Financial markets have generally reacted positively to low rates, pushing up asset prices. However, low rates point to a worrying lack of economic growth and the increasing risk of deflation. Indeed, the relationship between rates and economic activity is tenuous. The cost of funds is only one factor among several complex drivers of demand.
In the housing market, demand depends on many things – the level of deposit required, existing home equity (the price of a house less outstanding debt), the ability to sell a current property, income levels and employment security.
And businesses, in the absence of growing demand for their products, are unlikely to borrow to invest in new capacity based purely on the low cost of debt.
In reality, low interest rates create economic distortions, especially where real interest rates (nominal rates adjusted for inflation) are low or negative.
Low cost of debt encourages substitution of labour with capital in the production process. Given that 60-70 per cent of activity in developed economies is driven by consumption, this shift reduces aggregate demand as employment and income levels decrease.
Low rates favour borrowing, encouraging substitution of debt for equity in financing structures and increasing financial risk. Where companies and nations are overextended, incentives to reduce debt decrease. In fact, low rates, which lower coupon payments, are economically identical to a disguised reduction of the principal amount of the loan.
Low rates discourage savings, creating a disincentive for the capital accumulation that would reduce overall debt levels. Lower earnings on savings should encourage spending, stimulating economic activity, but may perversely encourage greater saving to provide for future needs, reducing consumption and demand. For an individual saving for retirement, a drop in interest rates from 5 per cent to 4 per cent requires an 18 per cent increase in savings each year to reach the same target sum over 30 years.
Low rates also increase the funding gap for defined benefit pension funds. In the US, for every 1 per cent fall in rates, pension fund liabilities increase by about $180bn.
Low rates also feed asset price inflation. Low costs of borrowing encourage investors to seek investments with income, feeding demand for shares that pay high dividends and for low-grade debt. A resurgence of structured products, where investors take on additional risk, which they have not fully understood, to generate higher income, is driven by low rates. In previous cycles, this has led to large losses and costly disputes between investors and dealers. In this way, low rates encourage mispricing of risk, creating asset bubbles.
Minimal opportunity costs allow investors to hold assets that pay no income in the hope of price increases, evidenced in demand for commodities and alternative investments such as art works. Money tied up in non-productive investments reduces the flow of capital and economic activity.
Low interest rates also provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as government bonds. Assuming bank deposits of $6tn and a difference between borrowing costs and government bond rates of 2 percentage points, this equates to a transfer to the US banking sector of about $120bn.
Low rates do not necessarily increase the supply of credit. Risk aversion and higher returns on capital encourage banks to invest in government securities, eschewing loans. In the US, bank holdings of cash and government securities currently exceed the outstanding volume of commercial and industrial loans.
Internationally, low interest rates distort currency values, and encourage volatile and destabilising short-term capital flows as investors search for higher yields.
A sustained period of low rates, such as the one the world is experiencing, makes it difficult to increase the cost of borrowing. Levels of debt encouraged by low rates rapidly become unsustainable when they increase, as is evident in Europe. This reinforces the financial distortions implicit in the policy.
For the moment, policymakers are relying on the advice of actress Tallulah Bankhead: “Cocaine isn’t habit forming. I should know – I’ve been using it for years.” But reliance on low interest rates, like all addictions, is dangerous. It is also ineffective in addressing the real economic issues.
Source: http://www.ft.com/intl/cms/s/0/372a405c-480e-11e1-b1b4-00144feabdc0.html#axzz1l0bJLxBP
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