Inflation, often likened to a genie escaping from its bottle, has the power to stimulate and destabilise economies. Using interest rates as their primary tool, central banks attempt to tame this genie, sometimes using a wrecking ball.
Geoff Cook (pictured), chair of Mourant Consulting, Alex Last and Ben Robins, partners at Mourant, a law firm-led professional services business, explore the nuanced world of central bank policies, particularly focusing on the implications of repressive interest rates, as well as alternative measures aimed at safeguarding economic stability, paying special attention to their impact on investment flows through small-state International Financial Centres (IFCs).
The state of Repressive Interest Rates
Central banks historically deploy interest rate adjustments to rein in inflation. The logic is straightforward: central banks aim to curb spending and borrowing by raising interest rates above the inflation rate, thereby reducing demand, and dampening inflationary pressures. However, this approach carries inherent risks and consequences.
On the one hand, repressive interest rates can cool inflationary pressures, preventing the economy from overheating and safeguarding price stability. By incentivising saving, that encourages responsible financial behaviour and mitigates the risk of hyperinflation.
However, the flip side reveals a darker reality. Repressive interest rates can stifle economic growth by increasing the cost of borrowing for businesses and individuals. Small and medium-sized enterprises (SMEs), already vulnerable to financial shocks, face heightened challenges in accessing affordable credit. Expensive and restricted borrowing support can lead to a surge in business closures and job losses, exacerbating unemployment and widening socio-economic disparities.
Insolvencies more than doubled in the UK from the end of 2021 until 2024 at the same time as the Bank of England increased interest rates 14 times to 5.25%, a level not seen in decades, heaping pain and pressure on small businesses and households alike. According to Begbies Traynor, an insolvency firm, the level of 'significant' financial distress leapt to 30.8% year on year as of March 2024, with more than half a million companies affected.
A similar toll has been taken on international investment, with credit scarce and, by historical standards, very expensive. The Bain Private Equity Report 2024 records a stalled market in 2023, crediting the slowdown to the sharp and rapid increase in central bank rates.
The pain may continue if, as predicted, Core PCE inflation in the US fails to hit the 2% target until 2026. Recent announcements by the US Federal Reserve, the European Central Bank, and the Bank of England signal an abundance of caution. However, the old policy responses are less effective in a landscape reshaped by a global financial crisis, a pandemic, and rapidly changing demographics.
In a world where labour is often the most significant component of production, could it be that wage growth, spurred by cost-of-living increases, much of which is sustained by high interest rates, is too strong a force to be overcome solely by conventional monetary policy? In short, are high interest rates prolonging inflation?
Impacts on Small State IFCs
Small state IFCs, reliant on financial services as a cornerstone of their economies, are also susceptible to the effects of repressive interest rates. With limited domestic markets, these jurisdictions often rely on attracting foreign investment and fostering entrepreneurship. However, when central banks implement repressive interest rates, the cost of capital rises, restricting investment and hindering economic diversification efforts.
Still, those IFCs with significant banking and funds industries have benefitted substantially from increased margin income on banking deposits and money market funds. In addition, the demand for private credit funds formed in the IFCs has continued at pace since the interest rate rises in 2022 and as banks have pulled back from direct lending. Fund sponsors have also looked to a diverse range of alternative liquidity solutions ranging from NAV based credit facilities through to GP-led secondaries transactions and the formation of multiple continuation funds. All these products rely on and have underlined the importance of the leading IFCs.
Alternative Measures and Mitigation Strategies
Policymakers should consider whether conventional policy fully reflects changed circumstances in their battle to mitigate the worst effects of repressive interest rates while continuing to address inflationary pressures. Post-pandemic labour markets in developed economies are challenged by a lack of workers arising from falling population replacement rates and the difficulties associated with high immigration levels.
A debate around a more flexible and multi-faceted approach to tackling inflation that doesn't do massive damage to jobs and growth is warranted. Three additional policy levers that could perhaps tackle inflation include:
• Encouraging savings: Instead of relying solely on interest rate adjustments, policymakers can encourage saving through tax incentives and financial literacy programs. By fostering a culture of saving, individuals are better equipped to withstand economic uncertainties without resorting to excessive borrowing.
• Fiscal policy interventions: Governments can complement monetary policy with targeted budgetary measures, such as infrastructure investments and social welfare programs. These initiatives stimulate demand and create employment opportunities, mitigating the negative impact of repressive interest rates on economic growth.
• Increased pension contributions: Encouragement through fiscal measures and/or mandating higher pension contributions during high inflation serves a dual purpose. It removes liquidity from the economy, reducing excess demand and enhancing retirement security for workers. This initiative ensures a more equitable distribution of the burden of inflationary control.
Inflation is both a catalyst for economic growth and an indication of instability, and it demands a nuanced approach from policymakers. While repressive interest rates have been a cornerstone of central bank strategies, their indiscriminate application can have far-reaching consequences, particularly for SMEs. By embracing alternative measures such as incentivising savings, implementing targeted fiscal policies, and mandating increased pension contributions, policymakers can mitigate the adverse effects of inflation without sacrificing long-term economic prosperity.
Combining these measures with conventional monetary policy may lower the interest rates needed to achieve the required effect, therefore avoiding the undesirable destruction of businesses and livelihoods brought about by repressive interest rate policies. As the world navigates the complexities of inflation control, it is vital to strike a balance between taming the genie and avoiding the destructive force of the wrecking ball.
