Implications of Leaving Ultra-low Interest Rates

The interest rate has the power to push up or pull down economic output and asset prices; hence, the level of interest rates and its changes should be given due attention; this post is one such humble attempt.

Regarding investment decision-making, ‘Interest Rates’ would be the factor I care about the most, outside of a company’s fundamentals. So, it was irresistible when I learned that Edward Chancellor had come out with a book on interest rates (The Price of Time): I immediately bought it and started reading. Nothing could be timelier than a book on interest rates, considering the pivotal moment in the financial landscape that we find ourselves in.

The book contains valuable insights and thoughts on Interest Rates that are highly relevant now. In the book’s introduction, Chancellor paraphrases other eminent personalities such as the American journalist Henry Hazlitt, the French free-trade advocate and pamphleteer Frederic Bastiat, and the Canadian economist William White.

I am requoting some of their statements, which I found highly relevant to the present financial conditions.

Bastiat:

The bad economist pursues a small current benefit that is followed by a large disadvantage in the future, while the good economist pursues a large benefit in the future at the risk of suffering a small disadvantage in the near term.

Hazlitt:

It was as important for the health of an economy that dying industries be allowed to die as it was for growing industries to be allowed to grow.

Easy money creates economic distortions… it tends to encourage highly speculative ventures that cannot continue except under the artificial conditions that have given birth to them. On the supply side, the artificial reduction of interest rates discourages normal thrift, saving, and investment. It reduces the accumulation of capital.

White suggests that:

The sharp decline in interest rates encouraged households to spend more and save less. Although authorities believed that low rates would boost corporate investment, firms were investing less. Ultra-easy money was responsible for the misallocation of capital.

Easy money conditions impede, rather than encourage, the reallocation of capital from less to more productive resources. By lowering the cost of borrowing, ultra-easy money provided an incentive for investors to take undue risks. Given the low cost of borrowing, governments were unconstrained from running up their national debts.

Monetary policymakers might face trouble exiting from their ultra-low rates.

A major concern Chancellor expresses in the book is that:

To modern monetary policymakers, interest is viewed primarily as a lever to control the level of consumer prices. But influencing the level of inflation is just one of several functions of interest, and possibly the least important.

Chancellor states that:

Interest is required to direct the allocation of capital, and without interest, it becomes impossible to value investments. As a ‘reward for abstinence’ interest incentivizes saving. Interest is also the cost of leverage and the price of risk. When it comes to regulating financial markets, the existence of interest discourages bankers and investors from taking excessive risks. On the foreign exchanges, interest rates equilibrate the flow of capital between nations. Interest also influences the distribution of income and wealth.

The rate of interest – it’s level and changes – has a tremendous impact on asset prices, economic and financial conditions, the general prosperity of the populace, and the social and political stability of the nation. The interest rate influences people’s spending, saving, and investment behaviour. When interest rates are low, people spend more and save less.

But ‘spend more, save less’ is not a prudent financial behaviour. Although it provides small immediate gratification, those are followed by large disadvantages later. The failure to consider such second-order consequences, to which unfortunately many have succumbed, would be fatal once we return to more normal conditions.

The economic and financial conditions haven’t been normal for the past one-and-a-half decade. The global central banks embraced an easy money policy consequent to the global financial crisis of 2008-2009, and later the Covid-19 pandemic of 2020. They reduced interest rates to near zero and simultaneously injected massive liquidity into the financial system through quantitative easing.

However, those measures are expected to backfire once we return to more normal monetary conditions as they were taken without considering their second-order consequences. Disturbingly, the time of reckoning is already here because we are no longer in an ultra-low interest rates monetary policy environment.

Between March 2022 and July 2023, the Fed (the US central bank) raised its Fed funds rate from near zero to 5.50 per cent. Other major central banks followed suit, except for the Bank of Japan. In India, RBI raised repo rates from 4.00 per cent in April 2022 to 6.50 per cent in May 2023.

Due to these steep rate hikes, interest rates now in most major economies stay slightly above their long-run average. This could mean that it is payback time for the extravagant and imprudent behaviours that the ultra-low interest rate policy has bred. How we will pay for it and who will have to pay is contentious and ambiguous.

Almost everyone will feel the heat in some way. That’s for sure. However, individuals, firms, or governments with high indebtedness, low savings, and poor job security would be the most vulnerable.

A fall in income and wealth destruction are two foreseeable consequences of returning to normal conditions. The ultra-low interest rates enabled many weak firms to survive, and even, prosper. Such firms would become unviable and will soon fail under normal conditions. Their failures will result in job losses for its employees and capital losses for its lenders and investors.

