Podcast Host: Hasti Rabiei
Guest: Hamzeh Arabzadeh

Hasti: A year ago, many analysts were concerned that the aggressive interest rate hikes by central banks—introduced to combat soaring inflation—would inevitably lead to a hard economic landing and a recession. Now, if we examine the most recent economic data from developed economies, we see that, contrary to those earlier predictions, the overall economic performance has been more resilient than expected. At the very least, we cannot say that these economies have fallen into a recession. It seems that developed economies are holding up against high interest rates. However, some analysts warn that this resilience may not last, as the delayed effects of monetary tightening could still push global economies into recession. To start our discussion, how much have developed economies actually resisted high interest rates?

Hamzeh: If we take the United States as an example, the data suggests surprising resilience. In the third quarter of 2023, annualised GDP growth was 4.9%, a significant acceleration from 2.1% in Q1 and 2.2% in Q2. This strong performance was driven by robust consumer spending, with retail sales rising consistently despite higher borrowing costs. Some of this momentum may be seasonal—economic activity tends to rise in the summer months—but even when adjusted for seasonal effects, GDP growth remains well above expectations.

Comparing this to Q3 of last year, when growth was 2.7%, the US economy has clearly gained momentum rather than slowing down. Labour markets have also remained unexpectedly strong, with unemployment still hovering around 3.7%—only slightly above the 50-year low recorded in 2022. Wage growth has remained solid, further supporting consumer demand, while business investment has held up better than anticipated, particularly in tech and AI-driven industries.

In other major economies, we see a similar pattern of resilience, though with some variations. In the eurozone, growth has been weaker, but the region has narrowly avoided recession, with GDP stagnating in Q3 after a slight contraction in Q2. The UK economy has also remained sluggish, with GDP growth close to zero, but a sharp rise in job losses or business failures has yet to materialise. Japan’s economy grew by 2.1% in Q3, defying expectations of a slowdown, while Canada’s economy contracted slightly, reflecting the impact of higher borrowing costs.

Meanwhile, inflation has been easing. In the US, core inflation fell to 4% in October 2023, down from 6.6% in late 2022, suggesting that price pressures are moderating. The eurozone’s inflation rate declined even faster, dropping to 2.4% in November 2023—close to the European Central Bank’s target. However, this progress on inflation hasn’t come at the cost of a major rise in unemployment, which remains historically low in most developed economies.

Despite this resilience, many analysts caution that the current stability may not be sustainable. Several factors that have supported growth—such as excess savings from the pandemic and strong fiscal spending—are temporary. Additionally, as businesses and consumers gradually face the full impact of higher interest rates, economic activity could weaken in the coming quarters. The key question is whether this slowdown will be mild and controlled or whether it will tip major economies into recession in 2024.

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Hasti: What are these factors, and why do so many economists believe they are unsustainable?

Hamzeh: Tight monetary policy and high interest rates were expected to curb inflation by reducing demand. However, in most developed countries, demand has remained unexpectedly strong. In practice, monetary tightening has yet to fully translate into a slowdown in aggregate demand, and as a result, economies have not slipped into recession.

Several factors explain why demand remains elevated. One major reason is the significant financial support that households received from governments during the pandemic, leading to a surge in savings. These savings have not been fully depleted, meaning many consumers still have extra money to spend.

For example, estimates suggest that as of late 2023, American households still held between $900 billion and $1 trillion in excess savings accumulated during the pandemic. This savings buffer has allowed them to sustain spending despite high interest rates. As a result, the share of household consumption in disposable income remains near record highs, even as borrowing costs rise. In the eurozone, a similar pattern has emerged, where private consumption remains more resilient than expected, despite the European Central Bank’s (ECB) aggressive rate hikes.

However, these excess savings are gradually being drawn down. Estimates suggest that by mid-to-late 2024, most of these pandemic-era savings will be exhausted, meaning that households will no longer have an extra cushion to maintain their spending. When this happens, the full impact of high interest rates will start to materialise, forcing households to cut consumption, which in turn will slow aggregate demand. If central banks keep interest rates elevated for an extended period, this delayed transmission effect could push economies into recession.

Another key mechanism through which monetary policy affects the economy is its impact on firms—often referred to as the credit channel. High interest rates make it more expensive for businesses to borrow, limiting investment and increasing financing costs. This is already visible in the rising number of corporate bankruptcies. In the eurozone, business insolvencies surged by 13% year-on-year in Q3 2023, reaching their highest level in a decade. In the US, commercial bankruptcies were up by 30% in 2023 compared to the previous year, as companies faced higher refinancing costs.

However, one reason why the effects of high interest rates have not yet fully materialised is that many firms secured long-term loans at low fixed rates before the rate hikes began. This means their debt repayment obligations have not immediately increased. But as these loans mature, companies will have to refinance at much higher interest rates, leading to tighter financial conditions and potentially accelerating business failures.

This lag in the impact of monetary policy is one of the main reasons why many analysts believe the current economic resilience is temporary. Once pandemic-era savings run out and more firms face higher borrowing costs, the contractionary effects of monetary policy will become much more pronounced.

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Hasti: So, if I summarise your point, the reason why the current economic stability is unsustainable is that the full impact of high interest rates on household demand and businesses hasn’t yet materialised, correct?

Hamzeh: Exactly. Another key factor contributing to this fragile stability is that much of the current economic momentum has been fuelled by government spending and expansionary fiscal policies. Since the pandemic, the share of government spending relative to GDP has increased, and public debt has surged to unprecedented levels. According to IMF forecasts, by the end of 2023, budget deficits in France, the UK, Italy, and Japan will exceed 5% of GDP, while in the US, the deficit for the twelve months leading up to September reached 7.5% of GDP. This rise in government borrowing has played a significant role in sustaining economic growth.

