The End of Cheap Money? How Rising Interest Rates Affect the Global Economy

10th July 2023

As central banks around the world raise interest rates to combat inflation, this article examines the consequences for global markets, businesses, and everyday consumers.

In recent months, the global economy has been grappling with one of the most significant policy shifts in a decade: rising interest rates. The move, implemented by central banks around the world, is a direct response to the surge in inflation that has disrupted both developed and emerging markets. In this article, we explore how this adjustment—heralded by many as the end of cheap money—has reverberated throughout the global economy, affecting everything from corporate investment decisions to individual homebuyers.

The Shift from Easy Money to Tightening Policies

For the past decade, central banks had pursued an era of exceptionally low interest rates in a bid to stimulate economic growth after the 2008 financial crisis. Low borrowing costs encouraged businesses to expand, consumers to spend, and governments to borrow. This period, often referred to as the era of "cheap money," helped fuel a recovery but also created new challenges: namely, rising asset prices, skyrocketing debt levels, and an overheated housing market in many countries.

But as inflation began to climb—fueled by pandemic-related supply chain disruptions, soaring energy prices, and, more recently, geopolitical tensions—the policy that once seemed so effective has come under scrutiny. Inflation, which had been dormant for years, roared back with a vengeance, prompting central banks to shift gears. The Federal Reserve in the United States, the European Central Bank, and the Bank of England have all responded with interest rate hikes designed to cool the economy and bring inflation under control.

The increase in interest rates signals a sharp departure from the easy monetary policies that defined the previous decade. As borrowing becomes more expensive, the immediate effects are felt across a range of sectors.

The Impact on Global Markets and Investments

One of the first areas to feel the pinch of rising interest rates is the financial markets. Equities, which had been soaring for years amid low rates, now face a more challenging environment. Investors, who once flocked to riskier assets for higher returns in a low-rate world, are reassessing their strategies in light of the tightening. Higher interest rates mean that bond yields become more attractive, and capital flows shift away from stocks in search of more stable returns.

The stock market's reaction to rising interest rates has been volatile, and many companies, particularly those in growth sectors like technology, have seen their valuations come under pressure. The simple explanation is that as the cost of capital rises, the future profits of companies become less valuable in today’s terms. Growth stocks, which rely on future earnings potential, are hit particularly hard when the discount rate used to value their future profits increases.

However, the impact is not just confined to the stock market. The bond market has also seen significant shifts as interest rates rise. Governments and corporations that were able to borrow cheaply in the past are now facing higher borrowing costs, which could dampen investment and expansion plans. For emerging markets, in particular, the prospect of rising rates in advanced economies could lead to capital outflows, as investors seek higher returns in developed markets. This could place additional strain on countries with significant debt in foreign currencies.

The Ripple Effect on Consumers

For ordinary consumers, the most immediate consequence of rising interest rates is felt in the cost of borrowing. Mortgages, car loans, and credit cards all become more expensive as rates rise, and households with adjustable-rate debt may see their monthly payments increase significantly. The housing market is also cooling in many countries, as prospective homebuyers face higher mortgage rates, which reduce their purchasing power.

This shift is particularly noticeable in the United States, where the housing market has been overheated for years. With interest rates rising, mortgage rates have climbed from historically low levels, making it more difficult for first-time buyers to enter the market. In the UK, too, the housing market has seen a slowdown, with higher borrowing costs reducing demand for property.

At the same time, consumer spending—driven in part by cheap credit—has started to wane. As individuals feel the pinch of higher borrowing costs, discretionary spending on goods and services may decrease, which could have a broader impact on businesses that rely on consumer demand. Retailers, in particular, could see a decline in sales, as higher rates make consumers more cautious about spending.

Corporate Strategies in the Face of Rising Rates

For businesses, the challenge of rising interest rates is twofold: higher borrowing costs and a slowdown in consumer demand. Companies that were once able to finance expansion through cheap debt now find themselves paying higher interest rates on new loans. This could make it more difficult for businesses to fund new projects, particularly in capital-intensive sectors like real estate and infrastructure.

The immediate result is a shift in corporate behaviour. Many businesses are likely to delay or scale back expansion plans, particularly if they are unsure about future demand or the economic outlook. This could have ripple effects throughout the supply chain, as suppliers and subcontractors feel the effects of reduced demand for their goods and services. In certain industries, companies may even be forced to rethink their workforce strategy, as higher borrowing costs and declining consumer demand place pressure on profitability.

However, not all companies will be equally impacted by rising interest rates. Those with strong balance sheets and lower levels of debt may be better positioned to weather the storm. Companies in sectors that benefit from higher rates—such as financial services—may even see their profits increase as rising rates improve their margins. In contrast, companies in highly leveraged sectors may struggle as the cost of servicing debt becomes more burdensome.

A Global Perspective: The Impact on Emerging Markets

While the effects of rising interest rates are being felt around the world, emerging markets face a unique set of challenges. Many of these countries rely on foreign capital to finance growth, and higher interest rates in developed economies could lead to capital outflows, as investors seek better returns in the US or Europe. This could place additional strain on currencies, inflation rates, and overall economic stability in countries that are already struggling with high levels of debt.

For emerging market economies, the risk of capital flight is particularly concerning, as it could lead to a vicious cycle of depreciation, inflation, and higher borrowing costs. Countries that rely on foreign currency-denominated debt could find themselves facing a significant debt burden if their currency weakens, as the cost of servicing debt rises in local currency terms.

Some emerging markets, however, are in a better position to weather rising rates. Countries with strong economic fundamentals, low debt levels, and diversified economies may find themselves relatively insulated from the worst effects of tightening monetary policy. In these cases, the shift toward higher interest rates in developed economies could provide an opportunity to attract investment and foster economic growth.

A Cautious Optimism?

The rise in interest rates represents a stark shift in the global economic landscape. The days of cheap money are over, and businesses, consumers, and investors will need to adapt to a new reality of higher borrowing costs. While the immediate effects may be painful for many, there is a possibility that the higher rates could lead to more sustainable, long-term growth by discouraging excessive borrowing and curbing inflation.

As we look forward, it’s clear that the global economy will need to find a delicate balance between combating inflation and ensuring continued growth. Rising interest rates will undoubtedly have significant consequences for markets, businesses, and consumers, but they may also help to create a more stable and resilient economic environment in the long run. Whether or not this adjustment marks the end of cheap money—or simply a temporary shift—remains to be seen. The key, as always, will be to navigate this period of uncertainty with caution, foresight, and an eye on the future.