Toothless central banks: will the interest rate increases remain ineffective?

Péter Varga, Senior Professional Fund Manager, is of the opinion that the interest rate increases announced by the central banks will come with several unwanted side effects. In this interview, he explains the reasons for his scepticism.

What is the driver of the high inflation that we are currently seeing?

Inflation always occurs when demand is bigger than supply. Due to the production backlog caused by Covid, almost all companies are working at capacity, and yet they fail to satisfy demand as a result of a lack in machinery, commodities, or parts. The latter two, in particular, are currently causing issues for numerous companies. The causes are rooted both in the pandemic and in the war against Ukraine.

According to Federal Reserve Bank of San Franciso more than 50% of US-Inflation (PCE deflator) can be attributed to supply-driven and ambiguous facts.

What can the central banks do?

Neither the fight against the pandemic nor the termination of the war are ultimately up to the central banks. As a result, we will remain subject to high energy prices, which are a main driver of inflation. The central banks cannot pull more grain or fertiliser out of a hat by printing money. The only lever they have is to correct demand downwards. For this reason, they increase the purchase cost of goods and services.

How can this work?

Central banks can try to make this work by stepping up the interest rates on loans and inducing a higher propensity to save among consumers. This calms demand and reduces the price increase.

What effect does this scenario have on consumers?

The consumers feel it twice: first, their loan instalments (if they have a loan with variable rates) increase. And second, they feel it because of the rising prices for goods and services. The result is a significant loss in purchase power and a cash flow problem.

„The consumers feel it twice: first, their loan instalments and second, they feel it because of the rising prices for goods and services.“

Péter Varga, Senior Professional Fund Manager Erste AM

^{© Photo: Stephan Huger}

What does this mean specifically?

If the wage increases fail to thwart these effects noticeably, more and more debtors will find it hard to pay their instalments in a timely fashion. Consumption will also suffer (with the inflation-adjusted value of our wages falling). Companies are facing a similar situation; they will be in trouble if they cannot increase their prices, and they will have to expect a decrease in demand.

In summary: what future scenario do you expect?

This is hard to answer. From my point of view, there are various aspects that will influence the future.

Wage increases: since the labour market is tight, we might see significant wage increases. This does not automatically have to lead to falling demand; in other words, we will be living with inflation and high nominal yields in the long run. The so-called wage/price spiral will advance further. Without wage increases and interest rate hikes by the central banks, the high inflation would push down purchase power noticeably.

Interest rate increases: in order to fight inflation, some central banks have already increased their interest rates or taken preparations to do so in due course. The effects do not only affect debtors, but also investors: the correction suggests falling asset prices, e.g. for equities that end up in a bear market. Or for real estate, which records falling demand as it has become unaffordable due to purchase power losses and an increase in the interest rates on loans. Consumers feel less wealthy and accordingly reduce their consumption.

Ukraine war: if the war ends and the commodity supplies pick up again, we can expect a much more relaxed situation. This situation clearly highlights the fact that in a world with cross-continental supply chains and optimised production processes, it is impossible to pursue imperialistic policies without significant consequences for the global economy.

This means that geopolitics will decide the fate of the global economy?

That’s right. This is why I want to appeal to all influential politicians: the fight against inflation is largely in your hands, and not in those of the central banks!

For a glossary of technical terms, please visit this link: Fund Glossary (erste-am.at)

^{Legal note:
Prognoses are no reliable indicator for future performance.}