Should we prepare for permanently higher interest rates?
Recently, the European Central Bank and other central banks started to cut interest rates, sending out the signal that the fight against inflation will hopefully soon be successful. Inflation rates have fallen significantly in the eurozone and worldwide; however, in many places inflation is still slightly above the central banks' targets. Inflation is always associated with high costs. People in many other countries have suffered from the sharp increases in food and energy prices, for example. Nevertheless, we can be glad that there have not been even higher costs - such as a recession and a sharp rise in unemployment.
Even though interest rates have now begun to be gradually cut, it is quite possible that interest rates will no longer fall to the very low levels seen in the years between the financial crisis and the pandemic. There are indications that structural factors such as faltering globalization will increase inflationary pressure, which would lead to higher interest rates in the medium term. Until recently, globalization has dampened inflationary pressures. For example, the removal of trade restrictions such as tariffs has pushed down the prices of tradable goods. In addition, China's economic opening has led to the availability of several hundred million new workers for internationally active companies, which has contributed to the relocation of production facilities from advanced economies. The collapse of communism in Central and Eastern Europe had similar effects. Structural change was accelerated in the advanced economies, which was probably accompanied by job losses and wage pressure in industry, for example. However, one should not forget the major benefits of globalization, for example in the form of cheaper products, which have also contributed to low inflation.
At least two factors are now likely to bring these developments to an end, as the two economists Charles Goodhart and Manoj Pradhan have been arguing for some time. Firstly, demographic change is leading to structural labor shortages in many places. In many places, more people are already reaching retirement age than there are young people entering the workforce. This is accompanied by lower unemployment and more bargaining power for many employees, who are likely to enjoy wage increases in the coming years. As a side effect, stronger consumer demand will probably also increase inflationary pressure somewhat. Secondly, trade and geopolitical conflicts are on the rise, particularly between Western countries and China. Higher tariffs and other trade restrictions, together with geopolitical risks, are leading to price increases in international trade, which could further fuel inflation in advanced economies.
These developments, if they actually continue, are likely to prompt central banks in advanced economies to keep their key interest rates higher than in the years following the financial crisis. It would be positive if we no longer experienced phases with negative interest rates. However, the reasons for the higher inflationary pressure described above are associated with major challenges. For example, geopolitical conflicts are unpredictable and can cause enormous suffering. We are still inadequately prepared to deal with an ageing population. Our societies also have to deal with other major challenges, such as climate change and artificial intelligence. It is quite possible that these megatrends will make future economic development unsteady and unpredictable. In addition to higher inflationary pressure, this unpredictability and the associated shocks such as natural disasters and sudden outbreaks of war could also cause inflation to fluctuate more than in previous decades. We should therefore be prepared for the coming years to remain challenging for central banks with higher and more volatile interest rates.
