New challenges for central banks

During the two oil crises of the 1970s, triggered by a deliberate shortage of oil, the US central bank began to use the so-called core inflation rate instead of the normal inflation rate. This excludes the often highly volatile energy and food prices. The completely correct idea was that monetary policy cannot influence these prices. Now, previously irrelevant influencing factors are once again emerging, making a reform of monetary policy necessary.

On October 6, 1973 - almost exactly 50 years ago - Egyptian and Syrian troops attacked the Israeli army, which was standing on the Golan Heights and the Suez Canal at the time and was surprised by the attack. The Arab oil-producing countries turned off the oil tap to the Western world, which was still heavily dependent on oil at the time. The oil price suddenly rose sharply (Figure 1).

As a result, the US central bank realized that combating oil price-driven inflation with sharp interest rate hikes was not very promising, as the oil-producing countries were unlikely to be impressed by US interest rates in their pricing policy. For this reason, the aim was to make monetary policy independent of the very high fluctuations in the oil price since 1973, which had increased tenfold from 3.4% p.a. to 35.6% p.a. (chart 2). The focus was now on the core inflation rate, which excludes energy and food prices. This is significantly more stable than normal inflation in the USA and in the eurozone, which has adopted this concept (charts 3 and 4).

In recent years, other economic factors have changed drastically, which - like the oil price before 1973 - were stable for decades and completely unproblematic for inflation and likewise cannot be influenced by the central banks. The first factor to be mentioned here is demographics. Until around 2010, the number of people of working age in the major regions, which most analyses put at 25 to 64 years, rose steadily for decades (charts 5 to 7).

Since 2020, however, a sustained decline has set in in the eurozone and China, the consequences of which for inflation in the eurozone are already becoming apparent (chart 8). Until 2020, there was no correlation between the unemployment rate and the change in unit labor costs (wage share of companies' production costs) (blue dots in chart 8). The increase in unit labor costs was roughly between 1% and 3% and was independent of whether the unemployment rate reached 7% or 12%. From 2020, the increase in unit labor costs reached values between 2.5% and 6.5% from an unemployment rate of below 7%, because although the eurozone is on the verge of a recession (chart 9), the unemployment rate remains low (orange dots in chart 8, in Q2 2023 the lowest unemployment rate since 2010). Employers have obviously had to pay higher wages since 2020, even in an economically weak environment, in order to be able to find workers at all. The ECB would therefore have to raise interest rates more in these demographically difficult times than in previous, demographically more favorable times in order to push down inflation. However, this would put additional pressure on companies that are already burdened by structurally higher wage costs. It was precisely this double burden that central banks rightly wanted to avoid when they switched from normal inflation to core inflation 50 years ago; the scarce supply of oil in the 1970s corresponds to the scarce supply of labor today. Therefore, central banks should remove the demographic component of inflation and abandon the 2% inflation target from the era of favorable demographics and raise it to a higher 3% or 4%. Although a 2% inflation rate is certainly achievable in the short term, it is unrealistic as a long-term inflation target.

Even in the USA, which will have to cope with stagnation rather than a decline in the number of workers in the future (chart 6), wage trends will no longer have an inflation-reducing effect. Since the start of the sharp rise in the labor supply in around 1970 (see chart 6), the wage bill for employees in the US has fallen from 59% of national income to 52% today. The pressure on companies to raise prices has remained low thanks to over 50 years of falling labor costs. This trend is now likely to come to an end; the inflation rate in the USA will also rise for demographic reasons, although possibly not as strongly as in the eurozone or China in the long term.

The second structural inflation-increasing factor is the restriction of free global trade. Figure 11 shows the growing share of imported goods worldwide that are made more expensive by customs duties. In 2009 there were 73 import restrictions due to customs duties, in 2021 there were 2,041 cases. The share of imports subject to tariffs therefore rose from 0.6% of global trade to 9.2%. As a result, prices are rising worldwide without interest rate hikes being able to influence governments' tariff policies in any way.