Many new ventures were bred and even a few industries attained prominence during the last decade, primarily, fuelled by the easy money conditions. But their existence is possible only under the easy money conditions that fuelled them. A return to normal conditions might witness the failure of such firms on an industrywide scale. Such failures have every possibility of percolating into the wider economy and creating disturbances outside its immediate boundaries.

The cryptocurrency industry, which has already seen such massive disruptions and wealth destruction, is a typical example. But more could follow. Other sectors that have recently emerged or gained prominence under the easy money conditions include electric vehicles, green energy, and AI. They belong to the vulnerable class, and anyone exposed to them should tread cautiously.

However, despite more than a year into higher rates, it is confounding that none of these risks have materialised – other than the deflation of the cryptocurrency bubble. In March and May of 2023, a few banking failures such as Silicon Valley Bank, First Republic Bank, and Credit Suisse put markets under alarm. Thankfully, they were cleverly contained by authorities and seem to have dissipated without escalating into a major crisis.

Hazlitt states that ultra-low rates create market distortions. We have been in an ultra-low-rate environment for the past one-and-a-half decade, which surely must have created distortions. We are also certain that the easy money policies have ended, thanks to the steep rate hikes of 2022-2023. Hence, we should expect the correction of the distortions to happen soon. However, it is still unclear what the distortions are, how they will be corrected, and the consequences on the financial market and the general economy.

Chancellor’s book is instructive about the distortions and behavioural changes caused by an easy money policy. The book quotes the Canadian economist William White who suggested in his paper ‘Ultra Easy Monetary Policy and the Law of Unintended Consequences’ that ultra-easy money causes lenders and investors to take excessive risks. If so, most likely, large money must have flown into risky assets.

Risk is a relative concept. If we say ‘risky assets’, riskier than what? Government and high-grade bonds…? Then what comes to mind are stocks, emerging markets, venture capital, and private credit. The capital flow into risky assets could have seeded many new firms and drove higher the prices of risky assets, such as stocks.

New ventures and higher stock prices aren’t bad. They are essential for sustainable economic prosperity in the long run. They become troublesome only if the existence of the new ventures is possible only so long as the capital flow continues. Once the flow of money slows or stops, the ventures become untenable. Similarly, if capital flow is the only reason that is holding stock prices higher, then stoppage or retreat of capital flow would make the prevailing level of stock prices unsustainable, causing them to decline.

India being an emerging market is exposed to such a capital flight risk. Our currency depreciates if money leaves our country. Currency depreciation makes imports costlier and could fuel inflation. This would force RBI to raise policy interest rates, maybe towards 8.00 per cent or so as in 2013 – sometimes even higher.

We, equity investors, should be concerned if stock prices are trading at levels more than warranted by the fundamentals. I believe such conditions exist in the Indian stock market. Maybe not for the general market, but in certain corners of the market, particularly in the midcap and smallcap space.

One statement from the book that baffled me was ‘Very low interest rates are usually the calm before the storm.’ It has an ominous tone. I find it baffling because I had named my latest market outlook ‘Calm before the Storm’, and this was before I had bought or read the book.

We are still in the ‘calm mode’ despite rates being higher for almost a year. But a storm is coming, and we must prepare ourselves for it. The low rates and easy money lured people to forego or sideline prudent habits of thrift and saving. Now having returned to a normal money condition, we may see people slowly embracing such prudential habits again.

An immediate consequence of such a shift in people’s financial habits would be a slowdown in consumption spending. A slowdown in economic growth would soon follow as consumption spending is the largest driver of economic growth in most major economies, particularly the West.

The nature of habits is such that it is easy to start a bad one, but hard to let go of old ones. On the contrary, when it comes to good habits, it is hard to start a new one, but is easy to let go of an old one. The habits people gained during the easy money period aren’t not-so-good, which makes it hard to let go.

It could be one reason why the expected slowdown or asset price declines haven’t yet materialized even after a year into higher rates. People are still holding onto old unproductive habits despite changed circumstances. But they will be forced to let go and will let go, once the causes that enable them to still hold onto older habits disappear. Maybe that might be the trigger for the expected tribulations.

People are in a dilemma because what present times expect of them is hard: They need to give up some not-so-good habits and at the same time embrace some good habits – both are hard. Save more, spend less, and essential thrift are a few good habits we need to embrace now.

Another of White’s observations was that although authorities expected firms to invest more under an easy money policy, firms invested far less. This is true for the easy money policy period since 2008. Corporate investments never picked up; they remained sluggish. Instead, firms used the easy-money opportunity to buy back their shares, that too, at a breathtaking pace. In a few cases, firms utilised funds raised through debt to buy back shares, which I find very imprudent, particularly now that interest rates have risen.

Share buybacks boost stock prices but don’t contribute anything positively towards the company’s or economy’s prospects. Instead, if firms had utilised the capital to invest in their business operations, it would have created new jobs and output in the economy.

