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Global Economy Poised for Divergence in the Era of High Interest Rates

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Wei Hongxu

Global inflation has continued to climb throughout this year, posing a severe obstacle to economic recovery and development in all countries.

According to researchers at ANBOUND, this has put central banks throughout the world in a quandary: should they maintain interest rates low to continue driving the economic recovery, or should they raise rates to accomplish the inflation targets of monetary policy? For the moment, Federal Reserve, the most influential central bank in the world, has already made its choice to adopt an unconventional pace of policy tightening. European Central Bank (ECB) has also begun the pace of reducing the accommodative. Meanwhile, the Bank of Japan (BOJ) is still stuck to its present accommodative policy. However, in terms of the market, the U.S. Treasury yield already breached 2.0%, and most European sovereign debts have also moved away from the long-term negative interest rates. In Japan on the other hand, the BOJ has continued to intervene in the market, to cap a surge in government bond yields. Changes in the interest rate market have been generally predicted to lead to higher levels of global inflation in the future. While real yields remain down in the face of record inflation, nominal interest rates are moving away from “zero interest” and “negative interest,” sending the global market into an era of high-interest rates not seen in the past 30 years.

Agustin Carstens, the General Manager of the Bank for International Settlements (BIS) has warned that rising price pressure could keep inflation in many countries at its highest level in more than 30 years and pose long-term issues for central banks. There is evidence, according to Carstens, that consumer and corporate expectations are “moving away” from record lows and towards a “new inflationary era”. Carstens believed that almost 60% of developed economies now have inflation above 5%, the highest level since the 1980s, while more than half of emerging countries have inflation above 7%, the highest level since the financial crisis of 2008. Carstens said, “adjustment to higher interest rates will not be easy (for households, companies, investors, and governments)”, “it will be challenging to transition to more normal levels for rates and to set realistic expectations for the effects of monetary policy in this process”.

The persistence of high inflation recalls the “stagflation” era triggered by the oil crisis. For the time being, with the Russia-Ukraine crisis accelerating the shift in the energy landscape and driving up commodity prices, inflation which was thought to be “only for a while”, is likely to exceed the expectations of policymakers. This also means that inflation is becoming the primary focus of central banks, which have to adopt tightening policies, thus driving up interest rates. This action is bound to affect demand and the highly inflated capital market and could even lead to a new crisis. Carstens also admitted that “the necessary shift in central bank actions will not be welcomed either”.

In the perspective of ANBOUND researchers, as countries enter the policy tightening cycle one after another, the different pace of policies and economic recovery across countries will result in divergence in the global economy and turbulence in the capital market. This change will leave the global economy turbulent, complex, and volatile. Among them, the most affected will still be the emerging countries and underdeveloped countries. At present, it can be seen that data on consumption and employment show that the momentum of the U.S. economic recovery is still strong, and the Fed has already begun raising interest rates and is expected to begin lowering them in May. This pace of tightening is uncommon. Nevertheless, according to the expectation of the Fed, the fall of inflation may not be achieved in the short term, so the U.S. may face the “double high” situation of high economic growth and high inflation. In Europe, the ECB is believed to have a more complex approach to policy decisions. This is because the possibility of Europe falling into “stagflation” is greater since their economic growth has not recovered rapidly, coupled with the impact of the Russia-Ukraine conflict. The situation in China and Japan is different but similar in that the central banks of both countries have to adopt accommodating policies at different levels in response to the slow economic growth.

In this case, the risks are magnified for other emerging markets and developing countries in general, which cannot determine their monetary policy. Rising interest rate levels make it necessary for countries or regions that have brought in external debt to face higher interest expenses, and countries with worse external accounts will be faced with the pressures of capital outflow and devaluation at first. The current situation in Sri Lanka is a clear example of this. While some resource exporting countries would still benefit from the current distortions in global supply chains, some countries that are known for their manufacturing and that are dependent on exports have to face upstream and downstream pressures and difficult prospects.

The difference in the policies of the major central banks has led to a widening of the gaps between the major currencies and this is the situation that was not seen in the “zero interest rate” or “negative interest rate” era in the past. The dollar index approaching 100, while major international currencies such as the euro and the yen have depreciated to some extent. The widening of spreads between currencies will inevitably lead to cross-market capital flows. This is not good news for the stability of the economy, nor is it beneficial for capital market, and it will surely increase the divergence and difference in economic growth. Global capital flows at high-interest rates point to an era of turbulence and even a repeat of the “stagflation” that has occurred in the past.