Era of very low nominal interest rates is over

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Era of very low nominal interest rates is over

KUALA LUMPUR, Jan 20, 2024: Former Bank Negara (Central Bank) Deputy Governor Sukudhew (Sukhdave) Singh says the era of very low nominal interest rates is over.

“It would appear that central banks have finally recognised that to get inflation under control, they need to act sooner rather than later, and more forcefully than they had earlier anticipated,” he added.

Higher interest rates are generally a policy response to rising inflation. Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy. - Google Search

No News Is Bad News reproduces below a July 4, 2022 article penned by Sukudhew that is still very relevant to understand the complexities of balancing inflation and interest rates:

https://www.smefinanceforum.org/post/lessons-from-emerging-markets-runaway-inflation-and-how-to-contain-it

High inflation and the difficult policy choices for emerging markets

Sukudhew (Sukhdave) Singh

Sukudhew (Sukhdave) Singh

Former Deputy Governor, Central Bank of Malaysia | Former Independent Director, Khazanah Nasional Berhad

Published Jul 4, 2022

Based on statements made at the European Central Bank’s annual conference by the heads of the major central banks, it would appear that these central banks have finally recognized that to get inflation under control they need to act sooner rather than later, and more forcefully than they had earlier anticipated. As real interest rates have been made substantially negative by the rise in inflation, the era of very low nominal interest rates is over. While the very low interest rates and large-scale bond purchases by central banks had super-charged risk taking, the change in that policy stance is now likely to lead to risk-shedding, which will send negative shock waves through the economy and financial markets. The higher interest rates are likely to lead to a reassessment of risks across the world. As a consequence, a broad range of global asset prices are already being affected, including equities, commodities, housing and cryptocurrencies. 

How well individual emerging economies are able to deal with these shocks will depend foremost on how well these economies have performed and how well they have been managed. For example, domestic economic inefficiencies and supply constraints are likely to exaggerate the price pressures. A high dependence on imported consumer items as well as inputs for production will make domestic inflation higher and harder to control. It also depends on the policy buffers available to policymakers.

For emerging market central banks, the policy choices are stark. As domestic inflation has increased they also face the prospect of slower economic growth. However, not raising domestic interest rates may have consequences for monetary stability in terms of a significant decline in the domestic and external purchasing power of their currency. Having significantly negative real interest rates for a sustained period will only add to the risks facing the domestic economy. For open economies in particular, a failure to raise domestic interest rates could risk their exchange rates depreciating as residents and non-residents discount the value of holding domestic assets in favour of global assets offering better risk-return profiles. If the exchange rate assumes a depreciating trend it is likely to increase the incentive for outflows. Not only will there be direct capital outflows, but such outflows could also occur through other channels such as over-invoicing/under-invoicing, investments abroad, intra-company transfers, and exporters leaving their export proceeds abroad longer. This will pile on pressure on both the exchange rate and the foreign exchange reserves of the country. At some point, with the fall in the exchange rate and the decline in domestic asset prices, foreign capital inflows may resume but probably not soon enough to alleviate the central banks' present quandary.

Now, normally central banks are willing to tolerate some depreciation of their currencies especially when global demand is weakening. The problem with that strategy in the current circumstances is that it could lead to a worsening of imported inflation and further aggravate domestic inflation.

Where does that leave central banks in emerging markets? Ultimately, central banks will have to raise domestic interest rates and/or use their foreign exchange reserves to hold up their currency values. Using precious reserves to defend the exchange rate is a time-limited strategy because at some point the decline in reserves could itself become a confidence issue for the exchange rate. Therefore, what we are likely to see is central banks trying to maintain a judicious balance between higher interest rates and intervention to support the exchange rate. Countries that have healthy current account surpluses on their balance of payments have more policy space for the central bank but that space is not unlimited. 

The rise in interest rates will be painful for borrowers, especially in countries where there has been years of aggressive credit expansion. Households and businesses with high debt will obviously be most vulnerable. Households in particular will be caught in the pincer of higher inflation and rising interest rates. If as expected, the high inflation persists well into 2023, and global economic growth falls, then loan loses and bad debts in the banking system will probably also increase. Fiscal policy may be used to ease some of the pain to the economy. However, this is assuming that fiscal policy has sufficient capacity and is itself not under stress. For example, the conflict over subsidies is already playing out in Malaysia as the government is caught between fiscal strains and the political backlash to the removal of subsidies. This reflects public expectations that have been conditioned over the years and the fiscal realities, especially where the conduct of fiscal policy has been less than optimal, as has clearly been the case in Malaysia. The choices are going to get harder, as leakages, debt-servicing, and the cost of the huge welfare program called the civil service come face to face with revenue constraints, making it harder for fiscal policy to play its counter-cyclical role.

High inflation is going to be painful, especially for the lower income groups, and it could give rise to political instability. Some governments may be tempted to use official statistics to downplay the situation but at risk of undermining the credibility of those statistics and the government. A transparent communication strategy on the true inflation situation and what the government is doing to alleviate the situation would probably be more useful, but this depends heavily on the competence of the government and policymakers in each country.

There are no easy policy choices and the policy path will be a testimonial to the caliber of policy makers in each country as well as the preexisting economic fundamentals of each economy. It will challenge the central bank's capacity to navigate the policy options, deal with the politics, and manage the implications for the economy and financial system. It will be a litmus test of the quality of the political leadership in terms of its ability to grasp the situation and bring together the different government agencies in a well-coordinated program to manage the impact on the economy, employment and living standards.