The low business investment by firms, despite money being available cheaply, might have a serious negative impact on the economy later. It could create a demand-supply mismatch in the future when the economy’s overall production capacity fails to meet its rising demand. This could stoke another bout of high inflation. Then central banks would have to raise rates further to contain the high inflation. But interest rates are already above their long-run average, therefore, further rate hikes might have disastrous consequences on asset prices and the general economy.

Among the many pivotal roles interest rates have, that Chancellor suggests in his book, an important one is its role in valuing investments. He suggests that without interest rates it is impossible to value investment. By discounting future cash flows, interest rates allow us to derive an asset’s present value.

Asset prices and interest rates are inversely correlated: as interest rates rise, the present value of future cash flow declines. So normally when interest rates rise, asset prices should decline to reflect the lower present value of future cash flows. In markets, this is achieved through a contraction in price-earnings multiple.

In India, the price-earnings ratio seems to have adjusted to some extent reflecting the impact of higher rates. The Nifty50 PE ratio is now at 21.90; it was at 23.63 at the start of 2022, before the rate hikes began. PE has declined by 7.5 per cent consequent to a 2.5 per cent rise in policy interest rates.

However, the US stock market performance is confounding. Although rates rose steeply, rather than declining, the PE ratio has expanded. The S&P 500 PE expanded from 24 at the start of 2022 when rates were near zero to 27.66 now when rates have risen to 5.50 per cent. This preposterous behaviour of the US market, and to a certain extent, of our market, too, could mean many things.

Markets being under the hold of mass hysteria is one possibility. Market participants have lost touch with reality. Chancellor suggests in ‘The Price of Time’ that ‘speculative manias tended to coincide with periods of low interest rates.’ Manias breed asset bubbles. And manias end with the bursting of the asset bubbles it bred. If current market price movements are driven by a mania that took root during the long period of low interest rates, then its eventual end is not too far off, considering the steep rate hikes of 2022-2023.

Historically, a time lag between rate hikes and bubble bursts is evident. More than a year passed since the Fed rate hikes of 2006 before markets crashed in 2008 with the onset of the global financial crisis. During the second half of 2007, the Fed cut rates, responding to signs of escalating distress in the financial system. But those steps couldn’t prevent the forthcoming onslaught. The prevailing consensus is for the Fed to cut rates this year. But history teaches us that betting on those rate cuts to save the day is futile.

A more lenient possibility is that the market considers the current high interest rates as a short-term phenomenon, consequent to measures taken under extraordinary circumstances, and expects rates to retreat to lower levels in the not-so-far future. Under this possibility, the market is not under the grip of a mania, rather its behaviour is reflecting its foreknowing ability, or in other words, it is discounting the future into prices.

If low rates cause economic distortions and capital misallocation, then why was it adopted in the first place? What is the rationale behind low interest rates? Whether low rates or high rates are appropriate for a healthy economy is a centuries-old debate – still ongoing with no definite answer yet.

However, regulating interest rates and money supply has been the go-to tool for authorities during periods of economic difficulties such as a recession, financial crisis, or high inflation. The obvious benefits of low interest rates put forth by its supporters are that it expands industry and trade, discourages idleness, people have more work, capital asset value increases, and finally, the economy prospers.

But low rates had its share of critics too, some with valid points. The 17th-century liberal philosopher John Locke was one of them, as per Chancellor in ‘The Price of Time’.

Locke found many disadvantages in reducing borrowing acts. He suggested that low interest rates adversely affect those who rely on interest income for their financial needs such as widows, orphans, old, and retirees. According to Locke, the major beneficiaries of low rates are the bankers and financiers, who pocket huge gains by not fully passing on the low rates to merchants and consumers.

Since low rates make credit cheap, there would be high demand by many who are not really in need of credit. Such misallocation of capital shall fuel financial booms whose eventual burst would put the economy in a worse shape than they were before rates were lowered.

The major argument by the supporters of low rates was that they encouraged and expanded trade by making credit easily available. But Locke argued that not to be the case. Lending is a risk-taking business and interest rates are how lenders are compensated for taking the risk. When rates are low, lenders shun disbursing credit as they are not adequately compensated for the risk taken. Under such conditions, money is more likely to be hoarded; then trade suffers, people have less work and remain idle, and the economy stagnates.

What is required is an appropriate rate of interest that makes long-term sustainable economic progress possible. Both low rates and high rates of interest have negative consequences, as we saw above. But how do we decide whether rates are high or low? In other words, what is the natural rate of interest?

