Tuesday 27 September 2016 by Opinion

Will normal interest rates ever return? One argument that points to a strong “no”

Governments around the world simply cannot afford higher interest rates.  The major economies of the US, EU, China and Japan are so indebted that any increase in rates has a greater impact on their budgets than prior to the GFC. What’s more, a slower economic growth forecast means a slower increase in their revenues, putting their interest coverage ratios under much more pressure if rates rise


What’s more, a slower economic growth forecast means a slower increase in their revenues, putting their interest coverage ratios under much more pressure if rates rise

Government debt has risen steeply while interest rates have fallen. Governments are now far more sensitive to changes in interest rates – higher rates will cost them more on their bourgeoning debt piles. 

While central banks are independent of government, they need to be conscious of government spending as it typically makes up around 20% of GDP for any given economy.  If a central bank raises interest rates, government interest payments will rise and force spending cuts elsewhere, impacting the economy as a whole.

World’s largest governments cannot afford higher rates

Interest costs for the world’s major economies are relatively benign at today’s rates, but indebtedness is very high.  This means that their sensitivity to rising interest rates is particularly acute.  Figure 1 shows each of the world’s largest four economies’ indebtedness relative to their size (Debt to GDP); debt relative to government revenues (Debt to Income); their current average interest rate (cost of funds); and their interest coverage ratio or the number of times that their revenue covers their interest costs (ICR).  It further extrapolates the cost of a 2% per annum rise in interest rates over five years.

Figure 1: Return to the ‘old normal’ interest rates is highly unlikely

Government debt today and sensitivity to return to historic normal rates

Current government debt ratios
Impact of 2%pa increase in rates over the next five years
  Debt to GBP Debt to income Average cost of funds (pa) Interest coverage ratio Interest coverage ratio GDP impact of displaced govt spending (current GDP in brackets)
Japan 232% 675% 1.3% 11.0x 4.4x -2.0% (0.96%)
China (incl SOEs) 80% 349% 2.9% 10.0x 7.2x -0.9% (6.25%)
US 105% 325% 2.5% 12.5x 8.0x -1.5% (2.13%)
EU 86% 183% 2.8% 19.6x 12.0x -1.5% (1.43%)

Source: FIIG Securities, OECD and Federal Reserve Economic Data

The GDP impact only considers the impact in terms of lower government spending, and assumes that governments would seek to recoup the extra cost through lower spending or higher taxes.  This is a crude assumption, but it is reasonable to assume that the already high sensitivity to fiscal debt would only rise if their cost of funds rose.

The results show:

  • Japan would fare particularly poorly.  Japan is only paying an average 1.3% pa to borrow money today.  Higher rates for Japan would very rapidly reduce GDP growth on the impact on government spending alone. Even a 1% increase in rates would put their ICR in line with global peers; a 2% increase would put them in perilous situation.  What’s more, around 33% of Japan’s GDP comes from government spending, so any increase in rates would be detrimental to GDP.  It is clear that Japan’s rates are not going to materially rise until debt can be reduced to well below 150% of GDP, that is not within the next 10 years at least.
  • China has more flexibility than Japan, but has a particularly low revenue base at just 22% of GDP (compared to 33 to 35% for the US and Japan and 47% for Europe).  This means that China needs GDP growth to continue in order for it to manage further debt or higher rates.  The biggest challenge for China is that higher rates will put upward pressure on their currency, damaging export competitiveness at a time when exports are already falling sharply.  So regardless of whether they can afford higher rates, China’s reliance on exports means that they will need to follow the moves set by their biggest customers: the US and Europe and their biggest competitor, Japan.
  • Europe’s financial stability is actually in better shape at present than the US.  Even if rates were to rise by 2%, their ICR would still be better than the US’s today.  That said, higher rates would contribute to greater instability in Europe with its wide range of debt ratios; interest costs take up more than 4% of GDP in Italy and Greece but just 1.6% in Germany.  However, Europe does not have the GDP growth that the US has, and faces more severe headwinds to fiscal stability due to its falling population and political instability.  Revenue collection is already very high so taxes cannot be increased further without worsening the already damaging population decline.  Europe cannot afford export competitiveness to fall, and so once again will be beholden to the path for US rates at one end and Japanese rates at the other. 
  • While not as extreme as Japan, the US would not fare well in terms of its ability to cover interest costs.  The ICR for the US falls sharply due to its relatively low cost of funds today, but will be made worse by the rapid rise in social security costs over the next decade, which are expected to jump by $500bn per annum in the next ten years.  On the other hand, the US has more GDP growth at present and so can withstand some of the shock that a jump in rates would cause via lower government spending.  An increase of 2%pa would be quite damaging to the economy as a whole, but a 1%pa increase would have an impact on the economy of around 0.75%pa and so might be justifiable to allow for some flexibility in the future.  

