The Covid-19 virus plagued the world, slowing down the economic growth in most countries for the past two years. The world hasn’t yet defeated the virus, and the Russian invasion of Ukraine eclipsed its importance and further complicated a fragile global economic recovery.

Around this time two years ago, most nations went on a lockdown and introduced restrictions on human mobility. The situation caused a significant decline in spending on travel, entertainment and other related goods and services. The people and businesses working in these industries felt the pain by experiencing a significant loss of revenue and other negative implications. One case in point is foreclosure.

Governments scrambled to save jobs by providing businesses with wage supplements and tax breaks. Governments gave their citizens financial incentives to spend their money, such as vouchers, in affected industries.

What is inflation?

Inflation refers to the general increase in the price of goods and services. It usually happens when too much money is chasing the same goods. For example, if a diamond has a price of $10,000 and 10 people can afford it. The supplier has an incentive to increase the price. Few people could afford the diamond if the seller were to increase the price. However, knowing that there will always be someone who can buy it at a higher price than the current price encourages the seller to increase the price.

When applied to common goods, inflation causes the price of the same goods to be more expensive, causing a decline in the purchasing power of money. A €100 note could buy €100 worth of goods in January 2021; however, a €100 note can buy €95 cost of goods at the end of December 2021.

US inflation has increased by 7% month by month since December 2021, meaning that inflation is compounded and isn’t reset to zero at the end of every month or year.

For example, say a product costs €100 at the start of the first year, and the inflation is 7%. The new price would now be €107 at the end of the first year. 

At the start of the second year, the price wouldn’t go back to €100, however, start at €107. Let’s assume that the inflation for the second year is 7% again. The price of the same good at the end of the second year would now be €114.50. 

The new price includes inflation from both the first year (€7 = €100 x 7%) and that of the second year (€7.50 = €107 x 7%). The price of the good would have increased by €14.50 in two years. 

Induced inflation

What started as a genuine incentive by Governments to stimulate consumer confidence and spending ended as a false pretence by certain retailers that it was “free money”. The reasoning was that the government was paying, and the client would only pay the difference between the original and the new price. This frame of mind encouraged further price increases, and other retailers followed suit. 

Supply-side inflation

Covid-19 restrictions to curb the virus also meant supply-side problems in the manufacturing sector. The lack of supply meant fewer goods or services for clients to purchase, motivating suppliers to increase prices—the law of supply and demand.

On the flip side, people and businesses who weren’t that financially exposed to the effects of the pandemic saved more than in previous periods. They spent less on travel, entertainment, hospitality, etc. More money was available in their bank accounts. Higher prices further incentivised them to buy less and save more. 

The business community justified the price hikes as problems created by supply chain issues and an excuse to compensate for lost sales.

Interest rates

Interest rates are tools disposable to central banks like the Federal Reserve to combat inflation. The primary objective of interest rates is price stability.

The Federal Reserve acts as the leader and sets interest rates, and the other central banks like the Bank of England and the European Central Bank (ECB) may follow. All the Euro area members must follow the interest rates given by the ECB. 

The idea is that lowering interest rates encourage people to save less and spend more. In this scenario, most people consider savings as dead money and that they’ll gain more if they spend it or invest it in stocks.

On the flip side, increasing interest rates encourage people to save more and spend less. People feel that they’ll get more value for money if they put it in fixed deposits and bonds rather than investing in assets like stocks or property. 

There are other tools to maintain stability, such as fiscal policy (e.g. taxes and rebates). Unlike interest rates set by the Federal Reserve, fiscal tools are set on a national level and vary from one country to another.

We will concentrate on interest rates, as they’re far more global and far-reaching than fiscal tools.

Interest rates during high inflation

During periods of inflation, central banks tend to increase interest rates to discourage consumers from spending, causing suppliers to reduce prices since it’s a buyer’s market. This scenario will reduce the suppliers’ profit margins as they have to compete against each other to get rid of their stock of goods, making them less profitable.

Most investors tend to sell shares and buy bonds instead in such circumstances. The idea is that consumers will buy fewer products and services, hurting the companies’ profits causing investors to abandon shares, as it would be more attractive to save than to spend money. Fixed deposit accounts at financial and corporate bonds will be more attractive as they’d give higher returns than shares.

