Low Interest Rates Through 2014 and Beyond

Ben Bernanke, in a speech on November 19th, made it very clear that the Fed is likely to hold interest rates low for an extended period of time.  This comes on the heels of similar comments by his likely successor at the Fed, Janet Yellen, during her confirmation hearings.  On top of this, inflation numbers released on the morning of the 20th show almost no increases in consumer prices over the past year and existing home sales have just registered a drop.  In related events, Larry Summers just gave a widely-noted presentation to the IMF in which he warned that the U.S. may be settling into a long-term economic malaise.  Larry Summers, who was previously a contender to be the next Fed chairman, surely considered his comments to the IMF very carefully.

After the stock and bond markets’ dramatic response to even a hint that the Fed’s bond buying program might be cut back, the so-called ‘taper tantrum’ this summer, the Fed is making its stance crystal clear.  Interest rates will be held extremely low for the foreseeable future.  This position solidifies with each tepid indicator confirming the lack of a meaningful economic recovery.

With every measure of price inflation low, and the labor participation rate at its lowest level in 35 years, there are good reasons to think that the U.S. economy is far from robust.  On this basis, the Fed policy makes sense.  Low interest rates should, in theory, stimulate borrowing to expand businesses as well as allowing consumers to buy more, thereby driving corporate earnings upwards.

There are two immediate problems that result from sustained low rates.  First, bond holders are getting an incredibly low return.  Second, speculators drive up the asset prices to irrational levels.  While there is no agreement on whether we are in a stock market bubble or not, the 30+% rise in the stock market over the past year is somewhat concerning in light of the broader economic indicators.  Low interest rates encourage investors to ‘leverage up’ (borrow more) and take bigger risks, driving assets prices up:

Variation in leverage has a huge impact on the price of assets, contributing to economic bubbles and busts. This is because, for many assets, there is a class of buyer for whom the asset is more valuable than it is for the rest of the public (standard economic theory, in contrast, assumes that asset prices reflect some fundamental value). These buyers are willing to pay more, perhaps because they are more optimistic, or they are more risk tolerant, or they simply like the asset more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the asset and drive those prices up.

The Leverage Cycle, Cowles Foundation for Research in Economics, Yale University

It is widely accepted that low rates and the resulting risk taking was a major driver of the financial crash in 2008.  There is no question that low rates drive prices of all assets upwards.  Back then, both the stock market and the housing market experienced rapid price inflation largely thanks to easy lending that encouraged people to take on more debt.  Today, levels of margin debt are historically high, which provides evidence that cheap money is a major factor driving the stock market upwards.

While the Fed focuses on price inflation in consumer goods, and this type of inflation remains low, asset price inflation in real estate and the stock market should be a concern to investors.  The evidence of a slow economic recovery is clear and the Fed’s policy makes sense from this perspective.  The major risk is that asset prices are decoupling from this real economy due to exceedingly low interest rates.

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