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10 reasons low interest rates may limit growth

Sitting on the desk of Reserve Bank of Australia Governor Philip Lowe most days when he arrives at work are letters from the public. Many are from retirees who have one complaint in this world of low interest rates. Lowe told a parliamentary committee last year.

“It's not uncommon for people to say to me they've worked hard all their lives, they've saved, they're frugal, they don't spend very much, they rely on interest income and they're having to cut back their spending.” 

The limits of low interest rates

The RBA Governor earlier that session said that for every dollar the household sector received in interest income, it paid more than two dollars in interest payments. So overall, lower interest rates help the economy because they enable more consumer spending. To extend such conventional analysis, lower interest rates promote business investment, reduce borrowing costs for governments, which frees up more spending, help exports by lowering a currency and create a ‘wealth effect’ that encourages household spending by boosting asset prices.

Such thinking has motivated central banks to reduce interest rates to rev economies such that low rates have been a mainstay since the global financial crisis of 2008. An obvious problem with interest rates as a macro tool is they lose their stimulus fizz when they are close to zero or even mildly negative.

UK economist John Maynard Keynes in 1936 spoke of the ‘liquidity trap’ when describing the limits of low interest rates as an effective policy tool. When uncertainty is so great, even low interest rates fail to generate enough demand to ensure full employment.

But Keynes was indicating that low interest rates could be ineffective as a macro tool. 

10 side effects stand out

The worry after 12 years of low and negative rates is that these settings produce side effects that make them counterproductive.

First, a core concern is that Keynes’s liquidity-trap concept seems to underestimate the dampening effect of emergency measures. Low rates seem to dent consumer spending and business investment because they signal that authorities are gloomy, even panicked.

A second side effect is that low interest rates have encouraged so much borrowing that consumer, corporate and government debt have reached an unprecedented level of GDP in many countries. This could prove a systemic risk. Even without such mishaps, future repayments are likely to reduce consumption and investment.

A third effect is that low and negative rates can lift asset prices. Lower interest rates push investors into riskier assets and argue for higher prices on property and shares, asset gains that tend to boost inequality. More tellingly, negative policy rates helped push bond prices so high that yields went negative – and widely so. The concern is that, if low and negative rates help the economy as intended, interest rates will move higher and puncture asset prices.

A fourth problem is that low and negative rates trouble the business models of insurers and pension funds that typically use the safety and positive returns of government bonds to help meet long-term liabilities.

A fifth spillover is the squeeze on bank margins, perhaps to the point of threatening financial stability.

Any crimping in bank margins brings a sixth problem: that at some level, low rates could backfire by forcing banks to restrict lending – a level known as the ‘reversal rate’.

A seventh handicap is that central banks have faced political pressure for hurting savers and rescuing reckless borrowers.

An eighth side effect is low and (especially) negative rates can, perversely again, force people to save more to attain a targeted level of savings.

A ninth drawback is that low rates can encourage unproductive investment.

A tenth criticism is that low rates help embed economies in the ‘debt trap’. This term describes how indebted economies need more debt to overcome the problems left by past debt. But at some indeterminant point this strategy must miscarry.


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Failure to generate economic growth 

These risks might explain why low rates have often failed to spark sustainable economic growth. The question arises as to whether such risks are worth taking to fight mild deflation which, in economic effects, is not much different from negligible, or zero, inflation.

No matter these doubts, low and negative interest rates appear entrenched for the foreseeable future. In such a world, policymakers will need to rely less on monetary stimulus and be mindful of, and perhaps take steps to mitigate, the side effects they are creating.

It must be noted that real interest rates are more critical economically than nominal ones. Low nominal rates have essentially failed to charge economies because they haven’t approached the negative real rates that stimulated economies over much of the 1940s to the 1970s. That said, low nominal rates have helped stoke some economic growth.

For all their side effects, low interest rates are yet to trigger an upheaval – a jump in inflation that would undermine bond prices whatever level they were at. But even with these qualifications, central bankers appear concerned about the side effects that low and negative rates are provoking. They are among the most vocal in calling for instruments other than monetary policy to lead the world back to prosperity.

 

Michael Collins is an Investment Specialist at Magellan Asset Management, a sponsor of Firstlinks. This article is for general information purposes only, not investment advice. For the full version of this article and to view sources, go to: https://www.magellangroup.com.au/insights/.

 

Click here to view the VIDEO - Magellan Live Webinar with Hamish Douglass – What Really Matters, broadcast on 13 October 2020.

 

For more articles and papers from Magellan, please click here.

