At its last meeting, the Federal Reserve said it expects to keep interest rates near zero through 2022. The move is mean to bolster the economy as it recovers from the coronavirus pandemic. But, low rates can have the opposite effect when they go on too long. They can lead to lower productivity and lower GDP. This phenomenon helps explain why we have been stuck in a slow growth economy for more than 12 years. It also has implications for future growth, as the Fed has embarked on a bigger program of even lower and possibly negative rates.
Less Pressure to Grow
So, how do low rates lead to lower returns? Consider the following example. Let’s say you want to borrow $1 million, and I agree to loan it to you at 10% interest for 10 years. You get the money, but you have to pay it back to me with sizeable interest, so it’s a liability you have to satisfy. That means you have a lot of pressure to figure out how to pay me back.
You plan to use that loan to start a business and do something productive with it. That way you can generate profits to repay the loan. If you can’t generate any profits, you will actually lose money because you owe me $1 million plus 10% interest every year. Thus, you better do something productive with this money. You rack your brain for a good idea that allows you to invest $1 million and make enough to pay me back and also pay yourself.
But, let’s say I lower the interest rate to 5%. Now you still owe me money but at a lower cost. So, you don’t have to do something quite as productive with the money to cover the interest. The 5% interest cost inspires you to do some thinking, but not quite as hard as when you owed me 10% a year.
What if I lower the interest rate to 1%? Now you don’t have to work nearly as hard to pay me back. You get the money and go on vacation for six months; heck you have 10 years to figure this out. And you only owe me 1% interest, so it is not much of a hurdle.
Marginal Investments Prosper
This is how low rates non intuitively lead to lower productivity and lower GDP. The reason is that the recipient of the money doesn’t have to do anything very creative with it to pay back the loan. They can invest in things with marginal profitability and slow growth and still cover the payments.
Lower rates work best when borrowers fear rates will rise again. For instance, let’s say rates are 10%, then we hit a recession and businesses pull back on expansion plans. Then my bank says they will lend me new money at 5%. I take it because I think it’s a good deal, as I am concerned rates will go back to 10% once the economy recovers. Other business owners also jump at the chance to borrow at 5%. This spurs economic activity and helps get us out of the recession.
But as the interest rates go lower and lower, and borrowers believe they will stay low, investors have less incentive to borrow and do something productive with the money. In fact, low rates encourage borrowers to invest in stuff that is marginally productive because they only have to pay 1%, or 0.5%, or 0.0%, interest on the money. And if rates go negative (as they already have in Europe and Japan), one could actually invest in something that loses money and still make money.
Encourages Financial Speculation
When rates get low enough, one of the easiest things to do with the borrowed money is to speculate in financial markets. You don’t have to start a business, you just have to be a nimble trader and cover the tiny interest charge or do a little better than your negative rate. This causes investors to chase marginal return investments because money is so cheap. And the more the Fed indicates it will keep rates low and make borrowing almost free, the more financial speculation this produces. It becomes a feedback loop.
No one knows what the appropriate level of interest rates is. Obviously, if the rate is too high, like 80%, few people would ever borrow money and the economy would not grow. But if the rate is too low, it encourages unproductive behavior. Unfortunately, the global financial markets are moving into an era of extremely low and even negative rates that will have profound effects on markets and potential returns.
It’s not our job to make value judgements about why the Fed has decided to intervene, expand its direct participation in financial markets, and continue to drive down rates. They obviously think they are doing the right thing to stabilize the economy, and they have multiple public policy objectives they are trying to satisfy. But the long-term effect of this type of intervention is often a slow or stagnant economy, decreasing financial market returns, and more volatile markets. The reason markets become more volatile is because they begin to trade more on monetary (Fed) intervention than on fundamentals.
Because of the steps the Fed has taken the last two months, as investors, we will likely have to address these issues for decades to come.
Disclosures: Above material is for information and education purposes only. Past performance is no guarantee of future returns. All investing involves the risk of permanent losses, and there are no assurances that any level of distributions can be supported by a portfolio. Consult your individual advisor for guidance specific to your circumstances.