The common wisdom over the past decade has been that interest rates are going to rise. I felt so good locking in a 3.5% mortgage rate earlier this year because that was a once-in-a-lifetime opportunity. Or was it? If you look around the world, something unusual is happening. We’re becoming addicted to low interest rates and withdrawing from them could be a long and painful process – if it ever happens. The way I see it, rates came way down as a way of combatting the economic downturn back in 2008-2009. The plan was to gradually hike rates back to neutral levels once the economy picked up. Here we are a decade later, with a fairly strong economy, and rates are seemingly on a path to 0.
Part of the problem is that it’s hard to take back stimulus once you’ve administered it. When the Fed even breathes a word about raising the Federal Funds rate above its current “neutral” rate, the stock market takes a nosedive. When that happens, the media starts talking about the economic slowdown that the Fed will cause by raising rates too quickly. The Fed eventually backs down from the pressure, changes their tone, and the market cheers that decision. No sitting Fed chief wants to be responsible for ending a decade-long bull market, right?
The Problem with Consistently Low Rates for Investors
Your first thought may be, who cares? Why not keep rates low forever. First, there’s a large class of investors that are pushed into some uncomfortable asset allocation decisions when rates get this low. Savers who love online bank accounts and CDs take a hit. Bond market investors who seek safety and rely on fixed income payments also take a hit. And pension funds that allocate a large portion of their assets to fixed income are making tough decisions right now. Do they buy more out of concern that yields will get even lower? Or do they lower their total return projection, a move that could impact future pension payments.
Low rates and a flat yield curve also hurt insurance companies that collect premium and invest with a long time horizon. If the 30-year bond rates hovers around 2% for an extended period of time, that could lead to higher premiums and reduced benefits for people who own or invest in life insurance policies.
Other Low Rate Concerns
Interest rates are the primary policy tool used by the Fed to stimulate the economy when it slows down. If we keep rates perpetually low, we won’t have that policy tool available to us when we need it. Fortunately, the Fed has raised rates enough times over the past few years to keep this policy tool intact. That said, we continue to get an unusual amount of pressure from the President to lower rates now to stave off any economic slowdown before it even occurs. This unprecedented vocalization has begged the question of “why not” bring rates down before the economic cycle matures rather than waiting. From my desk, it sounds great. The stock market cheers lower interest rates. However, there may be unknown risks to using up this policy tool now and not having it when we really need it.
There’s no question that low rates have a stimulating effect on the economy. Consumer borrowing is cheap, which keeps the price of assets like real estate stable and rising. It also creates a steady flow of money into the stock market from people seeking higher returns than they can get in the bond market and from bank accounts and CDs. That creates a wealth effect and raises consumer sentiment.
If we have low inflation and the economy doesn’t seem to be overheating, we can live comfortably in a low-rate environment for a while. I think the risk is when we raise rates higher at some point down the road. Withdrawing that stimulation is likely to be painful and expensive and its unclear how the economy will react.
As always, feel free to e-mail me with any questions.
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Author: Navigating the Financial Blogosphere
The opinions voiced on this blog are for general informational purposes only and are not intended to provide or be a substitute for specific professional financial, tax or legal advice or recommendations for any individuals.
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