Are low interest rates a solution or a problem?
Even nectar is poison if taken to excess.
If low-interest rates are good for the economy, it should be booming by now. After all, rates have basically been falling for 30 years. Over the last 10 years or so, short term rates have been held low by central banks. Just a few weeks ago, the U.S. Federal Reserve announced Operation Twist, which will keep rates at the longer end of the curve low as well.
Yay. Soon we’ll all be basking in the glow of a red hot global economy. So why does it sound like so many governments and pundits are preparing for perdition rather than prosperity? Why isn’t the low-interest rate elixir working its magic?
10 reasons low-interest rates aren’t helping – and maybe hurting
Lower rates are supposed to stimulate the economy by encouraging business investment, home buying and consumer spending. Operation Twist is supposed to accomplish more of the same. As John Mauldin points out “in a normal business-cycle recession such a policy might work. But in a normal business cycle, it has never been necessary.” Here are 10 ways low-interest rates are inhibiting a healthy economy:
1. Savers are suffering
Low-interest rates mean meager returns for retirees and risk-averse investors who can’t or won’t or shouldn’t have very much of their money at risk in the markets. This means they need to spend less, find a way to earn more income, or move farther out the risk spectrum. Mauldin aptly asks “Do we really want retirees increasing their risk by seeking more yield?”
2. Artificial boost to other asset classes
I’ve lost count of the number of times I’ve heard low-interest rates given as a good reason to jump headlong into stocks and commodities. A lot of investors did just that in 2009 and 2010 when it looked like the Fed would be able to engineer an economic recovery. That’s great for people invested in those vehicles, but the average consumer, many of whom do not own stocks or commodities, is now stuck with a rising cost of living, a slowing economy and a deteriorating employment picture.
3. Lower real returns
Real returns are what you earn after factoring in inflation. With CPI in Canada and the U.S. running over 3% and many fixed-income investments yielding under 2%, it’s not hard to see that real returns are negative. While many advocates buying stocks as a remedy for this, it’s important to remember that stocks can offer negative returns on their own via capital losses and that capital gains should be converted to real returns as well. If your stock portfolio is up 3% on the year and inflation is running at 3%, your real return is zero. (Dividends can help cushion the blow with regular distributions. ;))
4. Increasing debt loads
Many young people have become accustomed to very low-interest rates. Folks in their 20s and 30s find it hard to imagine that mortgage rates could go as high as 7%, never mind 12% as they were as recently as the early 90s. This tendency to presume low rates will persist as far as the eye can see has prompted many consumers, businesses and sovereign countries to take on astounding amounts of debt. Keeping rates artificially low does little to ameliorate our debt problem.
5. Decreasing net interest margins for banks
While central banks held short term rates down, global financial institutions made a lot of money borrowing short and lending long. So while they’re paying you less than 1% on your cash deposits, they’re charging you multiples of that amount for your mortgage. Heaven knows they needed a capital boost after the subprime debacle of 2008. But now the Fed is sitting on the long end of the yield curve as well, so that spread and its attending profit margins are quickly disappearing.
6. No help for U.S. housing
Interest rates have been low for over a decade now. Some would argue that this a major precipitating factor in the 2008 U.S. housing crash. Since then, rates have gone even lower but we have yet to see any measurable improvement in the housing market south of the border. The problem is not that rates are too low, but rather that inventories are too high and prices are still falling.
7. No help for businesses
John Mauldin points out that the latest NFIB (National Federation of Independent Business) survey shows that most small businesses are not suffering from a lack of lending, but from a dearth of sales. So lower rates are fine for carrying an existing line of credit, but there’s no need to take out a large business loan if the sales aren’t there to support expansion.
8. No help for consumers
Most consumers are trying to deleverage, so lower rates can help keep interest costs down. Still, there’s still a segment of consumers who will take the Fed’s promise to keep rates low for an extended period of time as an invitation to take on even more debt. With debt levels at or near record highs in many countries that doesn’t seem like a prudent course of action. And with sovereign sources of bailout funds struggling to keep up, it could be a recipe for disaster.
9. It didn’t work for Japan
Japan has maintained interest rates near zero for decades now and the result has been an ongoing deflationary depression. The Nikkei peaked around 37,000 in 1990 and hasn’t even come close to regaining that level over the past 20 years. Today it trades below 10,000. That doesn’t necessarily mean North American equity markets will follow the same path, but it’s got to at least be on the radar screen for investors.
10. Pension funds and insurance companies hurting
As recently as Monday, Sun Life Financial, generally considered to be a Canadian blue chip company, warned profits would fall well below estimates. Much of the miss can be blamed on sagging equity markets and pitiful returns on interest-bearing investments. That in turn led Moody’s to consider downgrading the insurer’s U.S. subsidiary. Sun Life is not alone. Analysts expect most insurers and pension plans to struggle to meet their benchmark returns, especially in light of Operation Twist.
Insurers and large pension funds depend on “safer” investments like bonds and term deposits to cushion their portfolios against market risk. Most of them have not modeled interest rates this low into their projections. With equity markets flat to lower over the past decade, insurance companies aren’t getting the returns they planned on and many pension plans are underfunded by a wide margin. If market conditions don’t improve, pension contributors and employers may be required to fill the gap.
Do you think record low-interest rates are positive or negative for the economy and financial system?