Interest Rate Parameters for an Economy
We are now officially on an interest rate hiking cycle. Interest rates, being just a number, can obviously rise forever, but the reality is they don't increase in perpetuity. There is a point when they become so high that nobody bothers borrowing at such a rate.
This then informs the interest rate hiking cycle. Four things to consider that act as parameters are as follows:
- Positive real rate (interest rate minus inflation) — rates have to rise to guarantee a positive real rate.
- Rate of Inflation — this matters because it’s part of the real rate calculation
- Defaults — if rates rise beyond a certain level that cannot be sustained by incomes, massive defaults kick in, risking a collapse of the entire system
- De-Facto Ban on Lending — positive real rates, above a certain level, is essentially an effective ban on lending because no one wants to borrow at such a punitive rate.
After March 2020, interest rates dropped to very low levels, getting very close to zero. A negative nominal interest rate was in the conversation. With inflation low, but higher than the nominal interest rates, most economies had negative real interest rates. A negative real rate means the lender is not really benefitting. The lender is subsidizing the borrower. The lender is effectively paying interest to the borrower. It's an awkward situation. It can persist in extraordinary times as central banks, in the command-style soviet type of economics, push interest rates to artificially low levels. The situation cannot persist for long because in the medium term it destroys lending because commercial banks eventually refuse to lend, not because they cannot make a margin, but because at those low levels, they risk lending to borrowers whose credit risk is not befitting. Other lenders disappear too.
Negative Real Rates are an effective ban on lending. They cannot persist for long.
The rate of inflation is crucial because it is an input in the calculation of a real rate. The absolute level of interest rates has to be viewed in conjunction with the absolute level of inflation. As long as interest rates are below the inflation rate, they have to rise further to make sense, or else you have a negative real rate. Zimbabwe currently has interest rates above 80%, but the inflation rate is even higher. What does this mean? This means the interest rate is not even high enough.
The policy makers will always be incentivized to raise interest rates as long as inflation runs hot above their target bands.
But then who wants to borrow at 80%. Only the speculators who play on the currency. Borrowing at 80% is never borrowing meant for productive investments. It is borrowing for speculative purposes. It is a bet that the inflation rate will remain higher than the nominal interest rate. Productive investments do not usually yield rates of 80% per annum. Thus, it can be safely concluded that all borrowing beyond a certain level (e.g 15%) is not really for the economy but for the gamblers in financial markets taking advantage of the situation. Once rates rise beyond the productive real return on capital, we can conclude that there will be an effective ban on lending in place, as the credit creation cycle can no longer spur the economy forward.
The same argument can be raised regarding positive real rates. Positive rates above 20% are punitive. Nobody wants to borrow at those levels. If inflation is at 10% and the prime lending rate is at 30%, the positive real rate is 20%. No serious productive business wants to pay beyond 20% per annum. That level of interest is typically beyond the rate of returns offered by productive investments.
And when interest rates (both nominal and real) rise above a certain level, pacing ahead of incomes, they effectively trigger massive defaults. In an inflationary environment, wage growth typically lags behind the prices of goods and services. Whilst corporate debt can be repaid from the rising corporate incomes, consumer debt defaults en masse. Mortgage debt, credit card debt, car loans, and student loans witness high default rates. There is a caveat, however. These defaults do not occur if there is hyperinflation. Under hyperinflation, all debt can easily be repaid.
When inflation is not yet in hyper mode, massive defaults at the consumer level are the first wave, a first order effect that then leads to a second order effect (second round wave of reduced incomes for corporates). As households spend more on repaying debt (e.g.g adjustable rate mortgages), they are left will little to spend on the inflated goods and services, thus reducing effective demand. Reduced incomes for corporates then trigger defaults. Notice how corporates firstly have rising incomes because of inflated prices and then have dwindling incomes as the second-order effects come into play.
So policy makers can raise rates by as many basis points as they want, but there is an economic limit that they can reach. If they raise beyond a certain level, it triggers defaults, which destroy the entire economic apparatus.
Mortgage Debt Example
Let's consider South Africa for example. At what rate do interest rates start to trigger defaults. The prime lending rate is currently 7.75% and we add a 2% risk premium to get 9.75%.
According to this article, 69% of total taxpayers in South Africa earned between R87,000 and R350,000. A person who earns R350,000 per year earns R29,000 per month before taxes. This person would be in the upper 30% of income earners. The monthly net income for this person would be R24,500.
