Global interest rates have been historically low for many years now. Many people assume that this is a great thing for the economy. To some extent, they’re right. But there are some dangers that lurk in rates that are kept too low for too long. For more information on how interest rates work, you might want to check out the following articles: Where Are Interest Rates Going? and Why Are Mortgage Rates Rising? Let’s look at the good, the bad and the potentially ugly ramifications of low interest rates.
In general, low interest rates are good for anyone who wants to borrow money. Here are a few examples:
When rates are low, it’s more affordable for consumers to borrow the money they need to finance homes, cars, education, and other forms of consumption. Keep an eye on interest rate trends to decide whether to choose a fixed or variable rate mortgage.
Companies need readily available credit to invest in their businesses, pay their employees on time, and manage their cash flow effectively.
Most governments at all levels, whether municipal, provincial, or federal rely, to some extent, on the credit markets to finance their operations. With multi-trillion dollar stimulus programs in effect world wide, lower interest rates can reduce the cost of borrowing dramatically.
In general, lower interest rates are seen as stimulative for the economy, as consumers tend to buy more, businesses invest more, and governments can afford social programs.
Low interest rates are usually not so good for lenders and savers like the following:
1. Older or Retired People
These folks usually want to avoid having too much of their money in higher risk assets like stocks, so they stick to fixed income assets like bonds, GICs, and savings accounts. Lower rates mean lower retirement income.
2. Risk Averse Savers
Some people naturally avoid risk. They have very low or no debt and they don’t like to invest in stocks, commodities or real estate. Low interest rate environments provide little or no reward for this kind of fiscal prudence.
3. Insurance Companies & Pension Funds
These large institutions need to achieve a certain level of return in order to ensure they have enough capital to pay out when they need to. They also need to mitigate risk for the same reason. Low interest rates make it very difficult for these institutions to achieve their goals.
Very low interest rates can lead consumers, businesses, and governments to take on more debt. They can also make it very difficult for retirees and other risk averse investors to achieve the returns they need.
Interest rates that are held too low for too long can lead to unintended consequences like asset bubbles, inflation, and other economic dislocations:
1. Real Estate Bubbles
Housing and commercial real estate prices can rise too high too fast, pricing some buyers out of the market. This can lead to a number of factors that might burst the housing bubble.
2. Commodity Bubbles
When inflation expectations rise (regardless of whether or not there is real inflation), investors tend to pile into hard assets like gold, oil, and base metals.
3. Equity Bubbles
Investors who are looking for higher returns may flock to stocks rather than fixed income instruments, causing equity prices to rise, perhaps out of line with reasonable valuations.
4. Debt Bubbles
Cheap money, especially when offered for extended periods of time, can lead borrowers to become complacent and take on more leverage than they can really afford.
Bubbles don’t become ugly until they pop. There are 2 main problems with any type of bubble: First, they always pop eventually. Secondly, we never know when they are going to do it.
Where Are We Now?
There’s a lot of debate over whether or not we’ve already seen the good, the bad, and the ugly for this cycle. I’m not an economist or a financial analyst and I’m not sure exactly what the path of rates might be. (I don’t think many economists or financial analysts know either.) Given their current levels, it seems like there’s nowhere to go but up. On the other hand, I don’t think central banks will hesitate to resume QE (Quantitative Easing) if the economy tanks again. Having said that, I don’t think we’ve seen the end of the ugly yet. There’s still a huge amount of debt out there and those levels are going to have to come down, whether through repayments over time, or writedowns by lenders. Either way, deleveraging is painful economically and will limit growth for a few more years. We can debate whether or not the central banks should have lowered rates so much during the crisis. For better or worse, it seems like they have bought us some time for banks to heal their balance sheets and more importantly, to deal with the root causes of the crisis. John Mauldin offers a few key items we need for Reform We Can Believe In:
- The Federal Reserve must remain independent.
- Credit default swaps need to be regulated and placed on an exchange.
- Too big to fail must go.
- Leverage limits on banks must grow as they do. (The larger the bank, the greater the leverage limits.)
I hope we have some time before the next crisis arrives. Whether or not we use that time wisely remains to be seen.