We live in a world where global trade is second nature. International trading restrictions continue to be lifted, and interest rates still play a significant role. Historically, the likes of the USA, China, and to a lesser extent, the European Union have dictated global interest rates. However, interest rate policy is also influenced by domestic issues.
Economic growth
The last 14 years have demonstrated a global movement in interest rates initially dominated by the 2008 US financial crisis, followed by the Covid pandemic. Countries worldwide were forced to slash interest rates to shore up ailing economies and inject an element of growth. While the rebound in interest rates continues at a different pace from country to country, the trend is the same.
As we have touched on in some of our earlier articles, domestic and international base rates dictate the cost of borrowing. When borrowing costs are relatively low, consumer spending and economic growth are encouraged. Conversely, if an economy is overheating, the central bank would increase interest rates, thereby increasing the cost of borrowing and reducing consumer spending.
Exchange rates
When focusing on the domestic economy, we tend to look towards inflation and other common factors. However, exchange rates are vital when taking an international approach to trade. A relatively high exchange rate will encourage imports but restrict exports. A relatively low exchange rate will boost exports but limit imports. Exchange rates reflect underlying economic performance, but interest rates can still be influential. The higher interest rates, the rate offered to lenders, the more attractive a currency is to investors, and vice versa.
The use of interest rates to protect exchange rates was epitomised by what became known as “Black Wednesday“. This was when the UK government was forced to exit the European Exchange Rate Mechanism (ERM). After increasing base rates to 10%, then 12%, and finally 15%, all on the 16th September 1992, the UK government eventually gave up the ghost and left the ERM. While this infamous chapter in the UK’s history demonstrates that interest rates aren’t always influential, they usually are in “normal” circumstances.
Inflation
There is a general misconception that inflation should ideally be avoided at all costs, but this is not the case. Moderate inflation allows economies to grow, prompting wage inflation, increased demand, price increases, business growth, etc. However, out-of-control inflation can lead to a spiralling increase in the cost of goods and services, which are not backed up by wage inflation. Eventually, as more and more goods and services become unaffordable, job losses will ensue, consumer confidence will disappear, and economies can crash. Interest rates are one of several tools central banks worldwide use to control inflation.
Commodity prices
The movement in commodity prices is influenced by various factors, most of which are beyond the control of global governments. Oil and gas are perfect examples where supply restrictions can lead to price spikes, prompting an increase in inflation.
A considerable increase in the cost of gas has led to a significant rise in UK and European energy bills. As these factors feed into the inflation calculation, inflation in the UK now stands at a 30 year high of 5.4%. This has placed the Bank of England between a rock and a hard place. Ideally, they would look to increase base rates to curtail consumer spending. However, the economy is still feeling the effects of the Covid pandemic. Many believe that the Bank of England is gambling that this spike in inflation is temporary; however, the longer it goes on, the more damaging it will be to the economy.
Interest rates and the global economy
It is fair to say that the last 14 years, since the US financial crisis of 2008, have placed both national and international economies in an unaccustomed scenario. Historically, interest rates have influenced everything from economic growth to inflation, consumer spending to exchange rates and more. While there is still a degree of influence when adjusting interest rates, this power has certainly diminished in the current environment.
We will return to a degree of normality at some point when interest rates will re-emerge as a primary but potent tool. On the global stage, interest rates allow governments to exact an element of manipulation to ensure their economies remain competitive. Balancing this international need with domestic issues is not easy.