For an interest rate of 9.75%, this person can afford a home loan of R1m with monthly payments of R9,554. If the interest goes up by 200 basis points to 11.75%, the monthly payment goes up to R10,837. If the salary doesn't rise, this person has to free up R1,283 from his budget to re-allocate to the mortgage repayment.
Budgets are typically tight and very hard to adjust. Let's assume he finds a saving somewhere. This could be less eating out, canceling a couple of entertainment subscriptions, cutting out the gym membership fee, etc. If this reduction of expenses happens on an economy-wide scale, it means fewer sales and revenues for the restaurants, gyms, and other businesses that provide discretionary goods and services.
This consideration makes it difficult for policymakers to keep raising interest rates. Sometimes raising rates doesn't necessarily tame inflation by chopping off excess demand. This is very true if the source of inflation is not excess demand. When inflation is a result of supply chain problems and supply side geopolitical issues, it cannot be easily tamed by controlling the demand side. If sunflower oil for cooking is up globally due to the Russia-Ukraine war, then it doesn't really matter what the level of interest rates in South Africa is. Increasing interest rates makes people afford fewer bottles of cooking oil but it doesn't magically increase supply so in the end people just suffer but prices don't really come down, especially for basic goods and services.
Now let's say the policymakers have to tame inflation with mortgage rates at 11.75 so they push rates further up, to obtain mortgage rates of 13.75%. The monthly payment on the million rand bond goes to R12,323.
If the cycle goes on until the mortgage rate gets to 18.75%, the monthly payment goes to R16,081. At this level, if the salary does not increase, the person has to free up R6,527 on his budget in order to pay the mortgage. Defaults will be widespread.
The prime lending rate reached an all-time high of 25% before in South Africa.
If it ever goes back to that level again, the mortgage rate on the million rand loan will be 27% and monthly repayment will be R22,677. There is no way a person earning a net of R24,500 can be able to pay that.
At a rate of 29.5%, the monthly payment will be higher than the net income of our person. Our person will simply not be able to pay the mortgage even if he dedicates 100% of his income towards that.
Simply put, the economy cannot afford a mortgage rate of 29%. To be more specific, the economy cannot afford higher rates without inflating incomes (salaries for consumers, and prices of goods and services for companies). Notice how self-defeating this exercise is: in order to increase salaries, companies have to increase the prices of goods and services. But the goods and services are purchased by consumers, so if they go up, it means consumers afford less and have to bargain for even higher salaries, so everything keeps going up (salaries and goods). This is why it is very difficult to tame inflation.
Before we even get to a mortgage rate of 29%, our person would have defaulted a long time ago. Many households cannot afford a 200 basis point increase in interest rates.
David Byrne and Robert Kelly studied how monetary policy passes through to mortgages and concluded that a 1% increase in installment is associated with a 5.8% increase in the likelihood of default.
For our person, at the initial conditions, a 1% increase in installment is R95. A 200 basis point (2%) increase in interest rates is actually a 13% increase in installments, meaning the likelihood of default actually increases by 77%. This might seem a lot academically, but when you put yourself in the shoes of “our person” who has to juggle an already tight budget, with very few discretionary items to cut off, you can see why the chances of defaulting are very high.
The moral of this mortgage story is that, even though central bankers can raise rates because they want to tame inflation, the economy might not be able to afford such higher rates.
Too much debt accumulated at Low-Interest Rate levels
This is the elephant in the room. Too much debt was accumulated at artificially low-interest rate levels. Raising rates will make it almost impossible to ever repay the debt. Most of the government debt around the world was accumulated at very low rates. If rates go up significantly, most governments will end up spending more than 50% of their tax revenues on interest payments alone. The same applies to companies and households.
What’s the Outlook?
Policy makers worldwide are going to be stuck in a tricky situation. Inflation is ravaging and does not appear to be transitory.
To tame inflation, they have to raise interest rates. Raising interest rates kills the economy before it fully recovers from the pandemic and global shocks.
High Inflation Kills the Currency.
High Interest Rates kill the Economy.
Killing the currency can be done by allowing inflation to run hot without raising interest rates. It allows for the debasement of value and debt. In the worst case, you hyperinflate and then reset the system.
Killing the economy is effectively an economic depression that preserves the currency by wiping out economic activity and allowing for a painful period whereby the economy pays for its past excess and sins.
Which one would you kill: the currency or the economy?