The Impact of Low Interest Rates - Outside View by Asad Dossani

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The Impact of Low Interest Rates
Dec 13, 2010

The financial crisis of the last two years led to governments around the world cutting interest rates in an effort to stimulate their economies. Once interest rates reached levels where it could no longer be lowered, they resorted to quantitative easing, to further push down long-term interest rates. The biggest culprit of this strategy has been the US Fed. However, most of the other developed economies have followed this strategy as well, notably Japan. The emerging economies like India and China have not pursued this strategy to a great degree.

Lowering interest rates can have bad long-term effects. They encourage borrowing and encourage taking on more debt. It can lead to stock market and commodity market bubbles as excess cash gets invested in different assets. It can also lead to situations where the average consumer has taken on too much debt, and faces trouble down the road.

This is not even the worst part. What is the foundation for having strong future economic growth? It is savings, of course. The more an economy saves, the more it has available to invest in the future. Having low interest rates can dramatically discourage savings. It is no coincidence that the fastest growing countries have high savings rates. Having low interest rates can hurt a country's long-term growth potential.

If this is so obvious, why are central banks around the world not raising interest rates? Why are they encouraging borrowing instead of encouraging saving? If a country decides to save more money, it will have to reduce its consumption. We will have to reduce spending, and this can lead to a recession. In the short-term, an increase in saving is a fall in spending a fall in economic activity. It is a straightforward example of short-term pain in exchange for long-term gain.

I'm quite sure that if the Federal Reserve were to shockingly raise interest rates tomorrow, stock markets would fall on average 5% around the globe. Maybe more. Of course, this is very unlikely to happen. Most central banks have made it clear that they intend to pursue a low interest rate policy for some time going forward.

Solving debt by taking on more debt is a terrible long-term solution. The best way to deal with debt problems is to pay down the debt and save more, even if it means a recession in the short-term. The RBI has been raising rates to combat inflation, and this is the right policy to encourage people to save money. Likewise, China is doing the same thing to deal with its own inflation problems. (Which is partly a function of its pegged exchange rate and the US printing a lot of money, forcing China to do the same to maintain its peg).

It is often said that the seeds of the financial crises in 2007-08 was caused by the low interest rate policy pursued by Alan Greenspan early in the decade as head of the Federal Reserve. Let us hope that we can learn from history and not repeat the mistakes of the past.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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1 Responses to "The Impact of Low Interest Rates"

R.Varadarajan

Dec 15, 2010

Can we sustain such high interest rates of 12 - 15% in India against the global back drop of 0-2% interest rates in the US Europe and Japan? Are we not attracting FII inflows?

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