rise.
Although the relationship between interest rates and the stock market is rather indirect, the two tend to move in opposite directions. Practically the only beneficiary in the corporate world is the banking sector, which can earn more money for the euros it lends.
On the other hand, this measure tends to encourage household and corporate savings, as the profitability of bank accounts will increase as interest rates rise. In any case, the inflation variable in the equation should not be lost sight of. It is worth bearing in mind what the real interest rate is, which is the nominal interest rate minus inflation. If instead of buying or investing in a good we decide to put that money in a current account and after a year we get an interest rate of 2% but the price of that good has increased by 3%, we are actually losing money.
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