A World with Higher Interest Rates

The past ten years have been characterized by extraordinarily low interest rates around the industrialized world. These rates have persisted in the wake of the recent economic crisis, as central banks have loosened monetary policy significantly. While a dramatic increase in interest rates over the near-term is unlikely, speculation is rife that such an increase is not only plausible, but could unfold rather quickly, impacting virtually every major sector of the economy.

This study attempts to take a more cautious and global approach in examining one possible future path of interest rates and their impact on selected sectors. Based on an analysis of global savings supply and investment demand, we suggest that a return to higher real rates could happen through the savings supply channel. In addition, higher inflation could result in a contractionary monetary policy and higher nominal rates.

This report analyzes some of the consequences of a rise in interest rates. One heavily impacted area would be debt service for industrialized governments. Here, we identify rollover risk as a key factor for determining the size and timing of the debt service problem in the near future. Our findings suggest that countries with low debt maturity would be more prone to debt service problems than countries with long maturity debt.

A high interest rate environment would create sets of winners and losers across the global economy. The U.S. Social Security system trust funds, for example, could avoid projected bankruptcy through higher interest income, while consumers with variable rate debt, such as students with private loans, would be hurt significantly. In addition, corporate pension plans would benefit from rising interest rates, while equity markets would suffer.

To understand how tightly the financial markets are tethered to interest rates, it’s helpful to look at May 2 to July 5 of this year.

Among the vast cohorts of losers − and a few winners − would be nations whose governments have taken on enormous debt, like the U.S., where outstanding public debt soared from $5.7 trillion in 2001 to $16.3 trillion in 2012. The reason is clear: rising interest rates would kick up borrowing costs, with the problem most severe in the U.S. where the average maturity for debt – lower than in any other industrialized country in the world – would trigger the need for quick refinancing. A five percent cent spike in interest (to the 7% average of the last 30 years) would force the U.S. government to commit as much as 25 percent of its revenues to debt service, prompting the need for draconian spending cuts. Foreign holders of U.S. debt such as the Chinese Central Bank would also suffer since the bonds they own would lose significant value.