Are interest rates too low?

Interest rates are low, but is this a problem?

In times gone by the worry was that rising interest rates stifled economic growth. The theory is that inflation (the rate at which the prices of goods and services go up) increases as spare resources (such as unused money and labour within an economy) are used up. Central banks might respond by increasing interest rates which makes borrowing and investing more expensive. This, in turn, tends to reduce inflation and economic growth.

Since the global financial crisis, however, interest rates and inflation have been extremely low, and this is making policymakers uncomfortable. Why?

This time it’s different

In the US, core inflation (which excludes more volatile prices such as food and energy) has declined recently, and is running below the targeted rate of around 2%. The employment rate is high which, in the past, has led to wage growth and that, in turn, tends to push inflation up. This is because (i) consumers have more money and that pushes demand for goods up which pushes their prices up, (ii) companies paying the higher wages have to pass on their increased wage costs in the form of higher prices of what they sell.

This isn’t happening at the moment as wage growth remains low. So while the Federal Reserve (the “Fed”, the equivalent to the Bank of England) seems to be meeting its aims of maintaining stable prices and maximising employment, the levels of interest rates and inflation could be considered to be too low.

What are the concerns?

One concern is that with economic growth and employment both looking robust, a faster rate of wage and price increases could be around the corner. If that were to be the case, then subsequent increases in interest rates by the Fed might be too late to prevent inflation getting out of hand, creating economic instability. But there are other reasons that might not seem so obvious.

Firstly, low interest rates reduce the returns on savings and that has a knock-on effect across other investments making the yields that they generate lower. This pushes investors towards higher-risk rated investments in order to potentially get “higher” (i.e. reasonable) yields. In other words, investors are having to take increasing levels of risk in an aim to maintain the same levels of returns. The more risk that is being taken, the greater the potential for incurring losses.

Another concern is that low interest rates put undue pressure on banks because it reduces the difference between what they pay to borrow and what they charge customers to whom they lend i.e. it squeezes the profit margin on a major source of revenue for them. With banks only recently regaining stability following the financial crisis, and with lingering areas of weakness (such as in the debt-laden Italian banking sector), this is another area of economic vulnerability.

What’s more, with interest rates so low, there is little, if any, room left for central banks to reduce interest rates in order to try to boost the economy should there be another economic hitch or political crisis. Therefore, the Fed is not alone in wanting to “normalise” interest rates i.e. bring them back up by a few percentage points.

Quantitative easing

Interest rates across the eurozone, Japan and the UK reached historic lows some time ago, before the financial system was deemed to have recovered from the financial crisis 10 years ago. This led central banks to try to find alternative means of stimulating inflation and economic growth.

Quantitative easing was adopted by central banks in all of the regions mentioned. This is where a central bank goes into the open market on which bonds are traded and buys huge volumes of them, mostly from financial institutions. The intention, in simple terms, is to provide those financial institutions with cash that they can lend to customers and, thereby, stimulate inflation and economic growth.

Implications for bonds

One of the side-effects of this policy has been to push the demand for and price of the relevant bonds (mostly low-risk rated government bonds) sharply up. The payment that bondholders receive each year in most cases is a fixed amount of money, the coupon; this usually does not change regardless of inflation, interest rates or the price at which the bond is valued. As a result, the bond’s yield (fixed coupon divided by the price of the bond) will fall if the bond’s price goes up.

Bond prices have been rising steadily for some years now taking yields close to all-time lows. But this could be about to change.

The Fed has ended its bond-buying programme and is now looking to start selling some of the $4.5tn worth of bonds that it owns. Other central banks are not too far behind, either wanting to stop buying or start selling the bonds that they have amassed. This means that the biggest customers for bonds, central banks, are trying to withdraw from the market. As demand falls, prices are likely to follow.

That’s not all. As central banks endeavour to push interest rates back up, it has the effect of making interest-paying investments such as bank deposits more attractive. As mentioned above, the coupon on a given bond tends not to change during its lifetime. Therefore, a fair number of investors will consider moving money out of bonds and into investments that can increase alongside rising interest rates. In short, that’s another way in which demand for bonds can fall.

Significance for investors

What these combined factors boil down to for investors is that the value of a portfolio of bonds might, over the coming year or two, be subject to broad market falls. If the investor has a diversified portfolio of investments and is able to tilt allocations towards bond markets with a more positive outlook (taking the risk levels into account at the same time) then these potential moves can be mitigated. But don’t expect bond prices to rise for ever.

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