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Are low interest rates a solution or a problem?

Even nectar is poison if taken to excess.

~Hindu Proverb

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?

Comments

  1. Rob Bennett

    I think we need growth. That’s what would make everyone feel more optimistic.

    The trouble with growth is that you can never get to it through use of the obvious path. If we knew the path to growth, we would have taken it at an earlier time.

    The more failures we experience, the more open we become to things we haven’t tried. Then we hit on the right thing. Then we’re groovin’.

    The low interest stuff is yesterday’s news. No one has any confidence in it, even the people doing it. Seeing this fail is part of the process we need to go through to get to what works.

    Rob

    • 2 Cents

      Yes, it seems more and more people are finally realizing that low rates are not the answer to this problem – wrong tool for the job. As you said, maybe that’s the first step toward more lasting solutions. Let’s hope!

      Thanks, as always, for framing this in an interesting way Rob! 🙂

  2. Peter

    The record low interest rates are very negative for me. I am retired and am basically earning zero on the pitiful low rates, once taxes are paid and inflation is factored in. The only plus, if there is one, is that if you have interest bearing accounts in rrsp`s or tfsa`s you will at least be protected from the tax, for now, at least on the tfsa`s. Low interest rates only encourage poor money management and lead to higher debt. Down the road this will lead to more people going bankrupt, which is also very negative.

    • 2 Cents

      Retirees are certainly suffering with low interest rates. I wonder how many advisors let them know 10-20 years ago that 1%-2% returns on fixed income investments could become a prolonged reality? Unfortunately, we live in an environment in which rates at 4% or higher might represent a “systemic risk”. How sad.

      Thanks for sharing your story Peter.

  3. Jim Yih

    Interesting article,
    I’m not sure I like the alternative . . . higher interest rates! I think that would bring more and bigger problems
    Jim

    • 2 Cents

      A gradual rise in rates might be just what we need to signal that the debt punch bowl has officially been shelved. It would also express confidence in the ability of the economy to function on its own. Perhaps they could do as they have been for all of the rate decreases: hint that it’s going to happen, and then proceed gradually. This might give markets a chance to normalize slowly and let everyone know it’s time to repair balance sheets.

      Thanks for your comment Jim! 🙂

  4. Brain Hartigan

    I think interest rate should be a reliable level. High or low interest rate will be bed effective to total economy. Thanks for sharing the important idea.

  5. My Own Advisor

    Nice stuff Kim!

    I agree, a gradual rise in rates might be (is) just what we need!

    How are these low rates encouraging savings again? Isn’t this what we want: a better balance of savings (with spending) to grow our economy?

    Let me get this straight, we are coming out of a debt crisis and we have an environment that continues to beat up the savings community and encourages spending. Am I missing something here? 🙂

    Small increases in rates are what we need, slowly getting back to “normal”.

    Nice post!

    • 2 Cents

      I like the idea of small increases. I’m not sure the economy could handle much more. It’s a tough balancing act and it seems we’ve back ourselves into a corner.

      Thanks for your comments Mark! 🙂

  6. BeatingTheIndex

    As much as I am enjoying these low rates, I would not want to see them go lower for us Canadians. On the other hand, I don’t want to see whatever recovery we’re going through scratch to a halt. We need a measured increase to a balanced level which keeps all parties at least content if not happy.

    • 2 Cents

      Low interest rates really are a bit of a double-edged sword. As mentioned in the article, they work great for a normal cyclical slowdown, but not so well for a balance sheet recession. The problem we face now is that we’ve lowered them (to no avail) for this balance sheet recession and have therefore lost a valuable tool for the next business cycle recession. Doh!

  7. Jon Evan

    It was a wise king who said: “The rich ruleth over the poor, and the borrower is servant to the lender”. Many believe usury is bad especially its excess. People need to borrow money for legitimate purposes like buying a house. Interest rates should be fair. Are the current levels fair?
    They are for the borrower and that is good for the economy. It is the politicians who are to blame for the current mess by borrowing beyond their abilities to repay. That’s the problem.
    The current interest rates are not the problem.

    • 2 Cents

      Current interest rates are artificially low to cushion the blow of excess leverage, but they also encourage more leverage and shoddy financial practices.

  8. Echo

    So would the BoC be expressing confidence in the economy by raising interest rates…or do they need to wait for some signs that the economy can stand on it’s own two feet before they act? Who moves first?

    • 2 Cents

      I think they need to wait for some signs that the economy is improving. The problem is that our economy in Canada is not as troubled as the ones in the U.S. and Europe, but the BoC knows that if the European debt issue causes another credit crisis, Canada will not be spared. Our banks and economy will take a hit too.

      Rates were held way too low in the early 2000s at the same time financial regulations were relaxed. Now, they can’t go much lower in the event of another crisis. In the meantime, savers are punished and annuities are a terrible investment for retirees.

      Thanks for the questions Echo.

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