What’s not to like about interest rates today? As of Dec. 31, banks were borrowing from each other at rates below 1 percent, the U.S. Treasury saw its 10-year borrowing costs fall below 2 percent, and homeowners enjoyed traditional 30-year mortgages at rates just under 4 percent. When you subtract 2011’s inflation of roughly 2 percent from these rates, many borrowers actually locked in inflation-adjusted rates below zero.
It appears that borrowers have never had it so good. So, why do I suggest we not celebrate these record-low discount rates?
I’m not being a curmudgeon when I observe that rates this low don’t seem to bear any resemblance to the economic conditions that surround them. They are just too low, given the obvious risks that now buffet business and financial decisions. And they are probably creating economic instability.
Investors somewhere are loading up on cheap loans and buying stocks, or bonds, or assets of some variety. In short, somewhere out there another major economic bubble is rapidly expanding.
That concern flows from the role of interest rates in a market economy. The price of a loan is determined by the demand for loans and the judgment of lenders about how likely the loans will be repaid. Both of these decisions have to do more with the future than the present.
Borrowers look into the future and ask, “Is my future likely to be one that will enable me to easily repay this loan? In other words, will I have a steady job and a growing income over the course of this note?” Lenders make a similar forecast: “What is the likelihood that the economy over the next several years will be good enough to enable my borrowers to pay their obligations to me?”
If a great economy seems likely, banks will lend at low rates until demand pushes rate up. If not, bank-lending rates will be much higher, because the risk of default by borrowers is greater.
We know, of course, that the near-term forecasts for northern latitude economies (including China) is not at all rosy. U.S. economic activity is raggedly emerging from its doldrums, European economies appear to be collapsing, and China is teetering on the brink of recession. All things being equal, lending rates should be higher than they are today. They should be reflecting these significant economic risks.
Instead, they are at or near record lows, and not just because demand is weak. The central banks, particularly the Board of Governors of the Federal Reserve, are holding rates down (in short, leaning against lending risk) in a coordinated effort to stimulate demand for credit. In other words, the central banks are trying to motivate more “normal” economic activity through low rates.
The concern is this: As borrowing picks up at these low rates, and in the presence of significant economic risk, it will go primarily to fund lenders whose projects would not be funded if rates were at their normal levels. When risky loans are made, the projects that are supported often depend on rates staying low. If rates rise because risk increases beyond the central bank’s ability to control, these are the loans that often collapse. Get enough of them, and the economy as a whole suffers.
One has only to remember the explosion in low-interest mortgage loans that were negotiated between 2003 and 2005 when the Federal Reserve was holding interest rates below market levels to stimulate the economy. The low rate increased demand for housing, and a mortgage bubble ensued. That, in turn, pushed up housing prices to record levels. The gas price shocks of 2007 increased risk beyond the Fed’s ability to control, cash-strapped lenders began defaulting on risky loans, and the housing bubble burst.
One never knows where an asset bubble created by sustained, artificially low interest rates will pop up. Speculators adore low borrowing rates, as does anyone who makes money from the churn of investment and financial activity. Look at the feverish pitch of Wall Street to see the truth of this. Cheap money is fueling a stock market rally that otherwise defies economic realities.
While Wall Street bond and equity traders enjoy this moment, the rest of us have to wait and see if the other shoe drops. To assume that today’s low rates are a cause for celebration ignores recent economic history and the crucial role this market price plays in economic decision-making. Indeed, prices matter so much in all other arenas of economic life that we ignore what interest rates are signaling now at our own peril.
• William W. Beach is the director of the Center for Data Analysis at the Heritage Foundation (www.heritage.org).