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Low Interest Rates


May 6, 2013

Interest rates in the U.S. have been quite low for about four years. They have been REALLY low since 2008. Economists are starting to worry about the effects of such a prolonged period of low interest rates. We could easily find ourselves with too much of a good thing. The purpose of this article is to look at some of the ramifications of this trend in interest rates.

The blame (or credit, depending on your point of view), is usually placed on the Federal Reserve Board (“the Fed”). Actually, all the Fed can do is set very short term interest rates, like overnight interest rates that banks charge each other. Long and mid-term interest rates are formed by market forces. The Fed hopes to influence the business and finance community, but ultimately, interest rates are set by borrowers and lenders and are a function of risk. If lending is perceived as risky, interest rates will rise. As the perception of risk falls, so do interest rates.

When the economy tanked in 2008, the Fed led the parade to lower and lower interest rates. The aim was to stimulate the economy. Low interest rates lower the cost of capital for businesses. It was hoped that those low interest rates would stimulate consumers to buy a lot of stuff and borrow to do it. It was also hoped that businesses would react to this demand stimulus by building buildings, filling those buildings with more machines and hiring more people to man those machines.

It didn’t happen nearly as much or as quickly as the Fed hoped. Success has been notable in automobiles and real estate. In both of those sectors, demand is hot and banks are lending to support that demand. When it comes to economic recovery, that’s what I’m talking about.

There is also some positive movement in the form of some “reshoring”. This is the return of some manufacturing lines of some of our larger companies that had been “offshored” to foreign countries, most notably China. Reshoring becomes more attractive as wages in China and other foreign manufacturing centers rise with their success and U.S. labor costs remain relatively low. The future and extent of reshoring will likely be determined by how U.S. labor and our Federal government behave.

But before our industry can really take off and unemployment return to 5% (about what some consider “full employment”), some headwinds must be overcome.

One such headwind is our political scene. Much of the blame for our slow recovery can be laid at the feet of the politicians who are practicing the fine art of gridlock. Democrats want to tax the rich and spend on the poor….and “invest” in infrastructure (spending money to make money). Republicans want to reduce the debt largely by cutting spending. Their mantra: “When you find yourself in a hole, stop digging!” Usually, sides will compromise. Not this time. This makes business leaders leery of what the future holds and they hold off on increasing production capacity.

Another headwind is the number of mismatched skills in our labor market. There is a shortage of STEM (science, technology, engineering and mathematics) graduates, but many of America’s youth have said, “Too hard! Let’s party!” So businesses have to look to the immigrant pool.

But I digress. Returning to the purpose of this article, so what can go wrong with having low interest rates for a long time? Lots. And the problems usually involve the low-risk environment that accompanies the low interest rates.

Even if they don’t want to increase capacity, low interest rates prompt businesses to grow by the merger and acquisition route. Businesses have been very profitable during the recovery period, starting in 2008. The increased productivity was largely achieved by technology and cost-cutting. Many companies are sitting on piles of cash. That, combined with easy borrowing, enables expansion by acquisition. Another questionable use of company cash are stock buy-backs. This tends to raise the price of the stock and increase the earnings-per-share, both of which usually result in happy shareholders and bonuses for company executives.

Low rates also mean that money sitting in banks doesn’t make much money. If, in fact, inflation is higher than interest payments, the result is a loss of purchasing power for money sitting in banks. This condition is known as “having negative real interest rates”.

This excessively low interest rate environment sets off a number of bad ideas prompted by the scramble by investors to find positive yield. Fundamentally, the interest rate of a loan or that being paid on deposit reflects the risk environment. So if an investor or saver wants a higher interest rate, they move towards buying the riskier investments such as “junk bonds”. Also loan creditors become hesitant to demand sound financial standards of the borrowers. This results in the issuance of what are called “covenant-light” loans. The increase in loans is also stimulating the revival of investment loan products such as collateralized loan obligations, which involve repackaging loans and selling “tranches” of varying risk features as investments. An excess of such products contributed to the large market correction of 2008.

Of course, artificially low interest rates can eventually result in asset “bubbles”, which, when they “pop”, result in corrections of the markets that are experiencing those bubbles.

All I wish to point out in this article is what some of the dangers are of having too much of a good thing, in this case low interest rates. We are not “there” yet. Some of these problems can best be described as potential problems, in some cases remotely so. It is just the usual American tendency of “anything worth doing is worth over-doing”. The more the Fed distorts market forces, the greater the potential for bad things to happen when those market forces correct to what they should be, given normal, free market supply and demand.

See also “Counter Moves to Inflation”

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