The increasing influence of industrial policy interventions by the respective governments on the domestic economy has the same effect (charts 12 and 13).

The geopolitical desire of many governments for a certain degree of self-sufficiency, i.e. the replacement of goods previously purchased abroad, such as microchips, with domestic chip production, is absolutely understandable. This reduces the risk of suffering a production stoppage due to a lack of deliveries of important supplier parts, as the automotive industry had to experience during the coronavirus pandemic. Nevertheless, there is an inflationary effect, as the products previously purchased abroad were imported because they could not be produced domestically at similarly low costs. These politically desired inflationary developments should also be taken into account by central banks, as interest rate hikes will not influence governments' drive for self-sufficiency or the widespread desire to reduce CO2 emissions. Figure 14 shows that the increased use of wind and solar energy in electricity generation is accompanied by higher electricity prices on average and thus has an inflationary effect.

In Germany, the high electricity price not only increases inflation, but is also a particular burden for the still strong industry, which is gradually lagging behind the average of the eurozone countries (Figure 15; the only graph in the special contribution by the head of the ifo Institute, Prof. Clemens Fuest, for the monthly report of the Federal Ministry of Finance, who points out the dangers of the German special path of an energy transition without fracking and nuclear energy).

The final influencing factor that will soon dampen the US central bank's courage to raise interest rates in particular is the enormous level of new debt in the US compared to the fairly solid eurozone, which has been almost 5 percentage points higher on average than the deficits of the 20 eurozone countries in the last 5 years alone (chart 16). US government debt amounted to 120% of national income in the second quarter of 2023 (chart 17, the comparable figure for the eurozone was 90.3%). The resulting interest expenditure is likely to far exceed the highest levels in US history (approx. 3% of national income in the 1980s, chart 18, blue line) in just a few years. This would probably overwhelm the US government, as the financial burden on the state due to the ageing population and the geopolitical situation, which continues to require high military spending, will certainly not decrease. So far, not only the US central bank but also buyers of US shares have ignored these foreseeable problems. If government deficits in the eurozone had also been at 9% over the last 5 years, the eurozone would have experienced a boom that would have far overshadowed the currently still growing US economy.

To solve this problem, the US government may be forced to raise corporate taxes, which are currently at an extremely low level (chart 19). When the national debt in 1945 was similar to today (chart 18), companies paid taxes to the government amounting to more than three times the interest expenditure. Today, the total tax burden on companies is less than a third of the interest costs expected for 2024. However, an increase in corporate taxes is unlikely to be politically feasible. In a few years' time, the US central bank will then have to lower interest rates again by printing money and buying government bonds, which will depress the US dollar exchange rate. Investors are currently not prepared for either rising corporate taxes or a falling dollar exchange rate.

However, the current interest rates in the USA will not only overburden the US government in a few years' time, but also the entire economy, including private households and companies. The US government currently has to pay interest of 5% on 10-year government bonds and 5.5% on 1-year bonds (source: Trading Economics, 27.10.2023). Private households pay 7.8% for the majority of their debt (real estate loans), the interest rate for 30-year mortgage loans (source: US Federal Reserve St. Louis, 26.10.2023), which are particularly popular in the USA. In between is the interest rate for corporate bonds rated BAA by the rating agency Moody's (currently 6.8%, source: US central bank St. Louis, 25.10.2023). This interest rate can be seen as an estimate of the average financing costs for the entire US economy over the next few years.

