Living in a world of higher interest rates

It is already clear who will bear the cost of inflation. Rising prices are due to hit households hard. Andrew Bailey, governor of the Bank of England, warned this week that Britons face a “historic shock” to their incomes. The same reality is faced by other households around the world. Those lucky enough to have savings are seeing them whittled away to cover dramatic increases in the cost of living. Signs are emerging that consumers have also been borrowing more through credit cards. While this usually reflects growth in spending, some economists are warning that this time, households may be accessing debt to make up for shortfalls in pay.

This kind of inflation — and its effects — demand a response that has come in the form of higher rates. The Bank of England has now proceeded with three consecutive rises in an effort to cool prices. The US Federal Reserve has sounded arguably even more determined to rein in inflation, while the European Central Bank has sent signals pointing in the same direction.

Yet determining the winners and losers from higher rates is more difficult to predict than the effects of inflation. While interest rates are often referred to as if they affect all borrowers equally, this can be misleading. The ultimate impact on households and businesses alike may depend on whether they are accessing short or long-term credit markets for their funding needs.

The most recent changes made to interest rates by the Bank of England and Federal Reserve target the cost of short-term borrowing. Prices on this kind of debt — such as short-term bank credit — are the most responsive to variations the BoE and the Fed have already made to their “bank rate” and “federal funds rate” respectively.

The ultimate intention of this move is to relieve pressure on prices by taking the heat out of the economy. But most directly in the line of fire will be those who make use of short-term loans — such as small businesses — as a way to manage cash shortages and to make day-to-day purchases. For those with sustainable levels of debt, rising costs of this kind, while painful, won’t be terminal. Unfortunately, it may be a different story for those who are highly leveraged and already on the edge. Higher rates are better news for households looking to save — interest on bank deposits and other short-term savings vehicles should rise.

What will end up happening to long-term borrowers is more uncertain. The supply of capital around the globe is still plentiful, which means that the price demanded for lending it should remain relatively cheap: in an ideal world, the cost of mortgages and long-term corporate borrowing will remain manageable.

There are complications though. Long-term rates are due to rise as central banks end their bond purchasing programmes. They may climb further if inflation is not brought under control. This kind of “higher for longer” world would have a direct impact on mortgage rates. Highly leveraged households would feel significant pain when their fixed mortgage rates come up for renegotiation. Some businesses would find themselves similarly squeezed as the cost of funding through corporate bond markets — used by many large businesses — increases.

Any analysis of who stands to lose the most from higher interest rates can only end with: “It depends.” Unsatisfactory as it is, this conclusion accurately reflects the nature of an economy that sits at a crossroads. The ultimate outcomes are uncertain, but one thing that can be agreed upon is that the sooner inflation is tamed, the better the prospects for all.