For this, Chancellor notes the work of the Swedish economist Knut Wicksell who in his influential book ‘Prices and Interest’ stated that “the natural rate of interest would be revealed by changes in the general price level: if interest rates were set too low, there would be inflation, and if too high, deflation.” Chancellor doesn’t seem to fully agree with Wicksell’s argument. According to Chancellor, “it (natural rate) is not just a question of changes in the level of consumer prices. When asset price bubbles proliferate, credit booms, finance crowds out honest endeavour, savings collapse and capital is misallocated on a grand scale, the chances are that market rates of interest are not aligned with the natural rate.”

As there was a spike in inflation globally during 2021-2022, it is reasonable to presume that the market rate of interest then was lower than the natural rate of interest. Global central banks resorted to steep interest rate hikes during 2022-2023 to contain inflation, and so far, they seem to have succeeded at it.

But despite a year into the rate hikes, the global economy, particularly the US, has remained robust. Does that mean the current market rate of interest is closer or aligned with the natural rate of interest? I wish that to be true, but it is very unlikely. It is quite hard to accept that central banks can so effortlessly exist from the easy money policy of more than a decade without any major repercussions on the financial and economic system. William White, the Canadian economist, suggested in his work on the ‘consequences of ultra-low rates’ that “monetary policymakers will find it hard to exist from ultra-low interest rate policy.” Considering these, I am quite sceptical about the current market optimism and economic robustness.

Policymakers embraced the easy money policy in 2008 consequent to the global financial crisis. For thirteen years since then, when rates were near zero, inflation never emerged as a risk factor. But again, as there was no inflation, it is hard to agree those ultra-low rates were the natural interest rate. Inflation (or deflation) is not a reliable determinant of the natural rate of interest. And I think, too much focus on inflation by authorities and regulators to decipher the economy’s health might have allowed slackness to swell in some corners of the economy and go unnoticed.

Central bankers’ easy money policy comprises two parts: 1) reduce interest rates to near zero; 2) augment the money supply by printing money.

The recently ended easy money policy was adopted in the wake of the 2008 global financial crisis, particularly after the collapse of Lehman Brothers in September 2008, to prevent the utter collapse of the financial system, which definitely would have had disastrous consequences. Despite the massive stimulus measures, equity markets fell more than 50 per cent, the unemployment rate in the US rose to 9 per cent, and there were more than 300 US bank failures. So, we can easily surmise that, without these measures, the impact of the financial crisis on the economic and financial system would have been apocalyptic.

But these were temporary measures adopted under extraordinary circumstances. Their timely withdrawal is imperative because if continued for too long, they can cause serious ill-effects: the principal being high inflation. However, once the anticipated high inflation never happened, authorities remained reluctant to withdraw the easy money policy, justifying their decision with the argument that they didn’t want to derail the nascent economic recovery. So, the easy money policy continued for more than a decade without any significant rise in inflation.

The authorities expanded their easy money policy in 2020 consequent to the disruptions caused by the Coronavirus pandemic. Only during the second half of 2021 did inflation rise enough to be taken seriously by central bankers.

Why did a decade of easy money policy go about without triggering a spike in inflation? Chancellor’s book has some answers. He points to the work of Richard Cantillon who had done some serious works on economics in the 18^th century. Cantillon suggested that if central banks print money and reduce interest rates, however, if the newly created money never leaves the financial system, then the central bank measure inflates financial assets but not consumer prices. Such measures could only cause a spike in consumer prices when the money slowly seeps into the wider economy.

We could surmise from this that in the decade since 2008, a large quantity of the newly created money stayed within the financial system, probably, inflating financial assets. That is why we never had a rise in inflation during the period. But, worryingly, gigantic amounts of money were created during this period, and that too, for too long. It is plausible that such conditions could have fuelled massive bubbles in financial assets.

As interest rates are now at a more normal level, the atmosphere that allowed such bubbles to develop, sustain, and go unnoticed has disappeared. Extensive studies into earlier asset bubbles and their subsequent burst reveal the emergence of a catalyst event in the final stages of an asset bubble that pricks the bubbles and deflates them. In the late 1980s, a statement from the Japanese central bank governor was enough to burst the Japanese real estate bubble.

In early 2000, the Fed’s withdrawal of stimulus introduced in the wake of Y2K led to the bursting of the dot-com bubble. In the first half of 2008, the failure of a few major financial institutions with exposure to the mortgage market, such as Washington Mutual, and Bear Sterns, triggered the global financial crisis.

Unfortunately, all previous catalyst events were identified retrospectively only. Attempting to determine such catalyst events prospectively is considered impossible. Trying too much at it might even make one schizophrenic. However, an asset bubble fuelled by a decade of massive money printing will surely be colossal. It would be the mother of all asset bubbles, and the adverse implication of its bursting on the financial and economic system would also be colossal in scale.

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