If the financing costs of the entire US economy (BAA-rated corporate bonds, red line in chart 20) have been more than 3% above the nominal growth of the economy in the last 54 years, i.e. above the dashed black line, the economy has always entered a recession (gray bars), with one exception. The simple reason for this is the fact that incomes then do not grow strongly enough to easily finance the rising interest costs; consumption and/or investments have to be curtailed. During recessions, government debt (blue line) grew strongly because the government had to support the economy. The only exceptions were the years from 1984 to 1987, when government debt showed high growth rates even without a recession. The reason was quite comparable to the current situation - corona and geopolitics. After the Soviet Union invaded Afghanistan at the end of 1979, the US government under President Reagen began a sharp increase in arms spending to deter the Soviets from further conquests that threatened Iran, Iraq and Saudi Arabia, which were very important oil-producing countries for the US at the time. The result was high government deficits, but also a strong economy that was able to cope with the high financing costs in the years 1984 to 1987 (red line above the black line without recession). In contrast to today, however, government debt was less than 50% of national income (today: 120%, chart 17).

Currently, financing costs have almost reached the black line again; the probability of recession is therefore increasing.

Some areas of the US economy are beginning to experience problems. At 7.5%, credit card default rates at all of the approximately 4,800 US banks that are not among the 100 largest banks have reached their highest level since the US central bank in St. Louis began compiling these statistics in 1991 (golden line in chart 21). Default rates for mortgage-backed securities backed by commercial real estate have also risen from 1.55% to 5.6% since the end of last year (chart 22). Owners of half-empty office buildings and shopping malls find it very difficult to service and repay their loans when the favorable interest rate of recent years expires and the subsequent loan becomes significantly more expensive. This is likely to happen increasingly not only in the USA, but also in Europe, although, as is so often the case, the better statistics are available from the USA.

Unlike the ECB, the US central bank is not only tasked with keeping inflation rates low, but also with promoting economic development. Therefore, there are currently not only the structural reasons (demographics, deglobalization, possible problems with the interest costs of the enormously high national debt) for not raising interest rates any further and reconsidering the monetary policy target of sustainable 2% inflation. In the meantime, inflation rates and core inflation rates in the US (and in the eurozone, charts 3 and 4) are falling significantly despite demographics and counter-globalization, which points to an imminent end to the debt-financed boom in the US; the eurozone is facing a recession anyway (chart 9). In addition, there are initial signs that the interest burden is becoming too great for weaker parts of the US economy (charts 20, 21 and 22). This increases the probability that the interest rate peak has been reached and that falling interest rates can be expected on both sides of the Atlantic as early as next year.

Finally, the question arises as to whether this can give the weakening stock markets in the USA and Europe a boost again.

It is not always the case that falling interest rates stimulate the stock markets. In the USA, this expected correlation can be seen from 1965 to 1998 and then again from 2009 (chart 23). The so-called correlation, a figure that can assume values between -1 (always opposite development) and +1 (always in the same direction), was more or less negative in the periods colored pink. Falling interest rates and thus rising bond prices caused share prices to rise and vice versa. Only between 1998 and 2009 was the correlation very positive at +0.90; falling interest rates were accompanied by significantly falling share prices. We have colored this area green because a positive correlation between interest rates and share prices for a portfolio consisting of shares and bonds means that falling share prices are partially offset by simultaneous increases in bond prices, while in the pink areas share and bond prices are falling or rising at the same time.

Actually, there should be no green areas. Falling interest rates are favorable for shares in many ways. Most companies have debts, which cause lower costs and increase profits when interest rates fall. When interest rates are low, companies' customers can take out cheaper loans to buy their products. Low interest rates make it more profitable to invest in factories, houses or infrastructure projects, which are normally financed with loans. More investment means a growing economy and therefore rising corporate profits. Finally, falling interest rates make saving less and less enjoyable, so consumers spend more money.

