What’s so wrong with high interest rates?

IT COULD take a while for investors to adjust to higher interest rates. After all, it was four years ago in 2022 when central banks embarked on serious monetary tightening.

After a pause, they have started raising rates again, and it is quite possible that the cost of borrowing will remain elevated for longer, if we listen to what central banks around the world are saying.

The US Federal Reserve, much to President Donald Trump’s annoyance, was unanimous in its decision to raise the Fed fund rate in September. Trump claimed that the rate-setting board was hostile to the idea of lowering interest rates.

But hostility had nothing to do with it. Instead, it was the reality that US inflation could remain higher for longer that prompted the Fed to increase rates. The causes of sticky US inflation can be traced to clumsy policy decisions by Trump.

Meanwhile, Christine Lagarde, president of the European Central Bank (ECB), said that the bank’s decision to raise interest rates in September was a no-brainer. Every ECB policymaker at the meeting agreed that inflation risks were to the upside.

The bank is expected to raise interest rates again before the end of the year, as inflation is nearly double its 2 per cent target.

The order of the day

Other central banks that have raised rates include the Bank of Japan, Bank of Korea and Reserve Bank of Australia.

The Reserve Bank of India raised its benchmark policy repo rate for the first time in nearly four years. The hike was driven by rising energy prices, geopolitical pressures and climate change. India’s central bank said that rate cuts are off the table and future decisions will be dependent on inflation data.

Meanwhile, America is hoping that it can reduce energy prices by letting Russia release its diesel, which had been previously blocked by the US. The embarrassing back-pedalling by Trump is unlikely to work.

It is unclear how a temporary reprieve of sanctioned Russia fuel would lower prices, given that available diesel is still in short supply. It merely shifts the problem from one part of the world to another.

It would appear that we are entering a period when central bank monetary tightening could be the order of the day. It seems implausible that the rate of inflation would fall back to many central banks’ preferred target of 2 per cent for a while.

So, we will have to learn to live with interest rates staying higher for longer.

Winners and losers

Not everyone will be unhappy with higher interest rates; some investors might even welcome them.

Savers, for instance, would be delighted if rates stay elevated. They would finally earn higher yields on their savings accounts, money-market accounts and short-term certificates of deposits.

Those close to retirement might also appreciate higher interest rates. They can swap their savings for regular, guaranteed income payments for a set number of years.

In some instances, it could even be for the rest of their lives.

When interest rates are low, annuity rates can be abysmally low, too. But when interest rates rise, annuity rates and payouts could go up, regardless of what happens to inflation subsequently.

The reason why central banks are raising interest rates is to quell inflation.

When borrowing rates are high, consumer spending could drop, as indebted households cut back on discretionary spending. It could prompt businesses to delay capital spending and encourage people to save more.

The upshot is that demand for goods and services could drop, which in turn could force businesses to stop raising prices. Interest rates are, admittedly, a blunt tool to address inflation. But it works.

Jam today or tomorrow?

However, rising interest rates can also have an impact on the stock market. In particular, companies whose earnings will materialise only in the distant future could find themselves disproportionately affected. Their future profit when discounted to the present day could be worth less when interest rates are high.

That does not bode well for some businesses that are directly involved in artificial intelligence, where it can be more a case of a promise of jam tomorrow rather than jam today.

But for those businesses that can deliver large dollops of jam today, higher interest rates could be less of a problem.

Banks, for instance, could benefit as their net interest margins widen, thanks to higher rates. They might have to pay more interest to savers; but they can charge even more interest to borrowers, which would increase their net interest income.

Insurance companies could benefit, too. They could earn more from their investments in fixed-income assets such as bonds and government securities.

It is quite possible that stock markets on the whole could react badly to higher interest rates. But provided we own a well-diversified portfolio of assets, it could be a good opportunity to buy more of what we like at better prices.

For me, it couldn’t be easier. As an income investor, I can buy more at today’s more-attractive prices for tomorrow’s dividends.

The writer is co-founder of The Smart Investor