Low-Interest Rates Carry A Hidden Cost

One of the most remarkable features of our current economy is that interest rates are basically flat or 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 indicators were higher than what is being forecast today. Headline inflation rates have been and remain relatively low because of the slow economy and lack of demand. With short rates close to zero, real rates will stay negative. With ten-year government bond rates hovering around 2.5% and the three relevant central banks targeting an inflation rate of 2%, it would not take much for bond investors to actually lose money in real terms.

Debt Has Been Growing Much Faster Than GDP

The level of interest rates is normally viewed as an effort to balances several forces at work within an economy such as 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. This creates a full "risk-on" mentality that can wash away common sense.

The policy of rapid credit expansion while an interesting concept often brings with it negative consequences. Currently, it is being put to the test as new problems emerge in China where we saw the amount of GDP growth generated by each infusion of money decrease over the last four years. At the end of 2015 Chinese GDP to debt stood at a massive 258%. This should be taken as a warning that economic exhaustion and overcapacity results from continually priming the pump. In 2014 Wei Yao from Societe Generale warned the debt service ratio of Chinese companies has reached 30% of GDP the typical threshold for financial crises. This means many companies will not be able to pay interest or repay principal. She warned that the country could be on the verge of a "Minsky Moment" when the debt pyramid collapses under its own weight. "The debt snowball is getting bigger and bigger, without contributing to real activity," she said. The total credit in China's financial system is estimated to be as high as  221% of GDP and has jumped almost eightfold over the last decade.

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. This can result in problems being allowed 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 fail to make adequate provisions for bad debts. It also encourages banks to borrow short-term from the central bank and lend long-term to the government is a public subsidy that causes many taxpayers to scream foul! Another problem is that pensions also invest in bonds and use the income to fund future payouts. As yields fall it will make it harder for them to honor future obligations. 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. Lower rates in effect have caused many older Americans to hoard their wealth. Boomers have little choice but to, keep that older car for an extra 50,000 miles, cancel remodeling projects, and make the grand-kids fund their own education if that want to extend the life of their savings. This often means that 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.

On the flip-side, many people with little savings have rushed out to buy cars and expensive items they really can't afford and pulled consumption forward. Ironically as the country's most responsible citizens hunker down we see lenders leaning into the wind and playing Russian roulette with high-risk loans to those with poor credit records that may never be repaid or have to be written down. The premise being that when you charge interest in the high teens even after the write-downs you come out ahead. The bottom-line is that all the above trends and reactions to lower interest rates feed into a situation that is not particularly healthy, fair, or logical. As a result of these low-interest rates this "recovery" has been built on a false base and been far less robust than originally hoped. The legacy of Central Banks pursuing this "low rate" solution will be more problems down the road.