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The problem with 0% interest rates

THE US Federal Reserve has long held the financial world’s attention due to the anticipation that they are finally ready to raise interest rates from 0%. The majority of media focus has been on when they will raise rates.

However, the right questions to be asking are whether they will raise rates to normal levels at all - and why do we care what happens to US interest rates.

How we got here

The 2008 financial crisis took the global financial system to the brink of collapse and the US government and the Fed decided it was their job to save it. The Fed promptly dropped interest rates to the 0% levels where they remain up to today. In addition, they implemented an asset purchase programme named quantitative easing (QE), finance talk for money printing. 

QE and 0% interest rates were meant to provide temporary liquidity as a stimulus for the struggling economy. However, the recovery was far weaker than expected. Fast forward to 2015 and interest rates are still at 0% and the third round of QE ended just a few months ago.

A run of improved but over-hyped jobs numbers out of the US led people to speculate that the Fed is ready to raise rates, an event coined lift-off. The chair of the Federal Reserve, Janet Yellen, repeatedly hinted in mid-2014 that they were about to raise rates. Lift-off has been pushed back and back, and now the market is forecasting the first rate hike for December 2015.

Why do we care?

Low interest rates are used to increase the demand for credit and thus spending and growth. However, 0% interest rate can have a toxic effect.

Companies are in a riskier, unhealthier position:
• As debt has cheapened relative to equity, companies will become more leveraged (higher debt-to-equity ratios). This takes the form of share buy-backs and the preference for loans and bonds over equity.
• Companies are using the cheap debt to buy other companies, growing their earnings and per share performance without creating any real value. This can be seen by the current mergers and acquisitions boom in the United States.
• The required return on an investment drops, encouraging investments that would never be made under normal interest rates.
• As high quality bonds are no longer a viable investment, investors are led to less favourable investments in search of yield. This was a large factor in the growth of the sub-prime mortgage market that led to the 2008 financial crisis and is now responsible for the growth of the junk bond market which many experts believe will be the next bubble to burst.
• Companies are now addicted to low interest rates, as they will not be able to afford the higher debt repayments should rates rise.

The US government is headed to a crisis.
• It now has $18trn in debt, a large amount of which is in the form of US treasuries. This extreme level of debt has led to the rise of the ‘Tea Party’ conservatives in government, campaigning for a smaller government.
• These treasuries are purchased largely by the Fed through money printing, in addition to foreign investors like China.
• While the United States government will likely not default on their debt, the only way they can repay it is through inflation. The Fed will be forced to keep printing dollars in order to pay the debts.
• Inflation is as bad as default to the lender. Imagine you lent one million Zimbabwean dollars to Robert Mugabe and he repaid you one million of these dollars 10 years later. These dollars would not even buy you a loaf of bread. There has been no technical default but the effect is the same; inflation is default. While this is an extreme example, the analogy can be used to understand the risks of lending to the United States.
• The US government is also addicted to 0% interest rates. With $18trn in debt, there is no way they can afford interest rates at their pre-2008 levels.
• In my opinion, the recent fear of deflation stems from the growing levels of government debt as governments crave inflation because this reduces the value of their debt each year.

Transfer of wealth

Zero percent interest rates equate to negative real interest rates after taking inflation into account.
• This means that wealth is effectively being transferred from lenders to borrowers such as the United States government.
• Savers are being penalised as interest rates do not cover the effect of inflation, promoting short-term consumption at the expense of saving and investment. This results in a temporary steroid shot in the arm for gross domestic product growth at the expense of future years' growth.
• A less obvious point is that existing asset owners are favoured over new investors. Take the housing market for example. While lower interest rates make bond repayments cheaper, the result is an increased demand for housing, making housing prices higher. Therefore a new home buyer has to pay (and borrow) more and more for the house. The exact same phenomenon exists in stocks and bonds.

The outlook

Due to the above-mentioned factors, it appears impossible that interest rates in the US will return to normal levels in any reasonable timeframe.

The Fed stated in their September meeting that they did not raise rates for a few reasons, namely:
1. Volatility in global markets (China).
2. Further improvements in the labour market are still required.
3. Evidence of inflation returning to the 2% level is needed.

All three of these factors look set to remain as hurdles, as global stock markets continue their volatility. The labour market appears to be remaining stagnant at best while inflation remains stubbornly low. The S&P 500 just had its worst quarter since 2011, and it remains in negative territory for the year.

* This guest post is by Stephen Winter, author of the While You Were Working blog.

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