Low Interest Rates, and their hidden cost

One of the most remarkable features of the modern economy is that interest rates are negative in real terms and are expected to remain so. This is not unprecedented. Real rates were negative after the second world war and again in the 1970s. But in both cases, inflation was much higher than it is today. Headline inflation rates are now falling because of the slow economy and lack of demand. With short rates close to zero, real rates will stay negative. As for long-term rates, government-bond yields are below 2%, the three relevant central banks are targeting an inflation rate of 2%. Looking forward most bond investors now expect to lose money in real terms.

The level of interest rates can be viewed as a price which balances the desire for saving with the demand for investment. So negative real rates indicate that savers are incredibly cautious and that businesses are reluctant to invest in new projects during a very weak economy. Central banks attempt to affect this price by setting “base” rates at which they will supply liquidity to banks. Their intervention has had an impact, although it is hard to quantify. Note; the aim of these policies is to discourage saving thus boosting consumer demand. Low rates are also supposed to encourage business borrowing and boost employment, but often it also encourages savers to take on more risk than they should when they search for higher yields,

When an economy is growing rapidly, there is generally an abundance of profitable investment opportunities and businesses are happy to borrow at high real rates. In a sense, then, the level of real interest rates sets a hurdle by which profitable projects should be judged. If the rate is held at an artificially low level for too long, a big danger is that capital may be misallocated and flow into speculative investments. A recent report from the Bank for International Settlements points to a number of other problems that negative real rates can cause such as tempting borrowers into ignoring their balance-sheet problems. The result could be that the problems are left to fester, making it more difficult for central banks to raise interest rates in the future.

Banks may also become too optimistic about the ability of borrowers to repay, and have failed to make adequate provisions for bad debts. And the easy money that banks can make by borrowing short-term from the central bank and lending long-term to the government is a public subsidy that screams foul! Pension liabilities are linked to bond yields. As yields fall, the present value of future liabilities rises, this creates huge deficits for pension funds in future years. Low interest rates in the developed world may have had spillover effects in emerging markets, pushing up exchange rates, increasing speculation and causing asset bubbles (such as Chinese property) and, until recently, inflating commodity prices. We must keep in mind that when rates do eventually rise we will most likely see a painful unwinding of these investments.

Savers are suffering from these low interest rates.The leading edge of the massive Boomer generation knows that every dollar spent is a dollar it cannot re-earn or replenish. The logical thing to do is hoard their wealth. Boomers have little choice but to, keep the car for an extra 50,000 miles, cancel remodeling projects, and make the grand-kids fund their own education. With less interest income they are purchasing  a lot fewer electronic gadgets and spending vacations in the backyard. Tens of millions of Americans are either in this position now or about to become so. The '60s created a generation of hedonists that changed the mores of the nation. The early 21st century is creating a generation of misers that will change the spending habits of the country, as a result of these low interest rates this "recovery" may be greatly delayed.