Low Interest Rates – Implications

Following on from last week’s piece on yield curves we’ve been asked to set out the implications of low interest rates. First of all let us distinguish between “low” single-digit rates (a normal aspect of economic cycles) and “negative” rates (a new phenomenon).

In the normal course, low interest rates swing the advantage away from savers towards borrowers – or to put it another way – they encourage borrowing and spending because savings’ returns are diminished. As the economic cycle continues interest rates eventually bottom out and gradually begin to rise again shifting the incentives back towards savers.

In a “normal” economic cycle Central Banks try to stimulate economic activity by lowering rates and they try to stifle excesses by raising rates. By and large this has worked well in the past but the shock of the Great Recession of the late 2000s prompted a new line of attack from Central Banks – large-scale money printing (so-called Quantitative Easing QE). This resulted in significant boosts to the prices of financial assets but it is questionable whether it has actually stimulated global economies.

Negative interest rates are a clear sign of desperation – indicating that well-worn policies are not working well.

Their implications are far reaching. The insurance industry cannot sustain a business model in the long-term where its investment “growth” is negative. Employer and employee pension funds will never reach critical fund values if even the safest investments produce consistent minus returns. Savers will not survive on negative incomes. [Implications for DIRT are potentially whimsical. If deposit returns are negative there can be no savings tax – but will savers get a DIRT refund?].

In theory, interest rates below zero should be very positive for company and personal borrowers, including mortgagees. But in practice there are complications. Savers will not tolerate minus returns and will hoard cash. If banks cannot achieve an acceptable margin between borrowing and saving rates, then lending rates will not fall.

Hoarding cash is an interesting conundrum. If savers withdraw savings and stuff their mattresses – the government will slap a tax on cash. If cash hoarders retaliate by purchasing Sterling or Dollars the government will impose currency controls. This cat and mouse activity will do nothing to stimulate the real economy!

Negative interest rates will create complacent borrowers – easy, cheap money – and lead to unproductive habits. When the next recession hits Central Banks will be stymied. They will be forced to drive negative interest rates down further – causing even greater distortions for borrowers and savers. All agree that negative interest rates over an extended period create a high degree of uncertainty.

Uncertainty does not bode well for economic growth. That’s why the US Federal Reserve is going to extreme lengths to explain what it plans to do next. Unfortunately, the language code that it uses remains open to interpretation. The US Presidential debates, currently underway, and the Election on Nov 8th make it extremely difficult for the Fed to take any action without being accused of politicking.

The next move by the US Federal Reserve, most likely in December, (after the election) will be to raise interest rates in an attempt to break away from the negativity. We should all wish them well.