 

6 Comments
Steve
October 20, 2020

The basic mistake is to assume that borrowers would spend incremental savings from lower interest rates where it is pretty clear most use the extra cash to pay down debt faster. No real boost to the economy. Savers, particularly pensioners would be much more likely to spend additional income. The marginal propensity to save & consume is not the same between the two groups.
And of course the stupidity of encouraging more debt in a highly leveraged economy.

SMSF Trustee
October 21, 2020

I think it's a brave man that says the RBA has made a 'basic mistake' about something so fundamental as the transmission mechanism for monetary policy. The Economics Department at the Reserve Bank has researched this extensively - whereas yours is a rather partial and casual observation I presume.
I've lost count of the number of times the RBA Governor over the years has had that put to them in Q&A and how many times they've rebutted it with evidence. (Retirees might spend a bit more, but the overall average consumer doesn't - they save it.)
Your point about whether borrowers spend interest savings or borrow more is a valid question, the answer to which is at the heart of the RBA's call for fiscal policy to shoulder much of the weight of lifting the economy at present. Lower interest rates can only provide the opportunity for extra spending by business and household borrowers, but if there's a lot of uncertainty and other headwinds at play, then they are reluctant to do so. So if the government uses low interest rates to fund spending, then the spending does actually happen, with the direct and flow-on effects that comes with it. It's NOT stupid to encourage and facilitate that sort of debt and spending at the moment.

Steve
October 29, 2020

Still not convinced, I admire your trust in the economists who seem somewhat at a loss as to why their 'traditional' approaches aren't working and who just keep on digging (eg negative rates overseas!). The other significant element is the need to be 'competitive' with interest rates (ie not too high) lest the dollar appreciates too much. I think this is one of the main drivers of interest rates, one which the RBA has not alot of control over unfortunately.

C
October 18, 2020

Thanks Dudley. I agree. The less return l receive, the harder l have to save to hit my goal. Governments and Central bankers really need to consider behavioural economics more.

Dudley.
October 18, 2020

"The less return l receive, the harder l have to save to hit my goal.":

... and the further the your goal recedes due to asset price increases due to lower interest rates / yields - requiring you to spend less to save more - which reduces demand - which causes central banks to repress interest rates.

Whereas, for those who do not need to save and already have investments in excess of their needs, lower interest rates / yields result return in higher asset prices and effortless, but not riskless, capital gains.

TheIndebted Demand

Dudley.
October 15, 2020

‘wealth effect’ - that would be the NEGATIVE Wealth Effect.

Two most common reasons for having / wanting wealth are housing and retirement.

Decreasing interest rates / returns increase the price of both - which means more must be saved to provide both = NEGATIVE Wealth Effect.

Clearest is where an Accumulating Couple aimed to save at least enough assessable assets to earn at least as much as, but not be eligible for, the Age Pension when interest rates were 5% and inflation 2.5% and now faced with interest rates 1% and inflation 1%:

At the Age Pension Sweet Spot they expected to receive:
= 37000 + ((1+5%)/(1+2.5%)-1) * 400000
= $46,756

To exceed that using both returns and drawdown and retaining at least Age Pension cutoff assets of $876,500 they would have aimed to have saved:
= PV(((1+5%)/(1+2.5%)-1), (90-67), -46756, -876500, 0)
= $1,319,224
which would have provided the planned withdrawals of:
= PMT(((1+5%)/(1+2.5%)-1), (90-67), -1319224, 876500, 0)
= $46,756

With interest rates / returns now of 1% and inflation also 1%, they would have to aim to have saved:
= PV(((1+1%)/(1+1%)-1), (90-67), -46756, -876500, 0)
= $1,951,888
which, for the same outcome, is an increase in amount saved of:
= (1951888 - 1319224)
= $632,664
which must now come from increased income or decreased expenditure - the NEGATIVE Wealth Effect.

A Retired Couple, who can not add to savings, would see their withdrawals decrease from:
= $46,756
to:
=PMT(((1+1%)/(1+1%)-1), (90-67), -1319225, 876500, 0)
= $19,249
which is a decrease of:
= (46756 - 19249)
= $27,507
= -60%
which probably feels like NEGATIVE Wealth Effect.

Retired Couple could take more risk by such that nominal yield / returns increased from 1% to:
= (1 + ((1+5%)/(1+2.5%)-1)) * (1 + 1%) - 1
= 3.46%
which might feel like a NEGATIVE without a Wealth Effect.

Wealth Effect - phooey.

 

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