However, this fiscal expansion comes at a cost—one that is becoming increasingly difficult to manage as interest rates remain high. Governments are now paying significantly more to service their debts, which brings us to a major risk for the global economy: the growing burden of debt repayments.

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Hasti: What’s the problem with these budget deficits? Why could this level of government spending contribute to economic instability and push economies back into recession?

Hamzeh: The issue, once again, comes back to high interest rates. When borrowing costs were near zero, governments could sustain large deficits without immediate fiscal stress. But with interest rates now at multi-decade highs, financing public debt has become much more expensive.

This creates a fundamental tension between central banks and governments. On one hand, central banks want to keep interest rates high to curb inflation and impose fiscal discipline on governments. On the other hand, governments prefer lower interest rates to make debt repayment easier and avoid the need for painful spending cuts.

Let me give an example. In Japan, where public debt exceeds 260% of GDP, the interest rate on government bonds was just 0.8% last year. Even at that low rate, nearly 8% of Japan’s government budget was spent on servicing its debt. Now imagine the scale of this problem in countries where interest rates have risen much more sharply, such as the US and the UK. In the US, net interest payments on federal debt are projected to exceed $1 trillion annually by 2026, making it one of the largest categories of government spending—larger than defence or Medicare.

As debt servicing costs rise, governments will be forced to curb spending or raise taxes, effectively shifting toward fiscal austerity. This, in turn, would dampen economic growth, reinforcing recessionary pressures. Ultimately, high inflation, high interest rates, and high government debt create a policy trilemma: policymakers cannot simultaneously reduce debt, maintain expansionary fiscal policies, and control inflation.

This is the complex balancing act facing the global economy. Central banks need to maintain restrictive policies to keep inflation in check, but doing so increases fiscal stress, forcing governments to cut spending, which in turn raises the risk of recession. The world economy is now navigating an environment where recession risk, high inflation, elevated interest rates, and record levels of public debt are all colliding at the same time.

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Hasti: Given these conditions, what are the forecasts for the global economy?

Hamzeh: Many analysts predict that persistent inflation and high interest rates will, according to historical business cycles, eventually lead to an economic downturn. The standard sequence is straightforward: higher interest rates suppress economic activity, leading to weaker demand and lower inflation, which eventually prompts central banks to cut rates. However, the timing and severity of this adjustment remain uncertain.

Some forecasts suggest that if interest rates stay high for too long, they could push developed economies into recession by mid-to-late 2024. The US Federal Reserve, for example, has signalled that rates may remain elevated throughout 2024, and while inflation has declined from its 2022 peak, it is still above target levels in many economies. The Eurozone and the UK have already experienced stagnation, with GDP growth hovering near zero, while China is facing structural challenges that could dampen global demand.

However, beyond standard economic cycles, there are additional risks that could worsen the situation.

One major risk is the potential return of Trump and the reimposition of tariffs. A second Trump presidency could reignite trade wars, particularly with China and the European Union, leading to higher costs for businesses and consumers and further disrupting global supply chains. Given that trade tensions between the US and China are already at their worst since the 2018 tariff disputes, any escalation could significantly impact global trade volumes.

Another risk is the rise of protectionist policies and the growing reliance on industrial policy. Countries are increasingly introducing subsidies and trade restrictions to support domestic industries, particularly in strategic sectors like semiconductors, green energy, and defence. While these policies aim to enhance economic security, they also distort global trade and could fuel retaliatory measures from other nations. Crucially, these protectionist strategies require large-scale public spending, further exacerbating government debt problems.

A third concern is demographic ageing. As populations grow older, government expenditures on pensions and healthcare will rise sharply, increasing fiscal pressures. In many advanced economies, the old-age dependency ratio is reaching unprecedented levels—Japan and parts of Europe are already struggling with shrinking workforces, while the US is projected to see Medicare and Social Security costs surge in the coming decades. Without policy adjustments, ageing populations will add another layer of debt sustainability concerns.

Additionally, the costs associated with environmental policies are becoming more significant. The transition to a low-carbon economy requires massive public and private investment, which, while essential, imposes additional fiscal burdens. Since 2020, governments worldwide have allocated over $1.3 trillion to support clean energy initiatives, and these figures are expected to rise further. Balancing climate commitments with fiscal constraints will be a key challenge.

And, of course, geopolitical tensions—particularly the risk of war—remain a major source of economic uncertainty. Ongoing conflicts, such as the war in Ukraine, have already strained government budgets, and any escalation in global flashpoints (such as tensions in the Taiwan Strait or the Middle East) could force governments to allocate even more resources to military expenditures.

In short, while a traditional economic slowdown driven by high interest rates is a likely scenario, several overlapping factors—including trade wars, protectionism, demographic shifts, environmental policy costs, and geopolitical instability—could deepen the economic downturn and further complicate debt management for policymakers worldwide.

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Hasti:
So, overall, the outlook doesn’t seem very positive. Are there any factors that could improve it? Are there any trends that offer hope for the global economy?

Hamzeh
One source of optimism is the potential for AI-driven productivity growth. Higher productivity could boost incomes, offset the effects of central bank tightening, and counteract the impact of fiscal austerity. Economic data already suggests reasons for optimism. For example, US data released in November showed that productivity growth in Q3 was strong and significant.

This could be one reason why the real economy has remained resilient despite high interest rates. We also see this trend reflected in stock market data. Over the past year, the S&P 500 has grown by around 10%, but most of this growth has been driven by just seven big tech giants—particularly Microsoft and Nvidia. If we exclude these seven high-tech firms, the S&P 500’s performance over the past year turns negative. This highlights the outsized role of the tech sector—especially AI developments—in supporting the economy. There is hope that AI still has more transformative effects ahead, which could help mitigate the bleak outlook that warns about.