However, when confidence in a future growing economy is fundamentally shaken, falling interest rates are seen as a consequence of less investment in the real economy or in equities and more investment in safe bonds, further unsettling investors. This actually happened at the beginning of the green zone (chart 23) when Russia got into financial difficulties in the fall of 1998. Investors around the world withdrew their money from loans and bonds issued by weak debtors. As a result, the world's largest hedge fund at the time, LTCM, managed by two Nobel Prize winners in economics, collapsed with debts of over USD 100 billion. The highly decorated professors had overextended themselves with credit-financed purchases of bonds with poor credit ratings and the US central bank had to rescue the financial system for the first time since the Second World War (100 billion dollars was still quite a lot of money back then). Since then, investors have never known whether such a rescue would take place again in the next crisis. The next crisis came with the collapse of the inflated US residential real estate market from 2007 onwards. Generous lending - including to home buyers with poor credit ratings - had triggered the bubble. However, banks around the world were happy to acquire these loans as investments in the form of cleverly packaged securities. When these loans were no longer serviced on a massive scale, banks in many countries got into difficulties; in September 2008, the then rather large investment bank Lehman Brothers went bankrupt. The stock markets fell sharply, as did interest rates (positive correlation), as investors fled to safe government bonds. However, as the US central bank stabilized the US financial system shortly afterwards with numerous aid measures, confidence soon returned in the US - the correlation between equities and bonds became negative again.

In Europe and Germany, on the other hand, the green zone was much more durable (charts 24 and 25).

One important reason for this could be the ECB's two interest rate hikes, which later proved to be a mistake (chart 26).

In the summer of 2008, the ECB raised interest rates, although the US Federal Reserve had already cut interest rates sharply in view of the growing real estate problems and the ongoing recession (chart 27, red line below zero). However, the ECB found the rising oil price in summer 2008 more important, raised interest rates and noticed a few weeks later that the European economy was also crashing. The ECB now had to rush to cut interest rates, but the recession was much more severe than in the USA because interest rates were cut too late (Figure 27, 1st black circle). From 2011, there was another recession in the eurozone, but not in the USA. The US central bank had not only cut interest rates in good time before the Lehman bankruptcy, but also printed massive amounts of money immediately afterwards and stabilized the banking system in the long term. Under the influence of the Bundesbank, the ECB refrained from printing money, leaving the eurozone banking system weakened. Although the government bonds of Greece, Ireland and Portugal had already suffered heavy price losses in 2010 and those of Italy and Spain in 2011, the ECB once again raised interest rates in the summer of 2011 in a completely inappropriate manner (chart 26), thereby exacerbating an impending recession. It was not until the new ECB President Draghi, who was initially rejected in Germany, that the ECB also began printing money and stabilized the eurozone. Since then, the ECB has proved its worth, as it did a few years later during the coronavirus crisis. However, as confidence falls much faster than it is rebuilt when mistakes are made, investors in Europe were convinced later than in the US that a major economic collapse in the eurozone would be fought just as intensively by the central bank as in the US, and the correlation between equities and bonds only turned negative again in 2021 (chart 25).

As inflation rates have now fallen significantly, long-term interest rates have risen in recent weeks - an additional burden on the economy - and share prices in Europe and the US have already fallen by 10%, we can assume that the central banks have enough facts to argue against further interest rate hikes. As soon as long-term interest rates have stopped rising - which should not take long - the equity markets should stabilize and recover strongly, especially outside the US, as almost all equity markets (with the exception of the US) are now undervalued (see the capital market outlooks from August and September 2023, which you can find here and here ).

If the central banks abandon the inflation target of 2% in the coming years and are increasingly reluctant to raise interest rates, equities, investment funds, real estate and gold will perform very positively.

Finally, our key statements from the October 2020 Capital Market Outlook, which you can find here :

Three years ago, we described the major bubbles of recent decades, including the aforementioned real estate crisis in the US. The government bond markets were described as the biggest bubble of all time due to the extremely low interest rates, which were below zero for 10-year government bonds in Germany and 1% in Italy, and it was predicted that German government bonds would lose a third of their wealth value in real terms by 2030. This was a false prediction in that the loss of the aforementioned amount was already achieved after 3 years.

You can also download the capital market outlook here.