Watch commercial banks’ interest rates for clues on the future

While all eyes are on what central banks will do with interest rates, consumers and investors alike should really worry about what commercial banks will do.

Central banks’ interest rates are likely to remain deep in negative territory, in real terms, despite surging inflation fanned by Russia’s war on Ukraine, which came right on the heels of a supply chain crisis caused by the Covid-19 pandemic.

Analysts at Deutsche Bank expect the US Fed funds rate to peak above 3.5% next summer, with another 0.75 percentage points added by the winding down of the Federal Reserve’s asset purchases.

For the European Central Bank (ECB), they expect its main interest rate to increase by 2.5 percentage points between September and December this year. That would bring the ECB’s main interest rate to 2%.

Looking at inflation, it is already at a 40-year high of 7.9% in the US. In the eurozone, it is 7.5%, according to preliminary estimates by the EU’s statistics body Eurostat.

It is clear to see that central banks are far behind the curve, and quite happy to remain there. Even the multiple interest rate hikes expected by markets would not catch up with inflation.

But while central banks are comfortable with negative real interest rates, it is not at all clear whether commercial banks will be.

Higher interest payments

Commercial banks make their money on the difference between the money they lend and the money on which they pay interest – and savers are unlikely to keep putting money in accounts that do not offer returns at least matching, if not exceeding inflation.

Another reason why commercial banks will probably have to hike their lending rates quite a bit above inflation is their own debt.

Interest rates on credit for consumers and businesses will be crucial for the economy’s future.

Corporate bonds, including those issued by banks, have sold off as inflation has increased, with investors clearly expecting higher interest payments – which reduce the price of bonds.

To be able to afford these higher coupons – as regular interest payments to bondholders are known – banks will have to charge their debtors higher interest rates in return.

How they go about it with be crucial. Generally, a gradual increase is likely to cause less harm than a sudden one, of course.

But if, as they have done in the past, they continue to favour the property sector –  for example by following the Bank of England’s ill-timed recommendation and removing the interest rate hike stress test for mortgage borrowers —  double trouble could follow.

Firstly, they would push homebuyers even deeper into debt at a time when house prices are hitting record after record and the only way is up for interest rates.

Secondly, they would stifle economic activity by allocating less capital to productive activities such as manufacturing or services.

Stagflation, which was almost unthinkable before Russia invaded Ukraine on 24 February 2022, is now fast becoming the main scenario for some analysts.

The way commercial banks will deal with their debtors – by hiking their own interest rates way above inflation, and thus dampening credit — will determine how bad things get.