WE ALL know the dangers of high interest rates: borrowers end up having to fork out more, some people and companies with high amounts of debt will go bust, and the reduced disposable incomes and profits hit economic growth. But a policy of permanently low interest rates comes with its own distortions and risks.
UK interest rates remain in negative territory after adjusting for inflation: the consumer price index is rising by 1.6 per cent and the retail price index is up by 2.5 per cent, against a Bank rate of just 0.5 per cent. In America, the real Federal funds rate has averaged a little over two per cent since 1954; in the past six years, however, it has averaged around -1 per cent. Even if the Fed hikes rates from 0-0.25 per cent to 1 per cent by 2015, real rates will still be around -1 per cent after adjusting for two per cent or so inflation. Of course, private borrowers usually pay a market rate of interest which is higher than base rates, and having low official rates doesn’t necessarily imply a loose monetary policy. But it is wrong to assume that the only downside to low interest rates is the possibility of consumer price inflation – and that when price rises are abating, as they are at the moment, rates can and should stay low.
Gabriel Stein of Oxford Economics lists some of the potential problems with the present policy in an interesting note, aptly entitled “Too low for too long – the danger of ultra-low rates.” The first issue is that resources are inevitably misallocated. This happens if the rate at which banks lend to the rest of the economy is lower than the rate required to balance savings and investment – an excessively low investment viability threshold leads to too much corporate spending on the wrong things, a money and credit boom and eventually a nasty recession. The misallocation will be especially severe in those areas of the economy that are most sensitive to credit, including property.
Excessively low rates make it too easy for the government to run a big budget deficit and reduce politicians’ incentives to balance the books. Very low yields on risk-free investments tend to incentivise insurance companies and pension funds to move into riskier assets to preserve returns. At the same time, low rates increase pension deficits by bolstering the net present value of future liabilities.
A related but equally dangerous phenomenon is the hunt for yield: investors snap up riskier assets, reducing yield differentials to such a degree that risk premia become severely distorted. We are seeing this yet again with high yield bonds: the gap (or spread) between the interest rate (or yield) on junk bonds and those on investment grade bonds has shrunk drastically, and is now back to levels last seen in 2006. Risky borrowers are finding it irrationally easy to raise funds – as those foolish enough to have lent to them without being properly compensated for the extra risk will eventually discover.
There are other risks to negative real interest rates, including the rise of the zombie firm. Unviable companies are seeing their lives artificially extended, slowing down the reallocation of capital and labour to more productive uses and reducing economic growth.
Seemingly never-ending ultra-low base rates have also led consumers to change their behaviour in all sorts of sometimes contradictory ways. Some have borrowed too much, accumulating risk that they may not be able to handle when rates rise. Some have spent more, as a result of lower rates, and not deleveraged enough – others have spent less because their income has been hit by reduced interest payments or because they see low rates as a sign of economic weakness and are thus being prudent.
Low interest rates have benefits, of course, but also plenty of costs. It is time for policymakers to start to focus on the latter.