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Why Low Interest Rates are Bad for the Economy


Sounds like heresy, yes? Don't today's historically low interest rates allow more people to buy houses and cars and to finance other types of spending as well?

Well, yes, that is true to a point. It has a short-term impact as consumers lower their mortgage payments and some who are on the edge of being able to buy a home find it within their reach. Othes find new debt service is cheaper.

But, interest rates have been extremely low since 2009. I think those trends have largely run their course.

The problems are these:

1) Companies invest too much in appreciating financial assets rather than company growth. At these low rates companies are tempted to take on a lot of new debt because it costs so little. When it comes to managing a company, debt is useful to a point.

Instead, many companies are buying back their own stock with that borrowed money. Why? Partly, because most of the net worth of senior executives is in stock and stock options. Their bonuses, which represent most of C-Suite income, are largely based on the stock price. While everyone likes increasing stock prices, using increased borrowing to buy back shares is not the best foundation. How about growing the company instead?

2) Banks are finding that lending to consumers or businesses at these rates is not profitable. When things are unprofitable, they don't usually get done. When banks hold back on lending, the economy remains sluggish.

3) Ultra-low rates provide temporary cover for the U.S. government to keep borrowing at least a half-trillion dollars each year, further ballooning the national debt. Who has been buying those new bonds? - mainly the Federal Reserve. 

Sooner or later rates will go back to normal and the debt that was financed short-term at nearly 0% to 2% interest will be refinanced at 3%, 4%, 5%, 6% or more more - historically normal rates. We tend to forget what normal interest rates look like, our collective memory is so very short. 

According to the U.S.Treasury Dept, the average rate on all U.S. debt in December 2014 was 2.4%. In 2004 the average rate was 5%, so you can see how much has been refinanced lately and how much of the debt load is new.

Going back to the rates of 11 years ago would in a few years double the federal interest expense from 14% to 28% of the federal budget. Add the new debt at over a trillion every other year and that interest expense goes to 30-40% of the budget. Rating agencies will start to lower the credit rating of the U.S. Treasury, pushing rates and interest expense higher to real crisis levels.

The independent Congressional Budget Office (CBO) painted this same scenario in a report in 2013. 

The fact that Europe and Japan have embarked on their own quantitative easing programs, even with LESS THAN 0% interest rates on some European government debt makes this an international problem.

I wouldn't change current investing strategy based solely on this, but I think it would be wise for the Federal Reserve to start raising interest rates sooner rather than later.

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Comment   |  4 years, 3 months ago from Charlotte, NC