Central Banks Face a Growing Real Interest Rate Problem

This issue has been developing in quiet ways within the overall structure of the global monetary policy system, where central banks are finding themselves struggling to remain on top of what has become an increasing difficulty surrounding how to navigate through increasing levels of stress arising from real interest rates (interest rates adjusted for consumer price inflation). Those increased real interest rates have begun to generate significant amounts of stress across various economies in many different ways (a great many which were not designed to be dealt with in a text book environment under traditional monetary policy operational frameworks) over the past several months and are continuing to grow. This challenge is real, it is growing, and it is deserving of significantly greater attention than it is currently receiving in broader mainstream financial discussions.

To understand the relevance of understanding how very important real rates have become, let's take a look at what they represent in the real world. When we have low or negative real rates, borrowing is less costly (on an inflation-adjusted basis) which allows for a more free and easy flow of capital for investment, creates upward pressure on asset prices and drives increased economic activity. Therefore, when real interest rates rise the opposite economic and investment dynamics will be present. As an example, as real rates increase, the cost of debt becomes more expensive which results in businesses being more cautious in making investments, consumers begin to slow down their use of credit to purchase goods and services, and the overall level of asset valuations will decline as the discount rate applied to future earnings increases.

For many years, central banks maintained very low real interest rates due primarily to the 2008 financial crisis and the COVID-19 pandemic. The availability of cheap money during the lengthy period of low rates stimulated economies towards recovery and growth, but led to unprecedented levels of borrowing by governments, corporations, and households across the globe; debt amassed during this time was priced in anticipation of continued low rates.

With rising inflation, central banks have had to rapidly increase nominal interest rates and therefore real interest rates, exposing the weaknesses inherent in the highly leveraged environment that exists today. Governments with significant debt burdens are experiencing higher interest costs at the expense of other obligations. Corporations that previously borrowed at low rates have to refinance their debt at substantially higher rates today. Households with variable rate mortgages and credit card debt will immediately feel the adverse effects of higher interest rates as they will reflect in increased monthly expenditures.

Central banks are facing a dilemma in that any effort on their part to reduce interest rates too quickly could exacerbate inflation and increase the likelihood of an economic downturn or financial instability that they are mandated to prevent, whereas raising interest rates to solve inflation will create the same or similar outcomes.
There is no clean answer to the real rate problem. It is a consequence of decisions made across more than a decade, and unwinding it will require patience, careful judgment, and a willingness to accept some level of pain regardless of which direction policy moves.