The End of Zero: Prepare for a World With Higher Rates

The End of Zero: Prepare for a World With Higher Rates

Inflation and tight job markets are forcing the hands of central banks to end an era of ultra-low interest rates. The results will be profound.

by Justin Lahart / via The Wall Street Journal

Warren Buffett has compared interest rates to gravity. That is an especially useful way to think about them right now.

For the last two decades the developed world went from living on Mars, with barely a third of Earth’s pull, to the Moon more recently with even less. Now we might finally return to what used to be normal. For consumers, businesses and even governments, the transition will feel alien. Many will find it crushing at first, while others will be reinvigorated by a world where money costs something. Some that grew up on those extraterrestrial colonies simply won’t survive the transition.

On Wednesday, Federal Reserve policy makers didn’t just lift their range on overnight rates above near zero for the first time in two years but promised to keep on doing it through this year and next. The European Central Bank surprised markets earlier this month by setting the stage for rate increases later this year. The Bank of England started raising last year.

With Russia’s invasion of Ukraine pushing any relief on inflation into the future, and the job market in the U.S. particularly tight and getting tighter, the risk is that policy makers will be raising rates by more than they are currently signaling. And with the short-term interest rates that central banks control heading higher, long-term interest rates, which encapsulate investor expectations for what short-term rates will average over the long haul, seem likely to rise as well.

The low-rate environment that the world has become accustomed to has fundamentally altered how economies work. The companies that investors prefer putting their money into, the prices that people are willing to pay for houses and the spending choices that governments make have all been shaped by it.

Consider: Even though the current yield on the benchmark 10-year Treasury yield—the backbone of long-term borrowing costs around the world—has risen to 2.19% from 1.37% over the past six months, that only brings it to around its average level over the past decade. If it were to move to the average of 4.6% it carried in the 2000s up to the start of the 2008-09 financial crisis, interest payments on many loans could more than double. In the latter half of the 1990s it averaged 6.1%—a level which was perceived as very low at the time but which now seems onerous.

Low rates have reworked financial markets. Unable to achieve much in the way of returns by investing in Treasurys or other safe assets, many investors have pushed into riskier ones that offer the possibility of big payouts in the distant future. This includes the shares of profitless companies that, lottery-like, could come up big someday, and cryptocurrencies. It has also affected the types of startups that venture capitalists and other early-stage investors have backed. Rising rates could fundamentally change what sorts of assets investors want to plow their money into or how much they are willing to pay.

One place a shift in investor preferences from rising rates could shake things up is in the banking sector. Investors looking to bolster returns have funded a bevy of online consumer lenders and mortgage originators that have gone on to take market share away from banks. But those investors may be less keen on funding nonbank lenders if higher interest rates allow them to garner higher returns elsewhere. Old-fashioned banks, which are funded by deposits, should have the advantage since depositors tend not to move money out of the bank just because they can make a bit more lending their money elsewhere.

For many Americans, the place where rising rates would have the clearest effect is housing. Mortgage rates have been very low for a very long time, boosting people’s perceptions of how expensive a home they can afford—part of why home prices have risen so much. Millions of people who already owned a home have refinanced their mortgages, dramatically lowering their payments. Higher rates could both make homes less affordable while reducing the number for sale since current owners who locked in low rates won’t want to give that up.

But this comes at a time of revived interest in homeownership touched off by the pandemic. Millennials moving into their prime earning years could mean that many people will still be hankering for houses. Housing can weather rising rates, as it did in the 1970s, but with the cost of ownership rising even as actual home prices move sideways.

Rising rates could pose challenges for governments around the world. The U.S. government had high levels of debt even before the pandemic hit, and the trillions of dollars it spent on Covid relief only added to its IOUs. Low rates have made it easier for it to service that debt, but now it looks as if America’s ability to fund itself is going to get much more difficult. Many other economies are in the same boat. The European Central Bank has the added difficulty that rising rates could be most pronounced among its southern members, introducing fresh strains to its monetary union.

For emerging-market countries, higher interest rates in the developed world have traditionally made attracting capital more difficult, setting off many crises. Some past victims are better-prepared today, but a handful look vulnerable and that could spook global investors.

The extent to which rising rates cause chaos depends on our speed of re-entry—something central banks have only a limited ability to control. However bumpy the ride, a return to normal will feel like anything but that.

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