Currency implications

The reality of an interconnected global economy is that they interact through currencies.  Higher interest rates in one country mean their currency becomes more attractive relative to the others; more capital flows into that currency; and the currency goes up relative to the others.  Export competitiveness declines, creating downward pressure on interest rates.

So when we conclude from the above that Japan cannot afford any increase in rates, that China and Europe can afford some but have to watch the impact on their currency, and the US has more flexibility to increase but only by around 1%pa.  My best guess is that the US will eventually increase rates by around 1 to 2% and no more, but that they will be very slow to do so because Europe, Japan and China will be far more conscious of their currencies. 


All of this assumes that inflation remains benign and that the Fed in particularly is not forced to increase rates.  The economic outlook does not raise much chance of inflation, particularly given that energy, the most common cause of unexpected inflation, is capped by the US’s ability to increase production should oil prices rise much above US$50 a barrel. 

Trade winds across the globe

The inter relatedness of monetary policy is greater now than ever before because of the major economies’ higher indebtedness and due to the importance of global trade.  That said it is the US economy that will lead the march to higher interest rates because their economy is currently more robust and less export dependent than all the others.

The US will take the lead, but must be mindful of the others’ responses.  If the US Federal Reserve operates in isolation, the USD will rise too quickly and damage the US economy.  If they don’t increase rates, they won’t have the flexibility to stimulate the economy in the next downturn. 

As to the size of the rate rises – that will more likely be set by their own affordability, both government and private sectors.  Looking at government alone as per the analysis above, an increase of 2%pa appears unaffordable while debt is over 100% of GDP.  If the US can manage to pay down some debt gradually over the next decade, despite their rising social security costs, they might increase rates by as much as 2%pa, but more than this is very unlikely.  The forward costs of current social security policies alone will mean budget surpluses will be very hard to achieve in the US for the next 20 years at least, and changing those policies will take several election cycles.  The more likely scenario is that rates will rise by enough to put pressure on the government, but no more.  To my mind, an increase of 1.5%pa is the likely ceiling.

Assuming I’m correct, they will follow a very slow path eventually lifting rates by around 1.5%pa.  This is likely to mean an increase by 25bps in 2016, and 25 to 50bps for each year after until rates hit 1.75%pa.  Europe will follow with a lag of at least 12 months, but more likely two years.  That will mean the gap between the US and EU cash rates will reach as much as 1%pa.  Japan may not follow at all.  If Europe and Japan are slow to respond or do not respond at all, the US will certainly not exceed 1.5%pa in interest rate increases. 

The bond yields suggested by this analysis are as follows, with a comparison to the current yields (as at 23 September 2016).

Figure 2: US Government Bond Yields, Forecast from above analysis vs Current Market Yields

Source: FIIG Securities

We could run the same analysis using household or private sector debt ratios, but the data is less consistent across countries so the outcome would be less reliable. 

Where does all of this analysis leave Australia? We have extremely low government debt and very high household debt, so it would make more sense to assess Australia’s new normal interest rates using household debt levels.  But that’s for another day.


Central banks would need to be very confident about economic growth before raising rates anything like the 2%pa required to get back to even the lower end of historic levels.  The above analysis only looks at the GDP impact of lower government spending, and not the impact on the private sector.  And these forecasts are even at the assumption of increases occurring over five years. 

The US, China and Europe can possibly afford around half this increase, that is 1%pa, but Japan would be returned to a recession even with that small increase, and even before the impact on the private sector is considered.