Interest rate hikes in 2022

In March 2022, the Federal Reserve announced the first increase in interest rates since 2018, and it has maintained near-zero interest rates to foster growth. The interest rates increased from 0.25% to 0.5%.

The Federal Reserve plans to increase interest rates between 0.25% and 0.5% depending on economic growth, inflation and employment rates. Most analysts concur that the central bank will increase rates by at least 0.25% in every Federal Open Market Committee meeting, and there are at least six more planned meetings.

Rates may increase between 1.5% and 3% on top of the 0.5% announced in March 2022 to read 2% and 3.5%, respectively.

Many investors argue that a 3.5% interest rate isn’t enough to combat inflation and needs to increase to at least 5 or 6%, as the economy may face hyperinflation. 

The present objective of the Federal Reserve is price stability and low unemployment. Increasing rates may hurt their objective. Therefore, it needs to keep a balance. 

“This time, it’s different.”

Many were looking at 2022 as the year of recovery, where economies could go back to “normal”. 

World leaders shared the same optimism in 2021. Covid is far from over. If 2022 was supposed to be the year of economic recovery, the invasion of Ukraine and the financial sanctions or Russia dampened the hope.

During Covid-19, times were challenging. Supply chains became limited yet remained intact in one way or another. The Ukraine war created more woes in one month than Covid-19 did in almost two years, mainly due to the economic sanctions imposed by Western economies on Russia. 

The origins of this inflation cycle are attributed mainly to supply chain problems due to Covid-19, the war in Ukraine and sanctions against Russia. Unlike in previous periods, the cause of inflation isn’t because people are spending too much money, and therefore a lot of money is chasing a few goods. On the contrary, people are spending less due to the restrictions. People’s overall savings increased because they couldn’t spend anywhere.

Policy error

Some investors argue that the Federal Reserve shouldn’t increase interest rates as it would be making the problem difficult for investors to fund projects and kickstart the economy. They believe that the root of the problem is the number of bottlenecks in the supply chain. Once fixed, it will automatically trigger a price decline. 

It would be like cleaning a clogged pipe. The flow of water will increase. 

Unlike previous inflation cycles, the problem wasn’t central banks. Yet they are trying to fix a problem with the only means disposable to them – hiking interest rates.

On the other hand, fixing supply chain problems, in theory, is easier said than done. The easiest way would be for the war in Ukraine to stop, and the West was lifting its sanctions on Russia or seeking other sources to feed the global economy. 

Geopolitics isn’t as easy as it seems. It will take decades for Ukraine to recover from war and for Russia to have sanctions against it lifted and restore global relations.

Interest rate hikes and borrowing costs

Central banks’ interest rate adjustments may not mean anything for the layperson. However, these adjustments will affect their spending habits and lifestyle, especially if they’ve borrowed money from financial institutions.

There are two main types of loans – fixed and variable. 

Fixed rates

Fixed loans, as it implies, have a fixed interest rate, which is immune to the central bank’s interest rate policy. Fixed interest loan rates tend to be higher than variable interest rate loans. The best scenario for anyone taking a loan is to use a fixed rate interest loan during the start of an inflation cycle. Central banks are reactive to inflation statistics, and they lag when they decide to increase interest rates.

During economic stagnation, central banks may stimulate the economy by reducing interest rates leaving the borrower paying higher rates.

Variable rates

Variable-rate loans consist of the fixed part and the variable part. The fixed part is usually the product interest rates, e.g. a home loan may have an interest rate of 2.5%. The variable part consists of the interest rate imposed by central banks, e.g. 0.5%.

For example, a home loan that carries a rate of 3% can be of a product interest rate of 2.5% and a variable interest rate of 0.5% imposed by the central bank. If the central bank decides to hike rates from 0.5% to 1%, the new rate will be 3.5%.

While half a percentage increase may be insignificant in the short run, one has to keep in mind that interest rates affect future loan payments. Keep in mind that interest rates on loans use compound interest. 

Borrowing costs on home loans

The table below illustrates the cost of borrowing on home loans if central banks were to increase their interest rates. Let’s assume that the loan value is €250,000, known as the capital or principal, while the initial loan rate is 3% for a duration of 30 years (360 monthly payments).

