When interest rates rise, is that bad for the economy?

Published on: 16 December 2021

Current issues related to the economy, (responsible) investment, pensions and income: every week an APG expert provides a clear answer to the question of the week. This time: APG's Chief Economist Thijs Knaap compares interest rate increases to Formula 1: "When Max Verstappen applies the brakes, he slows down. But if that prevents him from losing control while taking the next turn, it was the right thing to do."


"That may be the hardest question of the week I have heard so far," Knaap states. "First of all, there is the concept of interest rates. For investors there are over a hundred different interest rates; for most consumers there are only two: the interest rate on their savings account and the interest rate on their mortgage. Often the former is lower than the latter. This is related to the term. Those who lend money for thirty years want a higher interest rate for that than for a short period. The interest on the savings account is usually close to the policy rate set by the central bank (in our case: the ECB). This is the 'short' interest rate, calculated over a short period. The 'long' interest rate is determined in the market, although the ECB is quite active there too." When you hear that "interest rate increases are expected," it's mainly about short-term interest rates. Those are set by central banks in such a way that inflation won't go too high. Inflation is currently quite a bit higher than the ECB's target. The expectation that these short-term interest rates will rise is therefore not surprising. Incidentally, few people expect the ECB to raise these interest rates as soon as 2022. In the US, however, that does seem likely. The Bank of England already raised its policy rate on December 16, from 0,1 to 0,25 percent."



If the central bank raises short-term interest rates, the idea is that this will slow down the economy a bit, Knaap says. "It's a hailshot: how strong this braking effect is and in what way exactly, you can't say in advance. But it usually works. Companies invest less, the exchange rates rise, causing exports to decline, consumers to buy less expensive products and to save a bit more, assets (in houses and shares) lose some value; these are the effects of an interest rate increase. So, an increase in interest rates is "not good" for the economy in the sense that it leads to lower output. But that's not the right way to look at it. When Max Verstappen slams on the brakes he slows down. But if that prevents him from losing control while taking the next turn, it was the right thing to do. The same principle applies to central bank directors. The economy must be prevented from overheating. Hence the brake action. This also leads to the curious phenomenon that central bank interest rate hikes are often a good sign. This is because they happen at a time when growth is too fast. There is too much optimism, corporate profits are soaring; it’s often during good times."


Whether this will also be the case with the current - possible - interest rate hikes remains to be seen, Knaap considers. "It does seem as though the upcoming interest rate hikes will occur under a somewhat less favorable star. The economy's capacity to deliver what, until recently, we considered quite normal has been limited by the Covid crisis. There is a shortage of all kinds of goods and personnel, which leads to inflation. Even then it may be necessary to slow down growth. But that’s not because there is too much optimism, in this case."


Continually lower

And then there is the long-term interest rate. The interest rate on, say, mortgages or government loans of ten years or longer. First of all, it is not a foregone conclusion that a - possible - rise in short-term interest rates will affect long-term interest rates. Knaap: "Short-term interest rates still go up sometimes (in the U.S. as recently as between 2015 and 2019) but the trend in long-term interest rates is that they continually get lower, seemingly regardless of what happens on the short-term side." And if long-term interest rates were to rise, predicting the economic effects would still be a tricky business. Long-term interest rates are determined to a very large extent by the market; it's a matter of supply and demand. Rising interest rates can mean two things, according to Knaap. "Either the demand for capital has increased, because, for example, new promising technology has been discovered that everyone wants to invest in - and that is a good sign. It could also be that the supply of capital is drying up, for example, because there is less lending and investment, due to declining confidence in the economy. And that's obviously a bad sign."


Coverage ratios

According to Knaap, the structural decline in long-term interest rates is mainly due to the fact that people (worldwide, but especially in Asia) have started saving more. And because capital goods (such as computers) have become increasingly cheaper. "Is that a good or a bad sign? I'm not really sure." For investors, interest rates indicate how much can be earned in financial markets. At low interest rates, the expected return is not as high. Knaap: "For pension funds, rising long-term interest rates are generally a good sign. It means that they can once again earn something to pay for those pensions."