Marc Cuniberti: There is a downside to low interest rates
Special to The Union
Interest rates worldwide have been ultra-low and at self-professed “emergency levels” for more than half a decade and are purposely set there by the U.S. Federal Reserve Bank and indeed most central banks worldwide.
The thinking is that ultra-low interest rates encourage people to borrow more and therefore they will have more money to spend.
I suppose this is true but is this any way to run an economy or foster a recovery?
When people borrow money to spend, is this a good thing?
Does it make for a good financial plan in your house?
Probably not, but the central bankers apparently seem to think what won’t work in a household budget will work on an economy many billions time bigger. Perhaps, as low rates do encourage people to take on more debt, but low interest rates can do other damages as well.
Low rates cause inflation. Just look at the housing market of the mid 2000s. The ridiculously low mortgage rates enabled fierce competition between buyers. Because of all the money flowing into the housing sector as the banks went hog wild cramming ultra-low interest loans to every buyer that walked in the door, house prices skyrocketed.
That fueled a speculative bubble where higher prices begat higher prices until the whole thing imploded.
Low rates also flood the markets with money as investors use low rates to borrow more than they would have had rates been higher. The lower the rate, the more borrowing there is. With so much money available, those wishing to borrow money, such as companies or individuals, have many sources to go to, which means they can shop around for the lender giving the lowest rate.
This ongoing competitive market place where dollars are everywhere drives borrowing rates further and further down. Some of this money finds its way into the stock and bond markets where investors seek better returns than the anemic low interest rate offered by savings accounts and CDs.
The higher demand drives the prices on bonds and stocks higher, which by definition can inflate dangerous asset bubbles (like the real estate bubble described above). These bubbles can pop later on causing financial havoc.
One only has to look back at the dot.com and real estate bubbles to see the damage bubble implosions can cause when things go in reverse.
Another hazard of low rates is marginal companies near the financial brink can borrow money to stay alive where otherwise they would have folded up tent by way of a bankruptcy filing.
Startup companies with poor business plans can also arise because of the low cost of borrowing. Low interest rates can foster “zombie” parasitic businesses which should be out of business but are kept alive by ultra-low rates. This perpetuates bad management, bad decisions and bad business models.
High rates on the other hand insure only the best businesses survive, which bring the most value to consumers and also use less of our natural resources. Inefficient companies allowed to survive through low rates also add to an already over supplied market.
For a real world example, take companies such as those that explore for, drill, or refine oil. Many should be dead and buried with plunging oil prices but are kept alive through low-cost borrowing. They then add to the supply and can cause further gluts which can exert more downward pressure on oil prices.
Although good for the consumer, gone too far, low oil prices can prevent some of these marginal producers from making a profit. In order to stay alive, they pump even more oil to pay their bills which floods the markets even more, causing more price reductions.
Such is the situation we find ourselves in today where many companies have borrowed so much cheap money, their combined production is driving oil prices to decade lows. Additionally there is an economic event called “mal-investment” which is also brought about by ultra-low interest rates. Low interest rates can cause inflation in certain assets and depressed prices in others. Low rates in essence give false signals about demand and supply to businesses by distorting prices either too far up or down. These false signals cause businesses to make wrong investment decisions which ultimately waste funds and resources which is the mal-investment part of the equation.
In conclusion, many problems can arise from rates kept too low for too long.
With the dot.com blow up and housing bust in our recent memory, both arguably brought about in part by ultra-low interest rates, the Feds are keeping rates low yet again. As a result many analysts predict new bubbles are forming in asset classes such as stocks and bonds.
An argument could be made that the Feds keep trying to halt the implosions caused by low-interest rates with even more low rates.
Is it conceivable that they fail to see the correlation between the economic implosions and their causes?
This commentary expresses the opinions of Marc Cuniberti should not be construed or acted upon as individual investment advice. Cuniberti is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at MKB Financial Services 164 Maple St #1, Auburn, CA 95603 530-823-2792. MKB Financial Services and Cambridge are not affiliated.
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