Sequence	Interest rate (%)	Monthly payment (€)	Total of 360 payments (€)	Total interest (€)	Notes
1	3.00	1,054	379,444	129,444	Initial loan rate
2	3.25	1,088	391,686	141,686	FOMC meeting 1
3	3.50	1,123	404,140	154,140	FOMC meeting 2
4	3.75	1,158	416,804	166,804	FOMC meeting 3
5	4.00	1,194	429,674	179,674	FOMC meeting 4
6	4.25	1,230	442,746	192,746	FOMC meeting 5
7	4.50	1,267	456,017	206,017	FOMC meeting 6
8	4.75	1,304	469,483	219,483	Speculative increase 1
9	5.00	1,342	483,139	233,139	Speculative increase 2
10	5.25	1,381	496,984	246,984	Speculative increase 3

The initial loan rate started at 3% (sequence 1) and the Federal Reserve decided to increase the rate by 0.25% (sequence 2) in the March 2022 meeting. The Federal Reserve proposes increasing its interest rates five more times (sequence 2 to 7). The expected interest rate increase will go from 3.25% to 4.5%. The monthly payments will increase from €1,088 to €1,267.

Speculators think that the Federal Reserve will increase interest rates beyond 5%. In this case, monthly payments will go up to €1,381 (sequence 10).

Sequence	Interest rate (%)	Monthly payment (€)	Monthly payment increase over the previous rate (€)	Total of 360 payments (€)	Total interest increase of 360 payments over the previous rate (€)	Incremenatal increase (€)
1	3.00	1,054	–	379,444	–	–
2	3.25	1,088	34	391,686	12,242	12,242
3	3.50	1,123	35	404,140	12,455	24,697
4	3.75	1,158	35	416,804	12,664	37,361
5	4.00	1,194	36	429,674	12,870	50,231
6	4.25	1,230	36	442,746	13,072	63,302
7	4.50	1,267	37	456,017	13,271	76,574
8	4.75	1,304	37	469,483	13,466	90,040
9	5.00	1,342	38	483,139	13,657	103,697
10	5.25	1,381	38	496,984	13,844	117,540

A quarter per cent increase in the interest rates means that the monthly instalment will increase incrementally from €34 to €38 over the previous rate.

The Federal Reserve has already increased interest rates by 0.25% and expects to increase the interest rate five times (from sequence 2 to 6). The monthly payment will go from €1,088 (sequence 2) to €1,230 (sequence 6), an increase of €142 per month, or €1,704 per year.

If Interest rates go above 5% (from sequence 2 to 10). The monthly payment will go from €1,088 to €1,381, an increase of €293 per month, or €3,516 per year.

The total interest rate payments will increase by €63,302 (sequence 1 to 6 – Federal Reserve) and €117,540 (sequence 1 to 10 – Speculators) over the lifetime of the loan.

A decline in purchasing power

If a borrower has a net salary of €30,000, the following table shows the percentage of the loan on the salary and the remaining amount they can use to settle other bills and savings.

Sequence	Interest rate (%)	Monthly payment (€)	Annual loan payments (€)	Annual loan payments (%)	Remaining amount after loan payment (€)	Remaining amount after loan payment (%)
1	3.00	1,054	12,648	42	17,352	58
2	3.25	1,088	13,056	44	16,944	56
3	3.50	1,123	13,471	45	16,529	55
4	3.75	1,158	13,893	46	16,107	54
5	4.00	1,194	14,322	48	15,678	52
6	4.25	1,230	14,758	49	15,242	51
7	4.50	1,267	15,201	51	14,799	49
8	4.75	1,304	15,649	52	14,351	48
9	5.00	1,342	16,105	54	13,895	46
10	5.25	1,381	16,566	55	13,434	45

If the interest rates increase as the Federal Reserve is expecting, the borrower will end up paying €14,758 (sequence 6) per year in instalments (sequence 1 to 6), from the present amount of €13,056 (sequence 2). In the likely event, borrowers will pay 49% (sequence 6) of net income in loan payments from the current rate of 44% (sequence 2).

Suppose the Federal Reserve increases interest rates as speculators are predicting. In that case, monthly payments will increase from €1,088 per month (sequence 2) to €1,381 per month (sequence 10), equal to annual loan payments of €13,056 (sequence 2) to €16,566 (sequence 10).

If the speculators are correct and the interest rates are higher than 5%, the borrower’s loan burden will increase from 44% of their net salary (sequence 2) to 55% (sequence 10).