Inflation is falling, but now interest rates are rising menacingly high – no one knows why. Because ‘electric’: The US car market is growing with large SUVs and pickups

One problem solved; the next one is already here. It has always been this way in recent decades, writes the American Nobel Prize winner Paul Krugman in his latest newsletter. And so it apparently is this time: “Goodbye inflation; Hello unsustainable debt.”

First about inflation. The supposed victory over inflation is surprising. So far, no central bank has made such a statement. But Krugman says it’s only a matter of time before the Fed and its counterparts abroad dare to say so openly: “but inflation appears to be a solved problem.”

Inflation is currently just a hair above the 2 percent per year where the Fed wants it to be. In concrete terms, inflation was only 2.2 percent over the past three months, Krugman says. If so, inflation would effectively be defeated.

But how does Krugman arrive at this 2.2 percent? Officially, much higher annual inflation was announced for the US. In August, the price index for personal consumption expenditure was 3.9 percent higher than in the same month last year. So almost twice higher than the inflation target.

According to Krugman, this 3.9 percent exaggerates remaining inflationary pressures. This includes price increases over the past twelve months, which will not be repeated. When you look at this 3.9 percent, you are fighting inflation that no longer exists.

Inflation has fallen significantly in recent months, so only more recent figures should be taken into account. To do this, Krugman takes the past three months’ inflation and extrapolates it out to a year. If things continued as they have for the past three months for a year, inflation would be just 2.2 percent. Battle won.

A strange economic cycle

It would be a surprisingly easy win. Prominent economists had long warned that the Fed would have to force the economy into a recession and push the unemployment rate to levels not seen in decades. In the past this has almost always been the case. Strong interest rate increases were usually followed by a recession.

But this time the recession is taking a long time, even though it has been predicted for a long time. It may take longer; it often takes a long time for the economy to respond to interest rate increases. Krugman’s argument is that there can be no recession this time. Because the current economic cycle is simply ‘strange’ – as a result of Corona.

The inflation shock was mainly caused by the pandemic. Supply chains broke and companies had to repair them. In the meantime, there were shortages and increases in inflation. When the economy returned to normal, inflation also increased.

Things are similar in Europe, Krugman says. “Disinflation is spreading across the Atlantic.” Inflation is falling rapidly in the eurozone. In September, inflation fell to 4.3 percent – ​​the lowest level in almost two years.

In Switzerland, consumer prices were 1.7 percent higher in September than in the same month last year. If things continued as they have for the past four months, Switzerland would soon have inflation below 1 percent again. The Swiss National Bank is also said to have won its battle against inflation.

So far so good. Actually.

But in recent days, interest rates have suddenly risen sharply – despite the emerging victory over inflation. In the US, yields on ten-year government bonds reached their highest level in sixteen years this week, and in Germany they reached their highest level in twelve years. No one really knows why.

The markets have capitulated

“It’s confusing,” says a former manager at the New York Fed and current chief economist at the bank, according to the Wall Street Journal: “No fundamental explanation is convincing.”

For a long time, the bond markets did not want to listen to the central banks. They could say as often as they wanted that their key interest rates would remain high for a long time; the markets wouldn’t buy this. They are betting on an early interest rate cut.

No longer. The bond markets have “effectively capitulated,” Krugman writes. The Fed recently went ahead and insisted that key interest rates would stay higher for longer and possibly go even higher – suddenly the bond markets started to believe it.

This in turn could lead to all kinds of new problems; some are already emerging. Or, as Krugman puts it: “Cracks are forming.”

What worries him most is that real interest rates – after deducting inflation – are currently higher than long-term economic growth. If this continues, it will have “huge and worrying consequences.”

The national debt would generally grow faster than the economy, measured in terms of gross domestic product. That wouldn’t work in the long run. Krugman: “The sustainability of high debt would become an important issue for the first time in many years.”

The consequences have reached Switzerland

The consequences have already spread to Switzerland. As ZKB analysts write, share prices fell in September – again. “The stock correction that started in May has continued.” The “spoil sports” included “the continued rise in long-term interest rates.”

And it wouldn’t stay that way. High interest rates in the US signal a possible new normal for financial markets around the world, including in Switzerland. There would be no return to the record low interest rates of before Corona. The interest burden would remain higher.

This would mean that the higher interest rate would reach more households that are currently still protected by a fixed-rate mortgage. There is often a risk that the interest burden will double. In 2024 alone, around 130 billion francs worth of mortgages will have to be renewed, advisor Moneypark has calculated. All were completed before the interest rate turnaround.

But are the bond markets really right? Krugman doubts it. Because the trend that pushed interest rates to newer and newer depths before Corona is still present: slow population growth.

Slow population growth means less need for new homes, new shopping centers, new factories or office buildings. Therefore, fewer investments are needed; Savings are less scarce and therefore their price, namely interest, is falling.

“Well, we still have population growth,” Krugman writes in his newsletter. “So why wouldn’t we expect rates to return to pre-COVID levels once the Fed stops fighting inflation?”

The only thing that is certain is that the worries in the financial markets are not over yet. (aargauerzeitung.ch)